The Agency Costs of Multi-Product Private Equity Suites: Towards a Post-Jensenian Paradigm

In 1989, the late Professor Michael C. Jensen predicted the eclipse of the public corporation at the hands of the US private equity sector. In so doing, Jensen provided what was, and largely still is today, the dominant intellectual rationalization of private equity as a market-institutional phenomenon. Jensen presented private equity buyouts as a golden bullet for the so-called agency costs problem in widely held companies, which he had first expounded over a decade earlier in his landmark 1976 article (co-authored with William Meckling) ‘Theory of the firm: Mangerial behavior, agency costs and ownership structure’.

However, over the course of the succeeding three and a half decades, the private equity sector has changed almost beyond recognition. Consequently, a world which in the 1980s was heavily US-centric and characterized by relatively small-scale, boutique finance firms has morphed into a globalized arena dominated by very large, multi-divisional and bureaucratically complex financial conglomerates, which are largely indistinguishable from their more established investment banking and financial-accounting counterparts. Notwithstanding these seismic contextual changes, the Jensenian model of private equity, together with its now-simplistic focus on mitigating owner-manager agency costs, remains the central theoretical paradigm through which private equity buyouts are understood within law and finance scholarship.

In our article ‘The Agency Costs of Multi-Product Private Equity Suites: Towards a Post-Jensenian Paradigm’, which we presented at the 2024 ECGI Conference on the Law and Finance of Private Equity and Venture Capital, we posit that a critical reappraisal of the continuing descriptive relevance of the Jensenian theory of private equity is consequently now long overdue.

The article charts the rise of multi-product suites (‘MPSs’) within the larger-scale segment of the PE sector today, explaining the powerful structural factors and economic pressures that have driven the progressive move away from monoline, purely-buyout-focussed platforms. It then identifies the ensuing agency costs arising from MPSs—specifically, between General Partners (‘GPs’) and Limited Partners (‘LPs’) of PE buyout funds—which have arguably just supplanted the traditional Jensenian owner-manager agency problem with a new, more latent, and more complex one.

Jensen’s agency theory rationalization of LBOs was predicated on capital gains being the core and dominant source of returns for LBO partnerships and, in turn, the buyout firms who acted as their GPs. It was therefore of critical importance that ultimate capital gains, as opposed to ongoing revenue streams from fees, remained the principal driving motivation for GPs’ dealmaking and subsequent portfolio management activities. However, as larger PE firms come to operate an ever-greater variety and scale of funds for clients, the ongoing fees charged on those funds become an ever more prominent component of such firms’ overall profitability. The negative flipside to this is that the actual performance-sensitive component of PE firms’ client income, namely the carried interest accrued on their funds, increasingly becomes the proverbial ‘icing on the cake’ as opposed to the principal performance driver for GPs.

In the case of many larger (and especially multi-product) PE firms, moreover, there is a common belief that management fees have now become a more important revenue stream than carried interest. This is especially so in the case of those PE firms (eg Blackstone, KKR, and Apollo) which have listed their management companies on public markets, where regular and periodic management fees typically constitute a more stable and predictable source of quarterly earnings growth than the relatively irregular, episodic, and variable nature of carried interest payments that depend on terminal dissolution of the relevant fund or asset for their realization.

Because of these developments, GPs who fail to meet the requisite (typically 8%) hurdle rate of return to earn carried interest on any fund can often still earn significant profits on their annual management fees alone. Moreover, since management fees are calculated by reference to funds under management rather than overall returns, there is a natural incentive for GPs to seek to maximize their aggregate volume of funds under management by utilizing drawdown facilities that permit them to make demands on existing LPs to release additional funds. This can, in turn, encourage an asset-gathering mentality whereby the relevant GP seeks continually to increase the scale and scope of its fund management activities to maximize its range and variety of potential fee streams, potentially at the expense of maximizing the capital value of its existing individual funds.

However, whereas market practice has been typically quick to move with the times, academic theorizing has by contrast been characteristically slow, such that the now-largely-outmoded, 1980s-inspired Jensenian model of PE remains largely dominant on a conceptual level today. Accordingly, we believe that the time is now ripe for shifting towards a new, post-Jensenian theoretical paradigm of PE, which is both cognizant of and responsive to today’s markedly different organizational climate and the more latent but complex agency cost challenges it presents.

Accordingly, just as the Blackstones of this world adapted the basic 1970s monoline LBO firm to a new scale and scope of sophistication in later decades, we hope to do the same here with Michael Jensen’s pathbreaking thinking on private equity. In so doing, we hope to help ensure that whilst the inventor may sadly no longer be with us, his invention unquestionably lives on for generations to come.  

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By Marc Moore (UCL) and Chris Hale (Travers Smith LLP)

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