For most of its history, the private equity industry was largely left alone by securities regulators. A basic assumption underlying this approach was that private equity fund investors are sophisticated and should therefore be able to engage in effective private ordering without outside assistance.

But this attitude started changing amid explosive industry growth and reports of hidden fees and conflicts of interest in the years following the global financial crisis of 2008. In the early 2010s, legislators created a new regulatory framework for the marketing and operation of private funds in the European Union and new industry-wide registration and examination requirements for private fund managers were promulgated in the U.S. More recently, the SEC went substantially further by enacting a set of rules that require sponsors to provide an extensive set of standardized, quarterly disclosures to their investors, mandate annual audits of funds, and restrict certain activities, among other things. Those rules have been formally challenged in federal court for exceeding the SEC’s authority and are currently under review in the 5^th Circuit.

Questions about how bargaining works in private equity funds – and whether it falls short of efficiency – have thus become extremely consequential for real-world policy. In a new article, I provide a short overview of the academic literature on private equity fund negotiations and the implications for law and regulation.

Theories of Inefficiency in Private Equity Fund Bargaining

Around the early 2010s, a number of voices started to raise concerns about whether market participants bargain efficiently in private equity funds. Private equity fund investors have frequently expressed discontent with industry practices (Institutional Limited Partners Association Report 2018; Institutional Limited Partners Association Report 2023). Even more visible, after Congress granted the SEC authority to perform industry-wide examinations of private fund advisers in the United States, the SEC announced that hidden fees and expenses were a huge problem and that the agency was concerned about the impact on investors like public pension plans and university endowments (Bowden 2014; Wyatt 2015). The SEC asserted that this misconduct was enabled by significant deficiencies in private-equity fund contracts.

Some scholars responded to this controversial history by searching for explanations. If private ordering produces worrisome outcomes in private equity funds, what could possibly be causing those problems?

Theories that Blame Institutional Investors

Various studies have claimed to find evidence of internal agency problems leading to suboptimal behavior by the institutions that invest in private equity funds (see, for example, Gompers & Lerner 1996; Hochberg & Rauh 2013; Bernstein et al. 2013; Andonov et al. 2018). One recent paper claims that private equity sponsors manipulate their reported returns primarily to “cater” to the desires of institutional investor employees, who personally benefit from smoothed or overstated returns in various ways (Jackson et al. 2023).

Another theory points to the fact that the decision about whether to invest in a fund often is made first by the investment department before the legal department has even seen the fund’s limited partnership agreement (“LPA”) or private placement memorandum (“PPM”) (Choi & Triantis 2012). This “two-staged bargaining” practice makes it potentially difficult for the legal team to threaten to pull out of the fund if they find problematic terms, thereby diluting the effectiveness of the negotiation process.

Public pension plans have also been identified as a potential source of inefficiency due to some of their distinctive features (Clayton 2022b).

Theories that Blame the Structure of Private Equity Fund Bargaining

Scholars have also posited that side contracting in private equity funds could contribute to inefficient outcomes. If powerful investors can use side letters, co-investments, and separately managed accounts to bargain for terms that benefit only themselves (such as fee discounts or no-fee co-investment opportunities), they might over-invest in negotiating for those terms and under-invest in negotiating for LPA terms that generate positive externalities for the other investors in the fund (Clayton 2020; Morris & Phalippou 2012; Magnuson 2018).

This theoretical work raises the question: Do we have evidence that this is happening, and if so, what form is it taking? Two recent studies seek to provide empirical insight into side letter practices. Interestingly, one finds that side letters very rarely contain terms of economic significance and instead are used almost exclusively to accommodate investors’ regulatory and tax concerns (de Fontenay and Nili 2023), and another suggests that terms having economic ramifications in side letters may be more common after all (Jeffers & Tucker 2023).

With respect to co-investments, recent research supports the idea that certain kinds of investors may commonly use co-investing to bargain for superior economic outcomes. Lerner et. al. find that top investors (defined as investors with better past performance) invest in “alternative vehicles” (including co-investment vehicles, parallel funds, and feeder funds) that have above-average market performance and that outperform the main fund of the manager sponsoring them (Lerner et al. 2022). Interestingly, however, they also find that the average performance of alternative vehicles is below the average main fund performance, suggesting that superior co-investment performance is reserved for top-tier investors only.

In addition to concerns about side contracting, scholars have also argued that large investors have incentives to bargain for overly complicated contracts because they possess resource advantages over smaller investors (Morris & Phalippou 2012). Other scholars have argued that the parties advising institutional investors have a vested interest in maintaining inefficient practices. Law firms representing sponsors, for example, may have self-serving incentives to seek aggressive pro-sponsor terms and avoid standardization (de Fontenay & Nili 2023). Extending this further, some scholars have applied “multiple agency theory” to private equity funds (Batt & Appelbaum 2021; Magnuson 2018).

Scholars have also suggested that inefficient terms in private equity fund contracts might persist due to path dependency resulting from industry standardization, anchoring effects, and herd behavior (Magnuson 2018). Another theory posits that the private equity model merely reflects inefficient actions market actors must take to avoid the application of the federal securities laws (Spindler 2009).

The Investor Perspective

There is very limited empirical data available to quantify the relative strength of each of the theories described above. When asked in 2021 to identify the top explanations for why investors accept problematic terms in private-equity fund LPAs, senior legal counsel at nearly 100 institutional investors pointed to a fear of losing allocation to managers’ funds and lack of bargaining power (Clayton 2024), though this finding is complicated somewhat by recent fundraising headwinds faced by sponsors (Ivashina 2022).

Counterarguments

Private equity’s extraordinary growth is often held up as a counterargument to the claim that there are significant inefficiencies in private equity fund bargaining (Peirce 2023). If the terms in private equity funds are so bad, so the argument goes, why would investors continue to allocate so much capital to the industry over the years? Defenders of private equity also point to research finding that the private equity industry has a track record of outperformance (see, for example, Kaplan & Sensoy 2015; Kaplan & Stromberg 2009; Metrick & Yasuda 2011; Harris et al. 2014), though this claim of outperformance is controversial (see, for example, Phalippou 2014; Ang et al. 2018; Driessen et al. 2012).

A few commonly cited studies suggest that bargaining problems are often ameliorated by market forces in the long run (Robinson & Sensoy 2013; Phalippou 2018; Brown et al. 2019). These results are nuanced, however, as the correction is often incomplete or fails to go into effect for a long time.

Implications for Policy and Future Research

Depending on the theory (or mix of theories) that one finds most persuasive, the optimal regulatory response may be different (Clayton 2024). For example, if bargaining problems are caused predominantly by coordination problems, you might respond with a different set of interventions than if the problems were primarily due to internal agency conflicts or conflicts with third-party advisors. Or if you are persuaded that market forces are effective at fixing bargaining problems, the proper regulatory response may be to do nothing at all.

The limited available data makes it difficult to prove or quantify the theories discussed above with a high degree of certainty. This leads to two conclusions. First, more research shining a brighter light on bargaining in private equity funds would be useful and informative (Clayton 2024). Second, it would also be useful for policymakers and scholars to find ways to measure the successes and failures of policy reforms and explore whether regulatory experimentation might be used to aid private equity funds policy (Lee 2013). Some studies have reflected on the cost and effectiveness of earlier reforms introduced by the SEC (see Kaal 2016, Honigsberg 2019; Jiang et al. 2023, Bates 2023), but more work would be helpful in the current evolving landscape.

This post comes to us from Professor William W. Clayton at Brigham Young University’s J. Reuben Clark Law School. It is based on his article, “Private Equity Negotiations,” recently published in the Palgrave Encyclopedia of Private Equity and available here.