Private Equity Fund Bargaining: What We Know (and Don’t Know)
The growth of the private equity industry over the past two decades has been nothing short of extraordinary. Yet research on the formation and governance of these funds—including the rights and obligations of general partners and limited partners and how those terms are bargained for—is remarkably sparse. Publicly available data about private equity fund terms and bargaining processes are exceedingly rare, and investors in private equity funds have generally been loath to share fund documents or other inside information with researchers due to non-disclosure constraints. This makes it difficult to document even basic facts about how various aspects of the industry work.
Against this backdrop, recent regulatory developments in the United States have forced a reckoning with two questions: How much do we know about the GP-LP relationship in private equity funds, and how much does that knowledge tell us about how that relationship should (and should not) be regulated? Starting in early 2022, the SEC commenced a rule-making process that proposed to overhaul and dramatically expand the agency’s traditional oversight of the private funds industry. This initiative put unprecedented pressure on both sides—those in support of increased regulation and those against it—to marshal their best arguments and best evidence in favour of their preferred outcomes. Ultimately, after a contentious and drawn-out public comment period, the SEC issued a disclosure-based final rule in 2023 that, while substantially less aggressive than the initial proposal, will nevertheless dramatically affect how the industry works.
In a new book chapter, I capitalize on this moment take account of what we know (and don’t know) about private equity fund bargaining. Much can be learned from examining the evidence that was produced by policymakers, market participants, and scholars during this rule-making process, but perhaps even more important, much can also be learned from the evidence that was not produced. The SEC’s initiative thus provides important insight into the limits of our knowledge of private equity funds and where more research and data would help to support an effective policy dialogue.
Academic Theories of Bargaining Inefficiency in Private Equity Funds
Starting around 2010, various industry observers raised concerns about whether private ordering was working in private equity funds. Most prominently, after Congress dramatically increased the SEC’s authority to examine private equity fund managers, the agency announced that hidden fees and expenses were a rampant problem in the industry and that private equity fund contracts suffered from a host of deficiencies that enabled misconduct by fund sponsors.
This controversial history prompted some scholars to search for potential explanations. What could be the causes of these alleged inefficiencies? This question has important implications for at least two reasons. First, it is difficult to prove objectively whether the substance of any negotiated contract is suboptimal. But if one can demonstrate that there are problems in the process by which the relevant terms have been bargained, it helps reinforce the idea that there could be significant deviations from what is optimal. Likewise, if no such flaws can be shown, it undermines such claims. Second, if we accept that there are deviations from what is optimal, understanding the flaws in the bargaining process that led to those deviations helps regulators identify the most effective, targeted interventions. In the private funds context, the relative sophistication of the parties makes it particularly important for regulators to be thoughtful and targeted if they are going to intervene.
In the chapter, I summarize the various theories that scholars have proposed to explain causes of bargaining inefficiency in private equity funds. Some of these theories, for example, posit that private equity investors suffer from various forms of coordination problems. Other theories identify possible sources of agency problems within institutional investors. Importantly, I note that because of the dearth of data in this area, these theories generally reflect scholars’ best efforts to explore policy questions and concerns in spite the limited available information. Acknowledging the limits of their knowledge, scholars’ policy proposals have generally been modest and limited in scope.
What We Learned from the SEC’s Private Funds Rule-Making Process
The need for answers to these questions became more urgent when the SEC released its proposed private funds rule. One critique of the proposal was that it did not provide a very robust accounting of what was causing the bargaining inefficiencies that it was seeking to fix. The proposed rule described some of the academic theories mentioned above in support of the proposed changes, but it did not provide any independent data to confirm the validity of those theories or acknowledge the data limitations of those studies. Instead, the proposal was largely anecdotal and based on a limited number of enforcement actions, and the SEC acknowledged that it lacked data to predict many of the market-wide economic effects of the proposed intervention. The proposal was met with harsh criticism from many industry participants and commentators who argued that it was beyond the agency’s authority and would not withstand judicial review.
The SEC proposal thus created a high stakes moment for industry participants and commentators. Whether you supported increased regulation or opposed it, this was the moment to marshal your best arguments and bring relevant data into the policy debate.
Unfortunately, while certain contributions during the comment period shed light on specific questions, perhaps the biggest takeaway was that no trove of data emerged to provide a substantially clearer window into private equity fund bargaining. Moreover, the SEC’s final rule, which was released in August 2023, also failed to introduce new sources of data that significantly sharpened our understanding of the causes of bargaining inefficiency in private equity funds, and the data that the SEC relied on were still almost entirely anecdotal or derived from investor self-reporting in the form of comment letters or surveys. The final rule, which was substantially scaled back from the original proposal, is being litigated. (An analysis of the legal challenge of the final rule is outside the scope of the chapter.)
The rulemaking process thus demonstrates how little we know about bargaining in private equity funds. Of course, this does not mean that the bargaining inefficiencies described by the SEC and the theories proposed by scholars should be presumed to be invalid. It also does not mean that the SEC was necessarily wrong to proceed with intervening in the face of this uncertainty -- the agency's willingness to listen to criticism and scale back the final rule to focus primarily on disclosure was certainly a positive development in this regard. The only thing we can really conclude with confidence is that unbiased, market-wide data is extremely hard to come by in this area. Yet the industry’s size and influence will likely only continue to grow, putting increasing pressure on these issues.
Where Should Research on Private-Equity Fund Bargaining Go from Here?
The need for more high-quality research on private equity fund contracting and the GP-LP relationship is clear. The better our understanding of potential bargaining inefficiencies and their causes, the better-equipped policymakers will be to craft policy—and make updates to past policies—in a targeted and effective manner. Scholarship seeking to empirically test the various theories described above and the claims made by the SEC in the final rule would be valuable. In addition, if the SEC’s final rule is not overturned, finding ways to measure the effects of the rule and compare how bargaining worked before and after the intervention would help bring greater clarity and accountability to the policy dialogue.
In recent scholarship, I have encouraged the SEC to build on a more robust policy dialogue by generating more objective data about private equity fund bargaining. Industry participants can also help support more effective policies, including by providing scholars with access to more objective data on industry contracting and making themselves available for interviews and surveys. Improvements in the commercial benchmarking products available to industry participants also present potential opportunities for collaboration between industry and academics. Studying this area has always required scholars to work creatively and overcome a distinctive set of challenges, but the potential for high-quality scholarship to lead to better policy in this important area is great.
William W. Clayton is Francis R. Kirkham Associate Professor of Law at Brigham Young University.
This blog first appeared on the CLS Blue Sky blog (here).
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