Intermediation in Private Equity: The Role of Placement Agents
U.S. Securities and Exchange Commission
University of Oregon – Department of Finance
Steven Davidoff Solomon
University of California, Berkeley – School of Law; University of California, Berkeley – Berkeley Center for Law, Business and the Economy
Abstract:
Intermediation in private equity involves illiquid investments, professional investors, and high information asymmetry. We use this unique setting to evaluate the use of placement agents and their economic effect. In recent years approximately 75% of private equity funds rely on placement agents for fundraising. Placement agents are associated with lower abnormal returns in a cross-section of over 30,000 limited partner investments, consistent with studies of intermediation in broker-sold mutual funds. However, returns are higher for funds employing a top-tier agent, and for first-time funds employing an agent, consistent with a certification hypothesis. The results indicate heterogeneity in agent quality where certain placement agents provide information-processing and screening benefits for investors, but that consistent with an influence peddling explanation a larger subset of placement agents appears to provide no tangible benefit with respect to returns.
Intermediation In Private Equity: The Role Of Placement Agents – Introduction
In 2010, Alan Hevesi, the state comptroller of New York responsible for the investment of the New York State pension fund, pled guilty to the crime of felony public corruption. Mr. Hevesi was sentenced to up to four years in prison for accepting over $1 million in gifts and campaign contributions from a private equity placement agent. The goods and money were provided in exchange for Mr. Hevesi arranging to invest over $250 million in New York pension funds in private equity funds.
Unfortunately, Mr. Hevesi’s conviction was not a singular event. In recent years, pay-to-play scandals involving private equity placement agents and public pension funds have been uncovered in California, New York, and Kentucky. The outcry and publicity has led to federal regulation and the outright ban on the use of placement agents by public pension funds in some states like New York. Meanwhile, a number of private equity firms such as the Carlyle Group have agreed with regulators to stop the use of placement agents when dealing with public entities.
These incidents cast placement agents in a negative light, suggesting to many observers that agents are doing little more than leveraging their public influence to extract rents. However, despite the bad publicity and enhanced regulation, placement agents are now more prevalent than at any time in history; they have become and remain common in private equity fund-raising. In 1991 virtually no funds used a placement agent, but by 2011 we document that about 75% of value-weighted funds rely on placement agents. This paper explores this seeming dichotomy, examining the determinants of placement agent usage, and implications for performance, using a dataset of 32,526 investments in 4,335 private equity funds.
Placement agents are financial intermediaries. They market private equity funds to external investors, known as limited partners (“LPs”), such as pensions, endowments, and foundations. There are multiple explanations for the rising prevalence of placement agent intermediation, with differing predictions about the economic impact on investors. In this paper we analyze the primary explanations for the use of placement agents: information production, certification, and influence peddling. We draw on evidence in prior studies of financial intermediation in different settings to examine whether placements agents in private equity are associated with value creation.
Explanations for placement agent usage such as information production, and certification are consistent with value creation. For example, placement agents could aggregate market knowledge acquired through continuous LP interactions on behalf of various funds, and pass this valuable information on to general partners (“GPs”) to optimize fund size and structure. Additionally, placement agents may reduce costs related to asymmetric information between GPs and LPs and manage the due diligence process, allowing GPs to focus on deploying funds raised. Placements agents could create value for LPs if they are able to discern fund quality ex ante, and reduce search costs by certifying high quality funds. This certification hypothesis is similar to the theory advanced by Booth and Smith (1986) whereby underwriters use reputational capital to guarantee product quality.
An alternative, more cynical, explanation for placement agent use holds that the agents are little more than influence peddlers, possessing no ability to credibly certify fund quality or aggregate market knowledge; they merely attract institutional investors through personal relationships, or worse, kickbacks or “pay to play” schemes illustrated by recent headlines. This explanation, where the intermediary is simply acting out of self-interest, is most similar to prior studies of brokers in the mutual fund industry. Much like Bergstresser, Chalmers, and Tufano (2009) assess the costs and benefits of retail brokers, we evaluate the economic effects of placement agents in the private equity industry.
In this paper we explore these theories of placement agent utilization by reporting statistics on the characteristics of funds, GPs, and LPs when placement agents are utilized, and examining their association with abnormal returns. We document that funds employing placement agents are more likely to obtain investments from funds-of-funds, less likely to obtain investments from public pensions or endowments, and more likely to obtain investments from limited partners in countries outside the general partner’s headquarters country. We also find that placement agent use is positively correlated with aggregate capital flows to private equity, fund size, and diversity of the fund investor base, and is negatively correlated with general partner experience. Fund performance is increasing in the number of agent-general partner relationships, in overall agent experience, and for first-time fundraisings affiliated with agent use. These findings are consistent with an information production and certification role for placement agents.
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