Does private equity have a moral and ethical problem?
On the whole, I think not.
The overall industry is better than its reputation, most GPs are decent, honest, value their reputations and generally do the right thing.
But some certainly “push the envelope”.
“Normal” codes of conduct and behavior stop applying and doing something or taking a gamble with other peoples’ money, even if morally questionable, is seemingly “ok” if it has limited downside.
And unfortunately, pushing the envelope seems to have become more and more frequent – also by the more prominent firms.
This is damaging to the reputation of the industry, erodes trust, increases costs, and ultimately impacts returns.
"If you don't have integrity, you have nothing. You can't buy it. You can have all the money in the world, but if you are not a moral and ethical person, you really have nothing."
Henry Kravis, Co-founder of KKR
Legal documents form the formal governance framework between the GP and the LPs
But these documents, as comprehensive as they can seem, cannot possibly capture each and every eventuality. Besides, they mostly grant significant flexibility to the GP.
Two things exacerbate this problem
Once invested, if a GP is not in clear legal violation of the legal agreements, it is difficult, bordering on the impossible, to get your money back – and even then, it will almost certainly be an expensive drawn out multi-year affair
GPs / PE Funds, being private, are by their very nature, are still relatively lightly regulated and not nearly subject to the same scrutiny as public companies
Consequently, for those so inclined, this leaves significant room to bend and in some cases break the rules, quite possibly to the detriment of investors and limited partners and at their expense.
Moral and ethics are important because contracts can’t cover everything
GPs are trusted by their investors, their Limited Partners, with millions and in some cases billions.
And, because of the limitations of legal documents and the light regulatory oversight, LPs to some extent commit this capital with the expectation that the GP will invest well, as has been agreed, and in accordance with what was said and informally agreed during due diligence.
Subsequent to DD, LPs accordingly rely on the moral compass of their GPs to treat the capital with which they have been entrusted, with the utmost of integrity and an ability to discern between what you can do and what is right and what is wrong.
“Ethics is knowing the difference between what you have a right to do and what is right to do.”
Potter Stewart, US Supreme Court Justice
Solid moral and ethical standards are critical for trust
It may not have shown up in mainstream news, but certainly some, mostly less well-known, firms have always pushed the envelope.
But lately, and not just because of aggressive deal making, this is also happening with the more well-known and prominent firms and is showing up in the mainstream news. See for instance these articles on Bloomberg and CNBC and in the Guardian and the FT.
News stories, more or less known and more or less egregious, like these erode trust and thus damage the tacit understanding that is pivotal to the LP / GP relationship.
And perhaps even more damaging, it feeds into a popular narrative that all PE is malicious and bent on profiting for themselves no matter the cost for other stakeholders or the wider public interest.
A lack of trust is a cost for GPs and LPs
Unfortunately, even though LPs spend ubiquitous amounts of time on due diligence, trust is very hard to judge and cannot be measured. So if trust in general starts to erode, LPs will want more investment documentation. This increases transaction costs, which then erodes returns.
Additionally, if firms that handle billions, often for public pensions schemes, are thought to lack trust and integrity. politicians and regulators will, private markets or not, increasingly feel compelled to step in with more regulation and oversight.
While it can be argued that this may be a good thing and overdue, it will also inevitably increase complexity and through that cost, again to the detriment of returns for investors.
Trust is becoming increasingly important
As GPs continue their push into the retail space, and regulators become ever more likely to let them do so, the importance trust, in the absence of strong regulation and investor protection, is critical.
As opposed to professional investors, retail investors do not have nearly the same level of understanding, resources or for that matter ability or access to do in-depth due diligence.
Consequently, retail investors have much less scope for deciding if they trust a GP. Instead they to a much larger extent than professional investors rely on the brand of the GP, their perceived integrity and reputation, and that they, as fiduciary duty requires them to do, will put their clients' and investors' best interests ahead of their own.
In this still very lightly regulated corner of finance it is still all about reputation and trust - this not least among the largest and most prominent firms. Because in the absence of trust will come ever increasing regulation and oversight, and while that, to some extent may be needed, it will also encumber the entire industry.
I leave you with this quote from Warren Buffet, which is well worth considering
"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."
Warren Buffett, Founder of Berkshire Hathaway