The Private Equity Negotiation Myth

Abstract

Private equity fund agreements have been criticized for failing to protect investors from exploitation by fund managers. One defense frequently used by the industry has been to invoke what I call the private equity negotiation myth, which claims that because fund agreements are highly negotiated, substantive concerns about their terms are unwarranted. This myth assumes that large investors will use their bargaining power to demand strong fund agreement protections for all of the investors in a fund.

This Article questions the private equity negotiation myth. First, I show that large investors’ incentives to negotiate fund agreements can often be weaker than the myth suggests. Because large private equity fund investors are commonly able to negotiate for individualized benefits outside of fund agreements, they have strong incentives to use their bargaining power to maximize individualized benefits before negotiating for better fund-wide protections. Individualized benefits thus can dampen the extent to which fund agreements are actually negotiated. Second, I show that large investors cannot always be expected to “vote with their feet,” either, by avoiding funds with suboptimal protections. When large investors have bargaining power, it makes them less sensitive to the quality of fund agreement terms because they can negotiate for individualized benefits that offset the harm caused by weak protections. As a result, the marginal investors in private equity funds—those whose preferences have the greatest influence on the quality of fund terms—may sometimes be ones that lack bargaining power rather than the ones that have it. Lastly, some of the largest institutional investors in private equity funds may suffer from internal agency problems that reduce their incentives to demand strong protections.

The private equity negotiation myth thus encourages policymakers to make policy decisions based on incomplete information in this $5 trillion industry. By challenging the myth and showing the true incentives associated with bargaining power in private equity funds, this Article contributes to important and timely policy discussions at both the state and federal levels on the regulation of private investments.

Keywords: private equity, bargaining power, fiduciary duties, securities laws, limited partnerships