Contrary to what some industry elitists may think, private equity behavior doesn’t transcend the greater finance industry. It is exposed to the same biases, the same aversions, the same subjectivities, and the same contradictions. It’s foremost a sales game, but also a game of control and discipline. And with that in mind, I’d like to discuss a range of human behaviours rarely talked about in the industry. I believe they have a profound effect on performance and differentiation in the private equity industry.
- Emotional Bias: when emotions related to a potential outcome prematurely affect the decision, emotional bias is said to exist. In private equity, the emotions of closing a deal create a bias towards making the deal a success. I spoke indirectly about this in my recent post, the superficiality of most due diligence. In my opinion, this is the single biggest threat to the objective appraisal of a potential deal; we tend to want to close deals more than anything.
- Loss Aversion: this occurs because it is human tendency to rank avoiding a loss higher than receiving a gain. Ask yourself how you would feel if you lost 20% on your stock portfolio versus missing the opportunity of a 20% return on a potential investment. In private equity, we think it’s fine to miss great opportunities, yet sinful to invest poorly. This has become dogma in the industry because it appears a more conservative and agreeable argument.
- Congruence Bias: private equiteers love to talk about hypothesis testing, almost as if everyone else just shoots from the hip. The problem is, most private equiteers only test hypotheses directly and only reject hypotheses in extreme cases. For example, a typical hypothesis is “the company’s customer base is sufficiently fragmented?” The subjectivity alone creates bias, but so too does the use of direct testing (testing the positive case rather than the alternative case). One solution is to test the alternative case and have to prove “customer base fragmentation” beyond reasonable doubt.
- Framing Bias: framing is about using past experience and other external information to give something context. Framing makes daily decisions more efficient; if you consider every decision with a clean slate, you’ll go crazy. However, conventional framing threatens objectivity in private equity. Conventional framing shows what people want to believe, rather than what’s true. It’s important to learn to reframe important information to understand it in its entirety. For example, if a founder wants to sell a business, it doesn’t automatically mean it’s bad, he may just want to sail the world or climb Everest.
- Information Bias: when we talk about the competitive advantage of our firms, we talk about superior information. When we negotiate deals with founders, we talk about asymmetric information. When we’re pressed on an issue we say we don’t have enough information. We just love information. However, as great as information may be, it needs to be the right information. Information bias is about seeking information that has less and less influence on the target decision. This occurs in private equity because more information is viewed as better analysis. But we lose site of the big picture; we get caught up in the process; we often fail to sit back and ask what the most important information could be.
I’ll leave it at those for now, which I think are the most salient cognitive biases that affect the industry. My suggestion to combating these biases is to acknowledge them, make them known, discuss them, and try to work around them with your team. Pull each other up every time they seem to creep back, not in an adversarial manner, but in a constructive and friendly manner.