A New Approach to Regulating Private Equity

Abstract

Much of the controversy around private equity has missed the point. It has focused on the relationship between private equity managers and the companies they control. Yet on average private equity managers do not seem to harm the companies they control. Meanwhile, a second key relationship has not received enough attention. This is the one between private equity managers and their investors. The reason it needs more attention is that private equity shows signs of “price shrouding” and market failure. Many people will find this idea counter-intuitive. It is widely assumed that big institutions, unlike retail investors, can “look after themselves” and always write optimal contracts. Indeed, the way financial markets are organized and regulated takes this for granted. We put forward two reasons why price shrouding may occur in private equity. We believe they are generic and may apply to other complex investments as well; and that these issues have broader relevance for policymakers.