The formulas, tricks and trade secrets of Private Equity

Principal Agent Problem Example

Sample Chapter

According to Wikipedia, the principal agent problem is as follows:

the principal agent problem… (addresses) the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent.

One of the most encountered real-life examples of the principal agent problem is the misalignment of interests within public companies. The primary interest of shareholders is to realise a favourable return, whereas the primary interest of the management team isn’t necessarily the same. Arguably, their interests should be the same, but managers may be more interested in working shorter hours, building a bigger (but not necessarily more profitable) business, or making high-profile (yet incompatible) acquisitions. This misalignment of interests is the principal agent problem.

Public companies have a multitude of strategies to surmount the principal agent problem. For example, issuing performance options to the management team creates more of an alignment with shareholders. However, the other interests still exist and the shareholders are still limited in their influence over the management of the company. Shareholders may be able to vote out CEOs and other executives by majority vote at general meetings, but this is a far cry from the granular influence that investors would benefit most from.

Logically, private equity represents a real solution to the principal agent problem (albeit, still not a perfect solution). Firstly, the principal (private equity firm) has much more influence over the agent (management team) to the point where they are an agent. For example, if a private equity firm wants updated debt covenant data from an investee, they can generally expect a response within the day. Try to request this from a public company, and in six months’ time, you may have a vague, ambiguous and sugar-coated announcement that doesn’t nearly include enough information. The reduction of information asymmetry is the key to private equity firms experiencing less of the principal agent problem.

So what’s my point? To most, the principal agent problem is a distant and clouded memory from b-school. But, surprisingly, it underpins the entire private equity value proposition for investors.

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