Traditional law and economics theory places great confidence in the ability of contracting parties to bargain for optimal contracts, and the legal rules governing business transactions reflect this confidence in many ways. In my new paper, High-End Bargaining Problems, which is forthcoming in the Vanderbilt Law Review, I question the wisdom of a formalistic faith in bargaining by identifying flaws in the bargaining process at the high end of the market, where parties have significant resources and expertise to aid them. My paper focuses on the private equity fund industry, which is widely regarded as one of the most elite contracting spaces in the market due to rigorous investor qualification laws and other distinctive features that support careful bargaining. There are few settings, if any, where contracting parties are more thoroughly vetted through legal rules to ensure sophistication. Notwithstanding these advantages, however, a close look reveals many issues. Drawing on proprietary survey data and dozens of conversations with industry participants, my paper provides a detailed analysis of bargaining problems in private equity funds.
My analysis starts with a discussion of the controversial history behind private equity fund contracting. For decades, private equity funds avoided regulatory scrutiny and operated almost entirely under the SEC’s radar. But in 2010, Congress gave the SEC authority to examine private equity fund managers across the industry for the first time. The SEC’s findings, announced in 2014, were shocking to most industry observers. Among other issues, the SEC indicated that violations of law or material weaknesses in controls relating to the payment of fees and expenses were found in over 50% of the managers that they examined, with private equity managers regularly charging hidden fees that were not adequately disclosed to investors and shifting expenses to investors without proper disclosure that those costs were being shifted. Scholarly estimates suggest that these hidden fees and expenses were quite material. The SEC emphasized various deficiencies in private equity contracts that made this misconduct possible, and ever since these initial reports, they have maintained a dedicated “Private Funds Unit” to focus exclusively on examining private funds. In effect, the Private Funds Unit has served as a full-time police presence in the industry for nearly a decade, and it has maintained a robust presence (the unit examines hundreds of private equity fund managers each year) through the Obama, Trump, and now Biden administrations.
