Spreading Sunshine in Private Equity: Agency Costs and Financial Disintermediation

The private equity (‘PE’) market is a typical example in which the benefits of financial intermediation would be large, due to substantial search costs and information asymmetry between investors and private companies. Therefore, investors such as pension funds, endowments, and insurance companies usually rely on the intermediation of external fund vehicles to invest in private equity. However, the PE market has been undergoing disintermediation—as some investors have been acquiring shares of private companies for investment purposes without the intermediation of PE funds (‘direct investing’).

Such a phenomenon potentially reveals agency conflicts faced by PE fund advisers when they intermediate investors’ capital for private equity investments. In the language of Holmstrom, it is easier to extract outputs from a relationship within the firm than from an outsourced relationship, because employees' activities are better monitored and broader incentive tools can be used other than high-powered compensation contacts that will inevitably distort the agent's inputs due to information frictions. Therefore, direct investing is consistent with investors’ efforts to internalize the agency costs of financial intermediation by organizing PE investment activities within their own firm boundaries.

At the same time, investors’ desire to reduce PE fees has been consistently cited as one of the most important contributing factors to the disintermediation of this market. If market monitoring and incentive contracts could fully align the interests of fund advisers and investors, investors would consider high pay justifiable since it attracts scarce managerial talent ex ante and rewards strong performance ex post. In fact, shielded from public disclosures, the hefty private equity fees have sparked intense debate among investors, regulators, and the media regarding potentially misaligned incentives between investors and fund advisers.

By quantitatively studying the role of regulatory oversight in addressing such inherent agency conflicts, this paper is a timely piece that informs the ongoing debate, as the SEC recently introduced a sweeping reform on private equity fees among registered advisers in order to increase fee transparency and protect investors. Specifically, I focus on the enactment of the Dodd-Frank Act to private equity funds, one of the most important regulatory changes in the US private equity markets.

Background Information

Although investors usually engage in thorough due diligence before investing in a fund, their monitoring tends to be much laxer after the fund closing. This phenomenon can be attributed to factors such as coordination frictions among investors and limited human resources as noticed by the SEC. Therefore, investors mainly rely on compensation contracts to incentivize their fund advisers. However, since numerous unforeseen contingencies could potentially arise during a PE fund's typical 10-year lifespan, the contracts are incomplete by nature and often include broad and vague wording, permitting advisers a wide latitude of flexibility that may allow them to charge fees and pass along expenses that are not reasonably contemplated by investors.

Besides direct compensation paid by existing investors, fund advisers are also incentivized through indirect pay for performance from future fundraising. However, unlike public-traded stocks that have market prices, the underlying assets of PE funds usually rely on interim valuations provided by advisers, which, if inflated to window-dress performance during fundraising, could mislead investors into committing capital to new PE funds.

Although characterized by such conflicts of interest, most PE fund advisers received little regulatory oversight because they could avoid SEC registrations due to an exemption that applied to advisers with fewer than 15 clients under the Investment Adviser Act of 1940. This exemption counted each fund as a client, rather than considering each individual investor in a fund. In 2012, Title IV of the Dodd-Frank Financial Reform Act of 2010 eliminated many advisers’ registration exemptions. As a result, a large number of advisers had to register with the SEC for the first time and become subject to examinations, rules, and mandatory disclosures through Form ADVs, which are regularly filed to the SEC by registered advisers to report detailed operational and disciplinary information.

Empirical Findings

I start by providing stylized facts about the Dodd-Frank Act. The reform has significantly increased the PE markets' regulatory oversight. First, it led to a sharp rise in the fraction of registered advisers in 2012, which has been persistent over time. Second, it results in a permanent increase in the number of Form ADV filings. Third, the composition of advisers that rely on different exemptions has been stable over time. Fourth, there is a limited aggregate change in fund characteristics—suggesting that fund advisers find it costly to strategically change their fundraising to qualify for new registration exemptions.

How does the Dodd-Frank Act affect investors’ trade-offs between investing via funds and direct investing? The Dodd-Frank Act eliminated the registration exemptions of many previously unregistered PE fund advisers and brought them to regulatory oversight. This reform effectively reduces the agency conflicts confronted by fund advisers. This reduction is arguably more pronounced for investors who have more pre-existing relationships with newly registered advisers as a result of the reform.

My paper documents that investors with high exposure to newly registered advisers subsequently i) commit more capital to PE funds, ii) make less direct investment, and iii) are less likely to employ their in-house PE investment teams. These findings suggest that regulation complements market mechanisms in addressing principal-agency problems and shapes the organizational structure of PE markets. While there are other factors affecting investors’ incentives to bypass private equity funds, such as LPs' growing need to control the timing of their PE investments, I show that my results are unlikely to be driven by these confounders.

In the end, I investigate the capital allocation implications of different PE market organization structures. Investors face high asymmetric information and uncertainty when financing private companies because of inadequate information about their activities and low asset tangibility. Such frictions are particularly costly for direct investments because of investors’ lack of skills in evaluating private companies and limited diversification in direct investments compared to their fund advisers. Although I find little evidence of adverse selection in lower-quality companies in direct investments, my findings indicate a preference among investors to finance more mature and larger companies. This suggests that while disintermediation in private equity markets enables investors to mitigate agency costs, it may influence how capital is allocated.

Yingxiang Li is a finance PhD candidate at the Sauder School of Business, University of British Columbia.

This post is part of an OBLB series on The Law and Finance of PE and Venture Capital. OBLB series are available here.