Intermediation in Private Equity: The Role of Placement Agents

The following post comes to us from Matthew Cain, Financial Economist at the U.S. Securities and Exchange Commission, Stephen McKeon of the Department of Finance at the University of Oregon, and Steven Davidoff Solomon, Professor of Law at the University of California, Berkeley.

In light of recent “pay to play” scandals, placement agents have been portrayed in a negative light, using inappropriate influence to gain business from pension funds and other institutional investors. In our paper Intermediation in Private Equity: The Role of Placement Agents, which was recently made publicly available on SSRN, we examine the determinants of placement agent usage and implications for performance using a dataset of 32,526 investments in 4,335 private equity funds.

Placement agents are financial intermediaries. They market private equity funds to external investors, known as limited partners (“LPs”), such as pensions, endowments, and foundations. In recent years approximately 75% of private equity funds rely on placement agents for fundraising.

There are multiple explanations for the rising prevalence of placement agent intermediation, with differing predictions about the economic impact on investors. In this paper we analyze the primary explanations for the use of placement agents: information production, certification, and influence peddling. We draw on evidence in prior studies of financial intermediation in different settings to examine whether placements agents in private equity are associated with value creation.

We document that funds employing placement agents are more likely to obtain investments from funds-of-funds, less likely to obtain investments from public pensions or endowments, and more likely to obtain investments from limited partners in countries outside the general partner’s headquarters country. We also find that placement agent use is positively correlated with aggregate capital flows to private equity, fund size, and diversity of the fund investor base, and is negatively correlated with general partner experience. Fund performance is increasing in the number of agent-general partner relationships, in overall agent experience, and for first-time fundraisings affiliated with agent use. These findings are consistent with an information production and certification role for placement agents.

Based on these findings, we test for value creation through a certification function. Placement agents can act as a certifier of quality for private equity funds, justifying their fees and use to the fund. Consistent with value creation through certification, we find significantly higher returns for first time funds that use placement agents. Additionally, we find significantly higher returns associated with top tier agents, where top tier agents are defined by number of funds placed.

However, we find only limited evidence that suggests these potential benefits manifest in higher fund returns outside of first time funds and top tier agents, and we find substantial evidence that in many cases the opposite is true. Across a variety of specifications, we find that funds employing placement agents experience lower net internal rates of return, on average. We also find that LP investment performance is negatively related to the presence of placement agents within a fund, particularly for public pensions.

Furthermore, consistent with influence peddling, a measure of the investor-agent relationship strength is negatively correlated with returns. In other words, the higher frequency with which an LP invests in funds affiliated with a given placement agent, the worse the returns are for that LP. Taking this to an extreme, where an LP invests in 100% of the funds affiliated with a given agent, this is an indicator of the strongest possible relationship strength between the LP and agent, and perhaps the most at risk of influence peddling. We find only three agents with overlap values of 100%: Arvco, Weatherly, and Diamond Edge. All three have been indicted on criminal charges.

Taken together, our results point to a nuanced relation between placement agents and value. The contrast between the positive association between agents and returns for segments of the private equity landscape where certification is most visible, and their negative relation with returns across most of the rest of the sample points to significant heterogeneity in placement agent type and quality. Placement agents, through repeated interaction with LPs, may be associated with a higher level of trust than general partners who only fundraise occasionally.

Our findings indicate that implemented and proposed regulatory bans on the entire placement agent industry could produce unintended consequences. It is conceivable that the states which have now banned placement agents may in fact experience lower public pension investment returns going forward, in cases where the pensions relied upon the certification role provided by top-tier agents. On the other hand, our results suggest that on average, public pensions often have the worst performance of all LP categories when investing in funds that use placement agents. The results imply that the placement agent industry is marked by heterogeneity in agent type and quality, suggesting that both regulators and investors should use discernment when evaluating the role of placement agents in private equity.

The full paper is available for download here.

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