Academic journal article Journal of Corporation Law

Broken Promises: The Role of Reputation in Private Equity Contracting and Strategic Default [Dagger]

Academic journal article Journal of Corporation Law

Broken Promises: The Role of Reputation in Private Equity Contracting and Strategic Default [Dagger]

Article excerpt

I will fight this until the day I die . . . . Private equity firms have taken over America, and we will fight it. These guys are getting away with dishonest behavior, and I won't tolerate it.

-Jon Huntsman, CEO, Huntsman Corporation1

I. INTRODUCTION

In the wake of the financial crisis, private equity firms strategically defaulted on a significant number of previously agreed-to takeover transactions. From 2007 to 2008, takeover terminations reached an aggregate transaction value of $168 billion, representing an economically sizeable 20% of our total sample period.2 The ability of private equity firms to walk from these transactions resulted from the unique private equity contracting structure which permitted the private equity firm to breach its acquisition contract with limited penalty. Historically, an unwritten pre-financial crisis understanding held that private equity firms did not back out of their arrangements to acquire takeover targets. In other words, private equity's relationship with a target was one in which reputation and trust played an important role filling an intentional contractual gap.3

However, the trade-off between reputation and buyout losses reached a tipping point in 2007-2008 as many financial sponsors faced potential losses in the billions of dollars on their bids for target firms of declining value.4 The 2007-2008 financial crisis thus provides a natural testing ground for analyzing reputation and contract design in the arena of private equity buyouts. In this study we examine a novel, hand-coded dataset of 227 buyouts between 2004 and 2010. We isolate a subset of acquisition agreements that became nonperforming at the discretion of buyout firms. Because the rate of bidder - initiated terminations increased significantly during the recent financial crisis, we focus our study on the contracting terms that are most closely driven by reputation and trust concerns.

If reputation has no value, then a private equity firm should walk away from any deal that declines in economic value before the acquisition is completed. However, we find that private equity firms are willing to bear losses on uneconomic, pre-agreed transactions up to about 5% to 9% of their fund sizes, or around $200 to $400 million in nominal dollars. Beyond these limits, reputational incentives no longer suffice to ensure contract performance. These results hold even after controlling for debt financing availability and other merger contract details that provide for an easy walk-away right. The sharp increase in bidder defaulting behavior around potential losses of 5% to 9% of fund sizes implies a discontinuous relation between buyout losses and contract nonperformance. In some specifications, we find that the probability of a nonperformance decision is nearly 100% for transactions that fall above the 5% border region of buyout losses relative to sponsors' fund sizes.

Our empirical analysis also documents the dynamic nature of contract terms in this relationship. We measure pre- and post-financial crisis bargaining among targets and private equity firms by recording reverse termination fees and the presence or absence of specific performance clauses.5 In the pre-financial crisis private equity contract, specific performance, or the ability to seek legal enforcement of the agreement, was generally barred. Further, the contract limited a private equity firm's monetary damages for breach of contract to approximately 3% of the transaction value, a cap known as a reverse termination fee.6 We find that contract structure is economically significant and that the size of a reverse termination fee and presence of a specific performance clause drives the decision of a private equity firm to renege on its contractual obligations. We also find that average reverse termination fees in post-crisis transactions are significantly greater than those observed in pre-crisis transactions. The penalty fees are about 50% higher for private equity firms with a previous nonperformance decision. …

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