First, he conflates the general partner–limited partner relationship with the relationship between the private equity firm and the portfolio company. The former is the subject of my article, and Mr. Haarmeyer says little to contradict my description of that relationship: basically, LPs receive little if any disclosure, liquidity, and control. In contrast, the private equity firm takes a very active role in the management of the portfolio firm’s affairs. I would posit that this is part of the reason why there is a substantial amount of litigation between portfolio companies and private equity firms, but little GP–LP litigation.
Second, Haarmeyer is mistaken about the economics of performance-based compensation. While “eating one’s cooking” by taking an equity stake and 20 percent carry may be an effective incentive to ensure optimal effort, it is a costly one because of the GP’s risk aversion. In a perfect world where disclosure or monitoring is costless, one would not rely on performance-based compensation at all, which requires an inefficient concentration in the manager’s investment portfolio.
A related technical point: it does not appear to be true, as Haarmeyer suggests, that private equity firms “tend to provide superior returns.” Rather, recent economic studies by Steven Kaplan and Antoinette Schoar (“Private Equity Performance: Returns, Persistence, and Capital Flows,” Journal of Finance, Vol. 60, No. 4, 2005) and Ludovic Phalippou and Oliver Gottschalg (“The Performance of Private Equity Funds,” Review of Financial Studies, Vol. 22, No. 4, 2009) find that, among buyout funds, net returns to investors (i.e., after fees) are below those of the S&P 500.
Third, Haarmeyer seems to view my position as being that private equity is somehow harmful. This is not my position at all. Rather, it is my view that private equity is often a preferable alternative to public capital markets, given regulatory inefficiencies in the public capital sphere. This is consistent with the growth of private equity activity as public capital markets have stagnated. However, it is also my view that some of these same regulatory inefficiencies distort private equity practices away from what would be a first-best optimum.
In sum, private equity has its place in the world, and is a valuable component of the capital markets. But it is not a perfect mechanism of unfettered contract, as some would suggest. My point stands that reforming the overbearing securities laws would lead to improvements in both public and private capital markets.
