The Investment Game in Private Equity

Abstract

Abstract Private equity investing and the relationship between the GP and the LPs are plagued with the risk of information asymmetries and agency costs, so the markets have developed several mechanisms to align the incentives of the funds and the investors, most importantly through disclosure and protections in limited partnership agreements. However, such agreements may not always deal with the most important asymmetries or agency conflicts, especially the hidden effort problem. From the fund’s perspective, there are also other relationships that affect its internal dynamics. They are the need for interest alignment between the fund (and the GP) and the managers of the portfolio companies, the risk of financial agency costs and the risk of strategic creditor actions. All of these relationships are regulated primarily by contracts. In this paper, I evaluate the game-theoretical framework, Investment Game, based on the analysis of the GP-LP investment-effort relationship supported by a brief analysis of the other relationships. I argue that, in most cases, the LPs are able to solve the GP effort maximisation problem making part of the fund regulation unnecessary. However, private ordering may not work in some cases. Despite these situations, the Investment Game enables, even when the LPs cannot affect the fund terms, an analysis of the GP effort level and the level of undisclosed private benefits. Therefore, the Investment Game also sets a framework for a data analysis of private equity investing.