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

Leveraged buyouts (LBOs) are transactions in which a private equity (PE) sponsor acquires a target company’s controlling ownership stake primarily using a significant amount of borrowed funds from banks. Our study, ‘Private Equity Sponsors, Law Firm Relationships, and Loan Contracts in Leveraged Buyouts’, focuses on a controversial issue in LBOs: many PE sponsors have prior relationships with law firms representing banks in LBO loan contract negotiation. In some cases, PE sponsors even designate their preferred law firms as banks’ law firms (ie, lender-side law firms), a practice referred to as the ‘designated law firm’ arrangement.

The relationship between PE sponsors and lender’s law firms in LBOs draws much attention from press media, practitioners, and regulators. For example, in January 2016, Andrew Ross Sorkin wrote an article in The New York Times titled ‘A Growing Conflict in Wall St. Buyouts’. In the article, he raised significant concerns about the designated law firm practice, in particular, whether a law firm with strong relationships with PE sponsors can faithfully act in the best interests of lenders. More recently, the International Organization of Securities Commissions (IOSCO) also highlighted the concern voiced by market participants that the PE sponsors-lender law firm relationship could compromise the independence of legal advice received by lenders and thus potentially harm creditors’ interests.

Our study examines how PE sponsors influence the selection of lender law firms in LBO loans and whether these pre-existing relationships between PE sponsors and lender law firms impact loan contract designs. We provide empirical evidence that, when a law firm has a strong pre-existing relationship with a PE sponsor, it is significantly more likely to be chosen as the lender's law firm for the LBO transaction. Moreover, we show that close relationships between PE sponsors and law firms result in weaker creditor protections, as evidenced by fewer covenants and a reduced likelihood of dividend restrictions being imposed. However, reputational concerns of PE sponsors or law firms can help mitigate these effects. Furthermore, we show that these loans are more likely to default: loans with strong PE-lender law firm relationships at origination are more likely to default within three to five years after issuance. This finding challenges the notion that more lenient covenants reflect better borrower quality or more efficient negotiations; instead, it points to a fundamental conflict of interest that harms creditors.

Our finding echoes the concern of diminished due diligence and monitoring incentives of lead banks in leveraged loan transactions. Under the structure of the originate-to-distribute (OTD) model, lead banks sell most loan shares to investors, such as collateralized loan obligations (CLOs) and loan mutual funds, and thus keep little ’skin in the game’ themselves. This reduces their incentive to perform thorough due diligence and monitoring. Moreover, banks may view accepting a PE sponsor’s preferred law firm as a reciprocal arrangement, thereby increasing their chances of securing future deals from the same sponsor. Our results support this conjecture, showing that creditors are more likely to be involved in the next deals with PE sponsors if they agree to work with a law firm that has a closer relationship with the PE firm in the current transaction.

Our study also indicates that market awareness of these issues is growing, as seen in the higher risk premiums demanded by loan investors when these relationships are perceived to compromise the integrity of loan agreements. The market appears to recognize the risks associated with these relationships, as loans involving a law firm with a strong relationship with the PE sponsor tend to experience weaker demand from loan investors in the primary market. This lack of demand often forces lead banks to offer loans at higher interest rates or with greater discounts. That is, investors require a higher risk premium when they perceive that the law firm might not fully represent the lender’s interests, ultimately resulting in the borrower bearing the increased cost associated with the potential conflict of interest.

The findings of our study have important implications for the ongoing debate about the role of private equity firms. While PE firms are often commended for creating value through operational and governance improvements of portfolio companies, there are also concerns about excessive leverage used in LBOs that incentivize PE firms to extract value from other stakeholders. Our study reveals that PE sponsors may leverage their relationships with lender law firms in loan contract negotiation to extract value from creditors. Given the higher spread and lower loan offering price, ultimately, the borrower bears the increased cost associated with the potential conflict of interest. Therefore, our paper suggests that any practice that can mitigate such conflict of interest will have important welfare implications. Our paper also highlights the agency problem of lead banks in the leveraged loan market under the originate-to-distribute (OTD) model.

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By Yijia (Eddie) Zhao (University of Massachusetts Boston College of Management), Douglas Cumming (Florida Atlantic University), Ruiyuan (Ryan) Chen (West Virginia University), and Binru Zhao (Bangor Business School)

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