“As repeat players, private equity firms use their reputations with creditors to mitigate the problems of borrower adverse selection and moral hazard in the companies that they manage,” according to the April 3 draft paper, titled “Private Equity Firms as Gatekeepers.” The author of the paper is Elisabeth de Fontenay, a Climenko Fellow and lecturer on law at Harvard Law School.
Adverse selection stems from the difficulty creditors have understanding the credit-worthiness of a particular company; lenders may compensate by charging all borrowers rates corresponding to the average expected credit quality, compelling good companies (charged an inflated rate) to borrow less and enabling poor companies (charged a discounted rate) to borrow more. Moral hazard refers to the incentives that a company’s management, often shareholders, may have to make decisions that benefit themselves and other shareholders over creditors.
Buyout firms can help mitigate both problems for lenders. In the case of adverse selection they can help lenders identify particularly strong companies, given their reputation for backing solid prospects. In the case of moral hazard, they can use their power as controlling shareholders to prevent management from harming creditors; they can also put more equity into a company if performance deteriorates. Sponsors have an incentive to do so in order to maintain their reputation with creditors, whose good will they need to finance subsequent deals.
“Private equity-owned companies are thus able to borrow money on more favorable terms than standalone companies, all else being equal,” the author writes.
Fontenay sees her paper entering the debate over the economic impact of private equity and how the asset class should be regulated. Critics of private equity, she notes, see the asset class as a “particularly ingenious type of wealth transfer” in which sponsors are the nefarious beneficiaries. Defenders, by contrast, point to the value sponsors add through hands-on management (when needed) and strong, focused corporate governance. “If the characterization of private equity as a mere shell game is warranted, the demands to curtail it should be heeded. But if instead private equity increases social welfare, the regulatory calculus is considerably more complex.”
Fontenay actually argues that the “corporate governance defense” of the asset class to be “not only incomplete, but overstated.” She writes: “We should think of private equity firms as being in the business of lending companies not only their operational expertise, but also (and perhaps more importantly) their financial reputations.”
Indeed, in her paper Fontenay describes sponsors as debt market “gatekeepers,” using their reputations for owning credit-worthy companies to help lenders make better decisions. Such a role, she writes, has become increasingly important given long-term trends in the capital markets. Whereas a few decades ago a single bank might have made a loan and held it to maturity, she writes, loans today are underwritten and distributed among many creditors, including hedge funds, CLOs and other institutional holders. “Today’s creditors are thus dependent on others to signal borrowers’ creditworthiness,” Fontenay writes. “Gatekeeping by private equity firms should be an increasingly valuable substitute for the traditional monitoring of borrowers by their banks.”
Download a copy of the paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2245156.