The economics-and-law literature on the principal-agent problem of public corporations is extensive. In their classic 1976 Journal of Financial Economics article, “The Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership,” Michael Jensen and William Meckling highlighted the conflict between small and dispersed shareholder “owners” and non-significant shareholding managers over the control of corporate resources. In a 1989 Harvard Business Review article, Jensen went on to predict the rise of “leveraged buyout associations,” or private equity groups and active investors, given their ability to address the principal-agent problem through leveraged buyout transactions that concentrate equity in the hands of management. These transactions are financed with considerable leverage (60–90 percent), LP capital raised by private equity funds with a finite life of 10–13 years, and GP and management capital, which align interests.

Hence, contrary to Spindler’s view, private equity fund partnerships specifically minimize agency costs and, one could argue, do so much more successfully and efficiently than mechanisms such as independent boards and securities regulation at public companies. Indeed, the “dramatic performance-based compensation,” or carried interest, GPs receive, which he points to as “inefficient and an incomplete substitute for investor monitoring,” goes a long way toward explaining the success of this market-based organizational mechanism. With their own equity at stake, GPs “eat their own cooking” and investors have less need to monitor. This is the very same model of “owner capitalism” that guides Warren Buffett and helps to ensure accountability and drive value creation.

If there were such severe constraints in the private equity partnership model as Spindler suggests, it is not likely we would have witnessed its dramatic growth across industries and countries to the point where, globally in 2007, private equity accounted for about 25 percent of mergers-and-acquisitions transactions. Before the financial crisis, the world’s most sophisticated investors — many of which are the stewards of retiree, insurance company, and endowment resources — were allocating more than half a trillion dollars per year to private equity. These investors allocate anywhere from less than 5 percent to over 20 percent of their capital voluntarily to this asset class — with good reason: private-equity firms, especially those with long tracks records, tend to provide superior returns and diversification benefits.

As one would expect from a voluntary, evolving market arrangement that is dependent on LP funding, there have been new adaptations to minimize transactions costs. For example, investors lacking resources or expertise to choose among funds can invest with the growing number of private equity “fund of funds” that assess GP track records and spread an investor’s capital across a diversified group of primary funds. There has also been a rise in dedicated secondary funds that buy LP fund stakes on the secondary market and hence provide liquidity and help investors rebalance their portfolios. Finally, last year the Institutional Limited Partners Association, representing 220 of the biggest pension funds, endowments, and sovereign wealth funds, published a list of “Private Equity Principles” to advance alignment of interest, fund governance, and transparency.

In the April 2010 issue of the University of Chicago Booth School of Business’s Capital Ideas, Chicago professor Steven Kaplan includes a number of short articles summarizing research that helps to demystify private equity. He notes another important reason why institutional investors are attracted to private equity: “Beyond the near term, private equity seems to be in a better position relative to other asset classes because the duration of capital matches the duration of assets — that is, long-term capital making long-term investments in companies.” Thus, the private equity partnership is a naturally mutually beneficial relationship, and as with Adam Smith’s invisible hand, it generates tremendous economic benefits above and beyond to the broader economy.