Preferential Treatment and the Rise of Individualized Investing in Private Equity

William Clayton is an Associate Research Scholar in Law and John R. Raben/Sullivan & Cromwell Executive Director of the Yale Law School Center for the Study of Corporate Law. This post is based on his recent article Preferential Treatment and the Rise of Individualized Investing in Private Equity.

Preferential treatment of investors is more common than ever in today’s 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 refer to in my paper as “individualized investing”—private equity investing by individual investors through separate accounts and co-investments. Separate accounts and co-investment vehicles are entities that exist outside of pooled funds, enabling managers to provide highly customized treatment to the investors in them. Estimates are that upwards of 20% of all investment in private equity went through these channels in 2015. Some anecdotal accounts suggest even higher levels.

Many of the largest and most influential investors in private equity 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 paper I make the case that these trends are efficiency-enhancing developments for the private equity 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. For example, when preferred investors use superior customization and control rights over the investment exposure of their individualized vehicles solely to achieve better diversification and asset allocation in their broader portfolios, non-preferred investors are unlikely to be affected negatively.

Other forms of preferential treatment 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 private equity capital is competitive, there are limits on the amount of zero-sum preferential treatment that we should expect. First, when managers are abiding by their duties of disclosure, investors can contract for protections against potential harmful treatment, and they can choose not to invest when managers refuse to grant satisfactory protections. Second, even in cases where non-preferred investors fail to negotiate for robust contractual protections—due to lack of influence or sophistication, or otherwise—there are certain non-contractual factors that limit a manager’s incentive to allocate its resources inequitably to preferred investors away from pooled funds. For instance, as discussed further in my paper, the gains from engaging in this kind of inequitable allocation will generally be difficult to sustain over the long term and difficult to scale up. In addition, the track record of a pooled fund has certain marketing advantages over the track record of an individualized vehicle, including the fact that it is often a cleaner signal of the manager’s talent level to prospective investors, making it a valuable asset when the manager is looking to raise capital.

The factors described in the paragraph above do not eliminate zero-sum preferential treatment, and their effectiveness will vary from manager to manager and will depend on how competitive the market for private equity capital is. But they do serve as checks on the overall amount of such activity in the private equity marketplace.

Finally, even zero-sum preferential treatment can increase the efficiency of private equity contracting 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 promote 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.

The full paper is available for download here.

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