Navigating Private Equity Dynamics: An Agency Theory Perspective

Abstract: The essence of the private equity industry lies in the intricate relationship between Limited Partners (LPs) and General Partners (GPs), intertwining financial elements with human interactions. This thesis employs agency theory to dissect the behaviors of the principal (LP) and the agent (GP), providing a comprehensive exploration of the current private equity landscape and impending market evolution. The industry's trajectory is closely tied to macroeconomic factors, as evidenced by the significant impact of rising interest rates in 2022, leading to pivotal shifts in dynamics. This study delves into two critical instances shaped by market conditions: increased risk of opportunistic behavior in fund managers' valuation techniques and the Denominator Effect, influencing LPs' allocation strategy. These challenges necessitate stringent countermeasures and monitoring to safeguard partnership integrity. Amidst the recent macroeconomic challenges, including high inflation and rising interest rates, the Private Equity Industry faces performance setbacks, straining the LP-GP relationship. This thesis explores the evolving agency dynamics, with LPs intensifying scrutiny over fund managers. Co-investments emerge as a potential solution, reducing barriers between LPs and GPs while maintaining recurring revenue for GPs. The study traces co-investment's historical development, analyzing the benefits and challenges in the LP-GP relationship. Similarly, it scrutinizes secondary transactions, emphasizing the growing need for transparency to address the "agency problem" between investors and fund managers in the context of industry evolution.