Private Equity Sponsors, Law Firm Relationship, and Loan Contracts in Leveraged Buyouts

Abstract

We propose that a private equity (PE) sponsor’s relationship with the law firm that advises banks (“lender law firm”) in leveraged buyout transactions leads to weakened creditor protection. Consistent with this conjecture, we present data that indicate when the PE-Lender Law Firm relationship is stronger, buyout loans are less likely to have a dividend payout restriction and have fewer covenants overall. This finding is robust using PE-Lender Law Firm geographic distance as an instrument for the PE-Lender Law Firm relationship. Lead banks that use PE sponsors’ relationship law firms are more likely to be included in the lending syndicate for the sponsor's next buyout deal. Loans with stronger PE-Lender Law Firm relationships experience weaker loan investor demand in the primary market and a higher likelihood of subsequent defaults. Taken together, our paper uncovers PE sponsors’ relationship with banks’ legal counsel as an important channel through which PE sponsors exert bargaining power in buyout loan contract negotiations and provides a new perspective to the debate on the controversial role of PE sponsors.  

Keywords: Private Equity, Loan Covenant, Law Firms, Leveraged Buyout