60 Pages Posted: 15 Mar 2016 Last revised: 19 Mar 2017
Date Written: March 16, 2017
Preferential treatment is more common than ever in the $4 trillion private equity industry, thanks in part to new structures that make it easier to grant different terms to different investors. Traditionally, private equity managers raised almost all of their capital through “pooled” funds whereby the capital of many investors was aggregated into a single vehicle, but recent years have seen a dramatic increase in what I call “individualized investing” — private equity investing by individual investors through “separate accounts” and “co-investments” that exist outside of pooled funds. Many of the largest and most influential investors have used these individualized approaches to obtain significant advantages that are often unavailable to pooled fund investors.
This raises a question that is both economic and philosophical: Can preferential treatment be a good thing for private equity? The idea of preferential treatment runs counter to many people’s intuitive sense of fairness, but in this Article I make the case that these trends are efficiency-enhancing developments for the industry when managers fully abide by their disclosure duties and keep their contractual commitments. Some forms of preferential treatment made possible by individualized investing create new value for preferred investors without harming non-preferred investors. Others generate what I call “zero-sum” benefits because they are accompanied by offsetting losses to non-preferred investors, but when disclosure is robust and the market for capital is competitive, there are limits on the amount of zero-sum preferential treatment that we should expect. Even zero-sum preferential treatment can increase the aggregate surplus for investors to the extent that pre-commitment disclosure gives investors a clear understanding of the quality of the investment product they are buying and the true price at which they are buying it.
Policy should seek to blend three elements. First, to support the efficiency gains made possible by individualized investing, it should support individualized contracting between managers and investors and not presume that preferential treatment is an inherently bad thing. Second, to minimize harms to non-preferred investors, it should promote conflicts disclosure, consistent compliance by managers with their contractual commitments, and clear performance and fee/expense disclosure. Lastly, policymakers should seek to pursue these goals at low cost, as non-preferred investors will likely bear much of the cost of policies designed to help them and high costs could have an anti-competitive effect.
Keywords: private equity, separate account, co-investment, customization, direct investment, bespoke contracting, exit rights
Suggested Citation: Suggested Citation
Clayton, William, Preferential Treatment and the Rise of Individualized Investing in Private Equity (March 16, 2017). 11 Virginia Law & Business Review 249 (2017); Yale Law & Economics Research Paper No. 532. Available at SSRN: https://ssrn.com/abstract=2746725