Misaligned Interests in Private Equity

Abstract

This Article examines the unique set of agency costs that arise from the separation of ownership and control in private equity funds. These funds operate without significant regulatory or legislative oversight. Instead, they are governed primarily by contractual arrangements between investors and managers that are poorly understood by legal scholars. This Article looks into the black box of these internal arrangements to provide a broad analysis of whether and how these contracts align or misalign the interests of investors and managers. It turns out that the compensation of managers, which is commonly thought to serve as the most powerful tool to align interests, is less effective than it appears on its face, and that its effectiveness depends on a number of variables, including the type of compensation structure used and how well a fund is performing. In light of the complexity of these incentives and how few mechanisms are built into private equity agreements to protect investors, it appears that many investors likely do not understand the extent of these agency costs. Considering the amount of value investors transfer to managers under these agreements and investors’ limited exit rights, it is worth investigating the unique agency costs created by this structure and exploring ways to improve the alignment of interests and make private equity a more transparent legal structure for investors.

Keywords: private equity, carried interest, management fee, preferred return, exit rights, hedge fund, tax distribution