PRINT THIS PAGE Behavioural Economics and the world of private equity 07/11/2006. Source: The Foundation For Behavioral Economics LLC. Michael D. Underhill, Chairman 
Behavioural Economics looks beyond assumptions on what is strictly "rational" decision-making as a field of study that combines psychology and economics in an effort to investigate occurrences in markets in which some of the agents display human limitations and complications. Private Equity is not a strictly rational business, therefore opportunities and risks arise from this reality in the industry. Private Equity as an asset class has performed exceptionally well over the years when compared to the public markets, but an investors approach to private equity should only be attempted by experienced investment professionals with additional guidance to build the optimal portfolio.
It is my experience that institutional limited partners best achieve an outperforming private equity portfolio by having an external manager or consultant dedicated to providing insights so that there is some kind of institutionalization to the decision making process and they can best remove emotion from their decisions.
Behavioural economics can help to analyze the decision making processes on a individual level with a pension fund investment officer (individual emotions), at the investment board level with "group dynamics" and even in the analysis of General Partner behavior or "pattern recognition". There is a large body of subject matter that we could cover, but I only have 1500 words to cover this article, so let's examine some of the dynamics with the GP community for the purposes of this brief discussion.
Even the most disciplined General Partner is still an "economic animal", so it is important to understand the established patterns and future potential behavior relating to the following.
- Market dynamics: Supply and demand, but also the desire to be back in fund-raising mode at the best time in the fund-raising cycle optimizing the GP's overall potential.
- Ambition to be successful widely recognized as the best and most powerful player in the market. (LBO/Mega Fund Giants)
- Desire for financial rewards, sometimes quietly making a lot of money for investors and themselves is the goal. (The quiet company)
- Tribal loyalty: Desire to build strong brand recognition. (Venture Capital Crowd)
- Group solidarity: Reinforce bonds with LP investors (Worker Friendly/Labor Sensitive Investment Principles for Labor Union and Taft-Hartley pension plans)
- Empire-building: expanding beyond the primary base (Leveraging a single strategy like distressed fund investing into a more broadly diversified business model)
The key to success with relationships between GPs and LPs is to be aware of some basic elements that function as Behavioural economic drivers:
- Incentive structures: They will always have an effect, sometimes unintended so one needs to consider a whole range of scenarios on how the key actors will act to the incentive structure.
- Terms and Conditions: This is really not just a negotiating thing, it really has to be seen as one of your few opportunities to anticipate and manage risk.
- Decision-making dynamics, group dynamics and interpersonal dynamics.
- Performance Measurement: Extent to which there is a fair measurement of performance for the fund, of the portfolio company managers, of the GP principals. (please see performance calculation appendix) We can provide a follow up article on this subject.
- Problem-solving dynamics: How does the GP group deal with a tough challenge or problem area, e.g., culture of blame vs. commitment to find a solution
All of these are very real factors that can be analyzed with a Behavioural Economic Framework quantitatively and qualitatively, but is it possible to quantify done to an exact measurement? Nothing has been developed yet, but The Foundation for Behavioral Economics has been reviewing data points using some multi-variate regression analysis and other statistical methods to help refine the process of decision making analysis and trend recognition. But for now, we need to come to the realization that the forces will change over time, even over the life of a single private equity fund in a single firm. So we need to consider how a wide range of changing variables could turn out, including how well will the GP group itself is able to anticipate, respond and evolve in the face of constant change.
How Institutional Limited Partners Can Mitigate Behavioural Aspects of Portfolio Management
The private equity market is unique with respect to two elements: investment selection and investment access. In order to create an outperforming private equity portfolio, it is essential that a private equity program is structured appropriately to effectively account for and manage these two elements.
Investment Selection: There is an extensive dispersion of returns among private equity managers. As evidenced by the last decade, top to bottom quartile managers have a performance dispersion of over 8,400 basis points (compared to over 1,200 in the public equity markets). Clearly, selection is critical to success in private equity. A median performing private equity portfolio over the last decade has only returned -0.5% (compared to 13.6% in the public markets). In order to be considered a performing portfolio, private equity investments need to have high-median to top quartile returns. Therefore, a private equity portfolio must be structured to make the best investment selections possible for its portfolio. First, it is essential to have solid market research, knowing the sub-sectors of the private equity market, the prospective deal pipelines, and the key managers.
This requires specialization and extensive resources. This is a continual process and requires dedication of time and resources to the asset class to stay abreast of the market. A solid base of market knowledge can then be complemented by experienced investors. This is achieved through having a team (internal/external support) of experienced market professionals making wise investment decisions based on detailed research and extensive market knowledge. There are a host of public pension plans that have developed successful, outperforming private equity programs through keen investment decision-making; typically these plans have at least one knowledgeable private equity investment professional on staff that works with an experienced external advisor or manager. I have found that relationships structured to appropriately align interests between these parties working cohesively as a unit have generated many of the top performing public pension fund returns.
Investment Access: Private equity investment access can be difficult. Fund managers have a short fund-raising window for accepting new capital. Investors have to time their ability to review the market, invest and close along these windows. Compounding the difficulty is the fact that managers do not accept capital from everyone. (Many times, they choose those dollars that represent the most attractive, long-term supply.) Additionally, capital is more readily available for outperforming managers, thereby increasing competition for space among fund investors.
Given these dynamics, market appeal (creating a brand in the market), timeliness (ability to execute quickly and efficiently), and relationships (depth of experience with the manager) are all critical components of gaining access to strong managers. My experience has proven this time and time again, particularly for large public pension fund investors. Techniques to structure a program in order to best leverage an investor's market position include an active brand campaign, a streamlined investment approval process, and an active external advisor with extensive established market relationships.
Portfolio Enhancements: Finally, there are a variety of other investment opportunities for private equity programs to pursue, such as co-investments, direct secondary purchases, and manager sponsorships (taking a direct interest in formative stage of a general partner). These investment opportunities typically require many of the techniques outlined above (extensive research, timeliness, appropriate internal/external staffing, and unique approval processes). If well executed, however, they can contribute meaningfully to portfolio performance.
We have briefly touched upon how Behavioural Economics plays a role in the world of private equity and our research is ongoing in the field, so like private equity the - body of knowledge is a fluid in nature. If you would like further information on our Foundation's research efforts, please do not hesitate to contact mikeunderhill1@aol.com.
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