Spreading Sunshine in Private Equity: Financial Intermediation and Regulatory Oversight

Should regulatory oversight play a role when market forces can potentially discipline conflicts of interest faced by private equity (PE) fund managers? PE fund managers, or general partners (GPs), play an important role in managing trillions of dollars of PE investments on behalf of investors such as pension funds, endowments, and insurance companies, collectively known as limited partners (LPs). However, the opaqueness of PE funds has received growing attention from investors and regulators. One of the concerns revolves around PE fees, compensation paid to GPs, since these fees are often perceived as excessive and opaque. Although such compensation can attract scarce managerial talent and reward strong performance, the outsized fees also reflect inherent agency conflicts in the delegated asset management, especially if these fees are difficult for investors to assess.

The Promise and Limits of Market Discipline

While various forms of market discipline, discussed below, act as the first line of defense in mitigating conflicts of interest faced by GPs, these market forces may fail to sufficiently align incentives due to pervasive information frictions in PE markets featured with a lack of market pricing and limited disclosure. 

• Compensation contracts: Key components of the compensation include management fees and carried interest, which incentivize GPs to act in the best interest of LPs. However, both limited partners (LPs) and general partners (GPs) possess some pricing power due to information and search frictions in the market. As a result, the compensation contract may also be part of the agency problem.  The complexity of PE fee structures, compounded by PE funds’ limited transparency, creates challenges for LPs to evaluate and oversee fees, potentially leading to rent extraction and inefficient contracting.

• Future fundraising: Beyond direct compensation from existing LPs, GPs are motivated by future fundraising opportunities based on their past performance. Unlike publicly traded stocks that have market prices, the assets within PE funds are typically valued quarterly based on interim assessments from GPs. These valuations are often outdated and may not capture the latest information. Consequently, the absence of mark-to-market valuations can result in inadequate market discipline and inefficient fund selection by LPs. Additionally, inflated interim valuations during fundraising periods can mislead investors and exacerbate these challenges.

• Ex-post monitoring: LPs can attempt to motivate GPs through post-investment monitoring. However, this approach can be prohibitively expensive due to GPs’ limited disclosure and LPs’ coordination challenges. While LPs can voice concerns through advisory committees if GPs make poor investment choices, their influence is significantly weaker compared to the board of directors, who can actively participate in corporate decision-making. Furthermore, if LPs were to interfere directly in the fund's daily operations, they would risk losing their limited liability status. The closed-end structure and illiquidity of PE funds also restrict LPs’ ability to govern through exits of existing fund investments, unlike investors in mutual funds or public companies.

Evolving Regulatory Landscape of PE Funds

Despite the potential limits of market discipline, most PE fund advisers in the US historically received minimal regulatory oversight, since they could avoid SEC registrations under an exemption provided by the Investment Advisers Act of 1940. This exemption applied to advisers with fewer than 15 clients, treating each fund as one client regardless of the number of investors within a fund. However, the Dodd-Frank Act removed this exemption in 2012, replacing it with much narrower exemptions based primarily on advisers' size and investment strategies rather than on potential agency conflicts. These adjustments reflect regulators' concerns about systemic risks in private funds following the 2008 financial crisis. Based on regulatory filings, the paper documents that many advisers including large GPs had to register for the first time, becoming subject to examinations, regulations, and disclosure requirements. 

Subsequent SEC examinations of newly registered GPs revealed widespread compliance deficiencies, especially in the PE fee arena, including misallocated expenses, hidden fees, and manipulated valuation of portfolio companies. If these payments were merely another type of compensation aimed at maximizing investor value, it is puzzling why they would be structured in such opaque ways.

Conscious of the agency conflicts in PE funds, the SEC recently implemented comprehensive reforms regarding PE fees. These proposed rules mandate, among other things, quarterly reports detailing fees, new auditing and bookkeeping requirements, and a prohibition on charging certain fees and expenses. Although these changes aim to increase transparency, they primarily apply to registered fund advisers. Additionally, GPs and other interest groups have challenged the SEC, alleging regulatory overreach, resulting in some of the SEC's oversight rules being overturned by a US court in 2024.

Main Findings

Conceptually, the Dodd-Frank Act substantially expanded the regulatory oversight of PE funds in 2012, enhancing market transparency and limiting GPs’ opportunistic behaviors. This paper finds that the enhanced regulatory oversight increases LP inventors’ PE market participation and reduces their incentives to bypass intermediation. Overall, better investor protection increases capital supply to PE markets.

Moreover, the paper shows that, when bypassing the intermediation, investors tend to finance more mature, larger, and less innovative companies. This contrasts to investing through PE funds, because pension funds, endowments and insurers typically lack the expertise to invest in private companies and the diversification provided by PE funds which can pool large amount of capital for PE investments. Therefore, by facilitating intermediation, regulatory oversight of PE funds mitigates the potential capital misallocation resulting from the disintermediation of PE markets.

Although these benefits are significant, it is crucial to recognize that regulatory intervention brings ongoing compliance and disclosure costs for PE fund advisers, most of which are likely to be passed on to investors. This could also distort GPs’ fundraising incentives and create opportunity costs for the SEC due to its limited resources. Consequently, the findings of this paper can contribute to the ongoing discussions regarding the costs and benefits of regulation for PE funds, which will have important implications for various institutional investors, their beneficiaries, and the broader economy.

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By Yingxiang Li (City University of Hong Kong)

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