A new approach to regulating private equity

Much of the historic controversy around private equity has focused on the relationship between private equity managers and the companies they control. Yet there is little evidence to support the notion that private equity managers, on average, harm the companies they control. Meanwhile, a different aspect of private equity has received too little attention: the relationship between private equity managers and their investors. The private equity market shows signs of the “price shrouding” that economists have described in consumer markets. This is counter-intuitive for anyone who automatically assumes that “sophisticated investors” write optimal contracts. It is also potentially troubling for regulators and policymakers, because they use the “sophisticated investor” assumption as a building block in the way they organise financial markets. We propose two explanations for why price shrouding may affect even “sophisticated investors” and suggest some remedies. Although this discussion is framed purely in terms of private equity, we believe it is relevant to other complex investments that are popular with “sophisticated investors”.