Broken Promises: The Role of Reputation in Private Equity Contracting and Strategic Default
51 Pages Posted: 23 Jan 2010 Last revised: 11 Sep 2012
Date Written: September 2012
This paper examines reputation and contract design in private equity acquisitions. We use a novel dataset of both completed and terminated private equity buyouts from 2004 through 2010. We find that private equity firms and targets rely on reputation to fill intentional contractual gaps. During the financial crisis private equity firms complete uneconomic, pre-agreed takeovers up to the point when estimated buyout losses rise to at least 7% of sponsors’ fund sizes, or $200 to $400 million in nominal values. Target firms are willing to engage with defaulting private equity firms in future transactions but they penalize these firms by demanding significantly larger contract nonperformance penalties. We conclude that both reputation and explicit contracting can play important and interrelated roles in private equity and complex business relationships generally.
Keywords: private equity, reputation, contracting, termination
JEL Classification: G34, G30, K12, L14
Suggested Citation: Suggested Citation