One Hat Too Many?: Investment Desegregation in Private Equity
University of Chicago Law Review, Vol. 76, No. 45, 2009
40 Pages Posted: 7 Sep 2008 Last revised: 12 Mar 2013
Date Written: August 28, 2008
The nature of private equity investing has changed significantly as two dynamics have evolved in recent years: portfolio companies have begun to experience serious financial distress, and general partners have started to diversify and desegregate their investment strategies. Both developments have led private equity shops - once exclusively interested in acquiring equity positions through leveraged buyouts - to invest in other tranches of the investment spectrum, most particularly public debt. By investing now in both private equity and public debt of the same issuer, general partners are generating a host of new conflicts of interest between themselves and their limited partners, between multiple general partners in the same consortia, and between private investors and public shareholders.
In this essay, we identify and explore these various new tensions that have begun to arise in the private equity industry. We then propose and examine an array of possible ways to eliminate or alleviate those conflicts, exploring the regulatory, fiduciary, and pragmatic strengths and weaknesses of each approach. General partners can seek investor unanimity or consent for follow-on investments, but certain tax and practical barriers complicate that approach. Alternatively, they can opt for a range of architectural prophylaxes to protect against conflicts. These add costs on everyone, however, and, experience in related fields shows, they do not work. Investors, for their part, can attempt to diversify their own investment holdings to counterbalance risk, but this still leaves some vulnerable to opportunistic fund managers, and may increase costs for all investors as well. We propose a less costly and more efficient solution: advisers and investors should work together to create a vibrant secondary market for private equity interests to create a salutary exit option, which would in turn discipline the investment behavior of fund managers in this turbulent new investing environment.
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