Our study examines how PE sponsors influence the selection of lender law firms in LBO loans and whether pre-existing relationships between PE sponsors and those firms affect loan contract designs. We provide empirical evidence that a law firm with a strong pre-existing relationship with a PE sponsor is significantly more likely to be chosen to represent the lender. Moreover, we show that close relationships between PE sponsors and law firms result in weaker creditor protections, as evidenced by fewer covenants and a reduced likelihood of dividend restrictions being imposed. However, concerns of PE sponsors or law firms about damage to their reputations can help mitigate these effects.Furthermore, we show that these loans are more likely to default within three to five years after issuance. This finding challenges the notion that more lenient covenants reflect better borrower quality or more efficient negotiations; instead, it points to a fundamental conflict of interest that harms creditors.

Our finding echoes the concern of diminished due diligence and monitoring incentives of lead banks in leveraged loan transactions. Under the structure of the originate-to-distribute (OTD) model, lead banks sell most loan shares to investors, such as collateralized loan obligations (CLOs) and loan mutual funds, and thus keep little “skin in the game” themselves. This reduces their incentive to perform thorough due diligence and monitoring. Moreover, banks may view accepting a PE sponsor’s preferred law firm as a reciprocal arrangement, thereby increasing their chances of securing future deals from the same sponsor. Our results support this conjecture, showing that creditors are more likely to be involved in the next deals with PE sponsors if they agree to work with a law firm that has a closer relationship with the PE firm in the current transaction.

Our study also indicates that market awareness of these issues is growing, as seen in the higher risk premiums demanded by loan investors when these relationships are perceived to compromise the integrity of loan agreements. The market appears to recognize the risks associated with these relationships, as loans involving a law firm with a strong relationship with the PE sponsor tend to draw less interest from loan investors in the primary market. This lack of demand often forces lead banks to offer loans at higher interest rates or with greater discounts. That is, investors require a higher risk premium when they perceive that the law firm might not fully represent the lender’s interests, ultimately resulting in the borrower bearing the increased cost associated with the potential conflict of interest.

The findings of our study have important implications for debates about the role of private equity firms. While PE firms are often commended for creating value through operational and governance improvements of portfolio companies, there are also concerns about excessive leverage used in LBOs that give PE firms incentives to extract value from other stakeholders. Our study reveals that PE sponsors may leverage their relationships with lender law firms in loan negotiations to extract value from creditors. Given the higher spread and lower loan offering price, ultimately, the borrower bears the increased cost associated with the potential conflict of interest. Therefore, our paper suggests that any practice that can mitigate such a conflict of interest will have important welfare implications. Our paper also highlights the agency problem of lead banks in the leveraged loan market under the OTD model.

This post comes to us from professors Yijia (Eddie) Zhao at the University of Massachusetts Boston, Ruiyuan (Ryan) Chen at West Virginia University, Douglas J. Cumming at Florida Atlantic University, and Binru Zhao at Bangor Business School. It is based on their recent paper, “Private Equity Sponsors, Law Firm Relationship, and Loan Contracts in Leveraged Buyouts,” available here.