The Failure of Private Equity

Abstract

Throughout the Fall 2007 and into the new year 2008 private equity firms repeatedly attempted to terminate pending acquisitions. The litigation surrounding these purported terminations and heightened scrutiny directed upon the terms of private equity agreements opened a revealing window on a number of supposed "flaws" in the private equity structure. This Article seeks to understand whether these failures existed, and if so, what caused them. It does so by examining the forces driving the construct and evolution of private equity and the rationale for private equity's structure and specific contractual terms. I find that the private equity structure to be a rich, textured environment. The terms of the contractual relationship between the private equity firm and the acquired company are analogous to an iceberg; they form only the publicly available view of a much deeper understanding between the parties. In the non-public sphere, parties to private equity contracts utilize norms, conventions, reputational constraints, language and relational bonding to fill contractual gaps, override explicit contractual terms, and achieve a negotiated solution beyond the four corners of the contract. The attorney as transaction cost engineer in the private equity context consequently structures the private equity contract by paying heed both to contractual terms and law, contractually created forces and non-legal factors. But attorney reliance on these extra-contractual factors and forces makes the private equity structure path dependent and resistant to change. In light of these findings, the failures of the pre-Fall 2007 private equity structure were particularly a failure by attorneys for acquired companies to innovate and negotiate terms in full contemplation of such events. Reliance upon extra-legal forces permitted these attorneys to negotiate facially flawed private equity contracts and otherwise justified sloppy and ambiguous drafting.

Keywords: private equity, reverse termination fee, contract, law and norms, mergers and acquisitions, path dependency, transaction negotiation

JEL Classification: N20, L89, L14, K41, K22, K12, G34, C71