Human Capital Evaluation in Private Equity Investment Decisions: Contemporary Practice & Challenges

Abstract

This paper investigates the processes involved in human capital (HC) evaluation in the investment of organisations by private equity (PE) firms. The significance of this issue relates to both the increasing importance of the PE industry in the wider corporate environment and the increasing recognition, within business and regulatory and financial communities, that the valuation and reporting of HC as a corporate asset requires attention. We examine the issue through the conceptual frame of HC evaluation by PE as an agency problem centred on asymmetric information. Findings are discussed from twenty-three semi-structured interviews with senior representatives of nineteen different PE firms with collective experience of over 3700 investments, to elicit insights into the nature, challenges and consequences of HC evaluation. The findings reinforce the agency perspective and characterise this setting as one featuring an aggravated form of asymmetric information-based agency problem. We find that the commonly employed HC evaluation methods are regarded as suboptimal in their susceptibility to heuristics and biases and to factors such as time pressure and interpersonal dynamics, potentially resulting in flawed judgements and negative investment decisions. We provide an analysis of the most commonly-reported consequences of shortcomings in HC evaluation, and offer recommendations for future research.