High-End Bargaining Problems

William W. Clayton is Associate Professor of Law at Brigham Young University Law School. This post is based on his recent paper, forthcoming in the Vanderbilt Law Review.

Traditional law and economics theory places great confidence in the ability of contracting parties to bargain for optimal contracts, and the legal rules governing business transactions reflect this confidence in many ways. In my new paper, High-End Bargaining Problems, which is forthcoming in the Vanderbilt Law Review, I question the wisdom of a formalistic faith in bargaining by identifying flaws in the bargaining process at the high end of the market, where parties have significant resources and expertise to aid them. My paper focuses on the private equity fund industry, which is widely regarded as one of the most elite contracting spaces in the market due to rigorous investor qualification laws and other distinctive features that support careful bargaining. There are few settings, if any, where contracting parties are more thoroughly vetted through legal rules to ensure sophistication. Notwithstanding these advantages, however, a close look reveals many issues. Drawing on proprietary survey data and dozens of conversations with industry participants, my paper provides a detailed analysis of bargaining problems in private equity funds.

My analysis starts with a discussion of the controversial history behind private equity fund contracting. For decades, private equity funds avoided regulatory scrutiny and operated almost entirely under the SEC’s radar. But in 2010, Congress gave the SEC authority to examine private equity fund managers across the industry for the first time. The SEC’s findings, announced in 2014, were shocking to most industry observers. Among other issues, the SEC indicated that violations of law or material weaknesses in controls relating to the payment of fees and expenses were found in over 50% of the managers that they examined, with private equity managers regularly charging hidden fees that were not adequately disclosed to investors and shifting expenses to investors without proper disclosure that those costs were being shifted. Scholarly estimates suggest that these hidden fees and expenses were quite material. The SEC emphasized various deficiencies in private equity contracts that made this misconduct possible, and ever since these initial reports, they have maintained a dedicated “Private Funds Unit” to focus exclusively on examining private funds. In effect, the Private Funds Unit has served as a full-time police presence in the industry for nearly a decade, and it has maintained a robust presence (the unit examines hundreds of private equity fund managers each year) through the Obama, Trump, and now Biden administrations.

Private equity fund contracting has also defied formalist expectations about bargaining in other ways. Law and economics scholars theorize that sophisticated parties will bargain for optimal non-price contract terms that maximize the joint surplus created by contracts regardless of how the balance of bargaining power is distributed between them. This bargaining power irrelevance proposition, which has been described as a “defining feature” of law and economics scholarship on contracts, is elegant in theory, but it is not how the private equity industry works at all. In reality, non-price terms in private equity funds vary greatly depending on the balance of bargaining power between managers and investors, with many scholars and commentators criticizing private equity terms for being one-sided and unlikely to maximize the joint welfare of the parties involved.

Analyzing the process by which private equity fund agreements are negotiated also raises serious questions about whether private equity investors and managers are agreeing on optimal processes for contract formation. As discussed in detail in the paper, the private equity fund contracting process is unusually time-consuming and costly, the bargaining incentives of the parties are distorted in problematic ways, and information flows are highly restricted in this market, hampering the efficiency of contracting in the market.

Interestingly, notwithstanding the substantial resources held by investors in this market, the active presence of a global trade association for institutional investors in private equity funds, and ongoing examination efforts by the SEC, many industry participants complain that progress in the areas described above has been slow. In fact, the SEC has once again made private equity funds one of its top regulatory priorities, voicing familiar concerns about the poor quality of private equity fund transparency and conflicts of interest. Chair Gary Gensler recently made clear that the SEC is contemplating taking an even more active stance in response to bargaining problems in this high-end space. My paper discusses various theories proposed by scholars over the years to explain why these bargaining problems exist in private equity, including various forms of agency problems and coordination problems, among other explanations.

Evidence of all of the problems described above can be found in the public record or through conversations with industry participants. However, because private equity funds are privately held, much of what scholars know about them is based on conventional wisdom and anecdotes. Drawing on a private dataset of survey responses from 70 institutional investors, my paper presents new survey data that reveals new problems with bargaining in private equity funds and also reinforces the relevance of some of the problems identified above. Among other things, this survey data shows that information flows are even more restricted in private equity funds than previously known, that the private equity fund bargaining environment is even more fractured than has been documented in the literature, and that fiduciary duties are a more contested and controversial term than contractarians would have predicted in this high-end space.

With elite investor qualification standards and various other advantages, few would disagree with the idea that private equity funds are a high-end contracting setting with many advantages over other real-world settings. Yet significant problems seem to persist in this market. I discuss three policy implications. First, I argue that these findings call for greater skepticism of formalist assumptions about bargaining across the broader spectrum of contracting settings in the market, including widely-held corporations, small businesses formed as LLCs, and elsewhere. Private equity funds provide a striking illustration of the fact that bargaining cannot simply be assumed to produce optimal outcomes in real-world environments. Second, I argue that these findings call into question the binary nature of federal securities regulation. The current approach implicitly embraces the idea that sophisticated parties will demand appropriate levels of disclosure and appropriate processes without any intervention by policymakers, but the private equity example shows that this may not always be realistic. Finally, I consider a range of possible policy responses with respect to the private equity industry specifically, including both voluntary steps to be taken by industry participants and regulatory responses.

The complete paper is available for download here.

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