ABSTRACT I. INTRODUCTION II. THE FINANCIAL CRISIS AND PRIVATE EQUITY A. The Private Equity Boom B. Private Equity on the Cusp C. Private Equity and Reputation D. Private Equity's Reputational Calculus III. HYPOTHESIS DEVELOPMENT IV. EMPIRICAL ANALYSIS A. Sample Construction B. Predicting Default From Contract Structure C. Estimating the Value of Reputation D. The Dynamic Nature of Reputation and Contracting V. CONCLUSION APPENDIX A APPENDIX A. Strategic Defaults: Reasons, Contract Structures, and Penalties I will fight this until the day I die.... Private equity firms have taken over America, and we will fight it. These guys are getting away with dishonest behavior, and I won't tolerate it. --Jon Huntsman, CEO, Huntsman Corporation (1)
In the wake of the financial crisis, private equity firms strategically defaulted on a significant number of previously agreed-to takeover transactions. From 2007 to 2008, takeover terminations reached an aggregate transaction value of $168 billion, representing an economically sizeable 20% of our total sample period. (2) The ability of private equity firms to walk from these transactions resulted from the unique private equity contracting structure which permitted the private equity firm to breach its acquisition contract with limited penalty. Historically, an unwritten pre-financial crisis understanding held that private equity firms did not back out of their arrangements to acquire takeover targets. In other words, private equity's relationship with a target was one in which reputation and trust played an important role filling an intentional contractual gap. (3)
However, the trade-off between reputation and buyout losses reached a tipping point in 2007-2008 as many financial sponsors faced potential losses in the billions of dollars on their bids for target firms of declining value. (4) The 2007-2008 financial crisis thus provides a natural testing ground for analyzing reputation and contract design in the arena of private equity buyouts. In this study we examine a novel, hand-coded dataset of 227 buyouts between 2004 and 2010. We isolate a subset of acquisition agreements that became nonperforming at the discretion of buyout firms. Because the rate of bidder-initiated terminations increased significantly during the recent financial crisis, we focus our study on the contracting terms that are most closely driven by reputation and trust concerns.
If reputation has no value, then a private equity firm should walk away from any deal that declines in economic value before the acquisition is completed. However, we find that private equity firms are willing to bear losses on uneconomic, pre-agreed transactions up to about 5% to 9% of their fund sizes, or around $200 to $400 million in nominal dollars.
Beyond these limits, reputational incentives no longer suffice to ensure contract performance. These results hold even after controlling for debt financing availability and other merger contract details that provide for an easy walk-away right. The sharp increase in bidder defaulting behavior around potential losses of 5% to 9% of fund sizes implies a discontinuous relation between buyout losses and contract nonperformance. In some specifications, we find that the probability of a nonperformance decision is nearly 100% for transactions that fall above the 5% border region of buyout losses relative to sponsors' fund sizes.
Our empirical analysis also documents the dynamic nature of contract terms in this relationship. We measure pre-and post-financial crisis bargaining among targets and private equity firms by recording reverse termination fees and the presence or absence of specific performance clauses. (5) In the pre-financial crisis private equity contract, specific performance, or the ability to seek legal enforcement of the agreement, was generally barred. Further, the contract limited a private equity firm's monetary damages for breach of contract to approximately 3% of the transaction value, a cap known as a reverse termination fee. (6) We find that contract structure is economically significant and that the size of a reverse termination fee and presence of a specific performance clause drives the decision of a private equity firm to renege on its contractual obligations. We also find that average reverse termination fees in post-crisis transactions are significantly greater than those observed in pre-crisis transactions. The penalty fees are about 50% higher for private equity firms with a previous nonperformance decision. It appears that targets demand a higher default penalty from tainted private equity bidders to compensate for a reduced level of reputation or trust between the contracting parties. Our results also imply that reputational incentives may not provide a perfect substitute for detailed contracting terms. (7)
Ultimately, we extensively document the unique and shifting contractual terms negotiated in private equity takeovers. We also document how trust and contractual terms can play dynamic roles in even the most complex contracting relationships. Our results have implications for those who study reputation and contract design. Prior studies have extensively analyzed the role of contracting and reputation in everyday commercial transactions principally in legal environments with weak rule of law. (8) But this is one of the first studies that we know of to find that these factors play a role in the most complex business relationships where formal contracting regularly occurs.
The remainder of the Paper proceeds as follows: Part II provides background on the structure of private equity transactions prior to the financial crisis and the role of reputation in that structure; Part III develops testable hypotheses for the value of private equity reputation; Part IV describes the sample and provides descriptive statistics and presents empirical findings; and Part V concludes by discussing the implications of our findings.
THE FINANCIAL CRISIS AND PRIVATE EQUITY
The Private Equity Boom
The years prior to the financial crisis were halcyon days for private equity. The easy availability of credit and the rising stock market created a ripe environment for private equity buyouts. (9) The rise of the collateral loan obligation securitization market which made credit more available to private equity funds as well as the flow of tens of billions of dollars into the funds themselves from investors seeking abnormal returns aided this environment. (10) The result was a sharp rise in private equity buyouts as Figure 1 shows.
Figure 1 reports the number and aggregate enterprise value of 277 private equity buyout transactions announced from 2004 through 2010. As can be seen, the number and value of buyouts rose exponentially from the second half of 2005 through the eve of the financial crisis, the first half of 2007. From 20 buyouts totaling $18 billion in the second half of 2005, the number rose to 50 buyouts totaling $364 billion announced in the first half of 2007. In 2006 and 2007, nine of the ten largest private equity buyouts of all time were announced, including the acquisitions of TXU for $47.23 billion, First Data for $29 billion, and Clear Channel for $25.7 billion. (12)
The flurry of activity came to a halt when the first pangs of the financial crisis hit the credit markets in 2007. (13) The results were immediate as private equity lost the ability to finance acquisitions. Both the aggregate value and average size of transactions reached an all-time peak in 2007. But deal activity dropped off sharply following this peak, with only two $100+ million transactions announced between the second half of 2008 and the first half of 2009.
While the financial crisis had an almost immediate effect on announced deal activity, it also left many buyouts pending on the cusp of the financial crisis. There were 31 buyouts announced in 2006 and the first half of 2007 that had yet to complete as of August 2, 2007. To complete these buyouts, private equity firms would need to access credit, which had dried up, to finance the acquisition.
Private Equity on the Cusp
The possibility of private equity firms reneging on their pending buyouts existed at the time because of the unique structure of the standardized private equity acquisition contract utilized prior to the financial crisis. This intricate structure was driven by private equity funds' reliance on debt financing to undertake acquisitions. (14) Without this financing, the private equity fund would be without sufficient funds to acquire the takeover target. (15) However, because of the need for regulatory and shareholder approvals, private equity acquisitions do not complete immediately. (16) Instead, a significant period of months typically elapses between the time the acquisition agreement is signed and when the acquisition is completed. (17) Private equity firms thus could not guarantee that this necessary financing would be available at this later time. Alternatively, the funds did not want to be obligated to provide their own financing if outside, third party financing became unavailable.
Prior to 2005, private equity firms had dealt with this issue by inserting a "financing condition" in acquisition contracts which conditioned the buyer's obligation to complete the acquisition on the receipt of outside financing. (18) In 2005, an innovation to the structure was made in what was then the largest technology buyout of all-time--the $11.3 billion acquisition of SunGard by a consortium of private equity firms. The structure of the SunGard transaction is set forth in Figure 2.
In SunGard, the financing condition was eliminated. Instead, SunGard entered into an agreement to be acquired with two shell subsidiaries. (20) The agreement specified that if the transaction did not complete, then the private equity firms would be liable for a reverse termination fee in the amount of 3% of the transaction value...