First, when managers are abiding by their duties of disclosure, investors can contract for protections against potential harmful treatment, and they can choose not to invest when managers refuse to grant satisfactory protections. But when disclosure is robust and the market for private equity capital is competitive, there are limits on the amount of zero-sum preferential treatment that we should expect. Other forms of preferential treatment generate what I call “zero-sum” benefits because they are accompanied by offsetting losses to non-preferred investors. For example, when preferred investors use superior customization and control rights over the investment exposure of their individualized vehicles solely to achieve better diversification and asset allocation in their broader portfolios, non-preferred investors are unlikely to be affected negatively. Some forms of preferential treatment made possible by individualized investing create new value for preferred investors without harming non-preferred investors. The idea of preferential treatment runs counter to many people’s intuitive sense of fairness, but in this paper I make the case that these trends are efficiency-enhancing developments for the private equity industry when managers fully abide by their disclosure duties and keep their contractual commitments. This raises a question that is both economic and philosophical: Can preferential treatment be a good thing for private equity? Many of the largest and most influential investors in private equity have used these individualized approaches to obtain significant advantages that are often unavailable to pooled fund investors.

Some anecdotal accounts suggest even higher levels. Estimates are that upwards of 20% of all investment in private equity went through these channels in 2015. Separate accounts and co-investment vehicles are entities that exist outside of pooled funds, enabling managers to provide highly customized treatment to the investors in them. Traditionally, private equity managers raised almost all of their capital through “pooled” funds whereby the capital of many investors was aggregated into a single vehicle, but recent years have seen a dramatic increase in what I refer to in my paper as “individualized investing”-private equity investing by individual investors through separate accounts and co-investments. Preferential treatment of investors is more common than ever in today’s private equity industry, thanks in part to new structures that make it easier to grant different terms to different investors.

Preferential treatment examples