Agency Theory for PE Firms
Agency Theory addresses the potential conflict of interest created between parties associated with a private equity firm: external investors, managers, entrepreneurs, and/or the owners of the private equity firm involved. Although managers’s compensation is aligned with the private equity firm in a way that rewards a common, shared interest; conflict between these parties can still arise and affect investor behavior.
There are generally three types of agency relationships:
1) A PE firm dealing with investors could attempt to advance its interests rather than prioritizing the investors’ interests. In this case, the PE firm is deemed to be an agent of its investors, the latter thus becoming principals.
2) A manager/entrepreneur could attempt to advance his/her interests rather than prioritizing the PE firm’s interests. In this case, the manager/entrepreneur is an agent of the PE firm.
3) A PE firm may have a motive to act in the best interest of managers, thus becoming agents to the firm’s investors.
There are also three types of common agency problems:
1) Moral Hazard: This situation refers to the agent withholding/hiding information from the principal and undertaking actions unknown by the principal in order to advance the agent’s interests.
2) Holdup: The agent uses deficiencies in incomplete contracts and, after certain costs have been covered by the principal, reveals his/her true intentions forcing the principal into new deals.
3) Adverse Selection: This takes place when one party, generally the Private Equity firm acting as the agent, has an information advantage over the other party, generally known as the principals. The agent will therefore be able to favor his/her interests rather than the principal’s.