In Praise of Preferential Treatment in Private Equity

Posted by William Clayton, Yale Law School, on Thursday, April 28, 2016

Preferential treatment of investors is more common than ever in today’s private equity industry, thanks to new structures that make it easier to grant different terms to different investors. For decades, private equity managers raised almost all of their capital through “pooled” funds whereby their investors’ capital was aggregated into a single vehicle, but recent years have seen a dramatic increase in what I refer to in my paper as “individualized investing”—private equity investing through separate accounts and co-investments. Separate accounts and co-investment vehicles are entities that exist outside and independent of pooled funds, enabling managers to provide highly customized treatment to the investors in them. Estimates are that upwards of 20% of all investment in private equity went through these channels in 2015. Some anecdotal accounts suggest much higher levels.

Many of the largest and most influential investors in private equity have been using these customized vehicles to negotiate for significantly better terms and more robust rights than are available to pooled fund investors. This raises a question that is both economic and philosophical: is preferential treatment a good thing for private equity? Should policymakers be restricting and regulating these trends, or should they be left alone, or even encouraged?

For many people, the idea of preferential treatment runs counter to a deeply ingrained sense of fairness. My paper makes the case that, while instincts favoring egalitarianism may be entirely appropriate—even virtuous—in many contexts, they should not inform private equity policy. When managers have free rein to bestow preferential treatment as they see fit, the outcome is generally a more efficient marketplace for private equity investment, with greater surplus available for investors.

A bedrock principle of the corporate governance literature is that when conflicts of interest exist, they are only problematic insofar as they lead to an appropriation of value from investors. The core contention of my paper is that most forms of preferential treatment enabled by individualized investing in private equity create new value for the preferred investors who receive the favored treatment, rather than appropriate value from non-preferred investors. This logic applies to the following forms of preferential treatment: superior customization of investment strategies and vehicle structuring, superior rights to monitor and control the manager’s activities, and superior fees. Individualized investing makes it much easier for private equity managers to grant these kinds of preferential treatment—indeed, these are the very reasons why so many private equity investors have been seeking to form separate accounts and make co-investments in recent years.

Importantly, a darker possibility must also be considered. In addition to the efficiency-enhancing forms of preferential treatment noted above, the rise of individualized investing also makes possible a problematic form of preferential treatment in private equity—one that does involve an appropriation of value from non-preferred investors to preferred investors. This form of preferential treatment—which I call “inequitable allocation” in my paper—occurs when managers allocate superior investment opportunities and other finite resources disproportionately to separate accounts and co-investors and away from pooled funds. Fortunately, as set forth in my paper, a close examination of the incentives of private equity managers and investors in today’s individualized industry reveals little risk of systematic inequitable allocation when the market is competitive.

The most important policy lesson from my paper’s analysis is one of regulatory restraint. Even though preferential treatment has reached unprecedented levels in private equity, and even though much of this activity is taking place behind closed doors, policymakers should avoid the temptation to over-regulate the practice. However, as the shift toward individualized investing continues apace, an interesting side effect emerges: the incentive for broad coordinated action among private equity investors will grow weaker as their interests become more individualized, making it more challenging for investors to advocate for industry-wide standards and best practices. Information disclosure is one example of an area where standardization can sometimes be beneficial, raising issues in private equity that resemble the classic debate in the securities literature over mandatory disclosure by public companies.

The full paper is available for download here.