Beware of Venturing into Private Equity

Abstract:     
Because a buyout fund buys 100 percent of the company and controls it, it has often been argued that buyout funds reduce the problems created by a separation of ownership and control. Buyout funds are in full control of companies but minority shareholders. The majority of the shareholders are the investors in the funds. This new governance structure may introduce new agency conflicts and preserve some of the old ones. To understand whether buyout funds reduce overall agency conflicts, we need to better understand the relation between buyout funds and their investors. As a step in this direction, this paper describes the contracts between funds and investors and the return earned by investors.

The average fund charges the equivalent of 8 percent fees per year despite a return below that of the Standard and Poor's 500. This excessive rent raise the question of why does the marginal investor buy buyout funds? I explore one potential - and probably the most controversial - answer: some investors are fooled.

I show that the fee contracts are opaque and difficult to quantify. In addition, compensation contracts imply lower fees at first sight than in reality. What generate large fees are some details of the contracts, not the big headline. Investors may thus underestimate the impact of fees. I also show the different aspects of the fund raising prospectuses that can be misleading. I then discuss whether investors can learn or whether this situation may persist. Finally, to further understand the potential agency conflicts between buyout funds and their investors, I discuss a few features of buyout contracts that exacerbate conflicts of interest, rather than mitigate them. For example, several contract clauses provide steep incentives that distort the optimal timing of investments, their leverage, their size and the number of changes operated in portfolio companies.

Accepted Paper Series