Private equity execs should stop sleeping around

Updated: Oct 18, 2012 11:58 PM UTC

FORTUNE -- There ought to be a rule in private equity: Executives at one firm cannot invest in funds managed by another, rival firm.

Common sense, right? For example, let's imagine that several top Bain Capital executives were invested in funds managed by The Blackstone Group (bx). And then imagine the two firms were competing over the same deal. Does it reduce the Bain executives' incentive to win the deal, if they have a personal consolation prize? And, if so, how does that square with the interests of Bain's limited partners? At best there is an conceivable conflict of interest, and at worst there is an actual one.

Actually, don't bother imagining. Check out this line from a lawsuit that accuses 11 private equity firms of conspiracy and bid-rigging:

Even Bain's senior executives, because they were also limited partners of Blackstone, were given the opportunity to co-invest in Freescale.

To be clear, I think the suit's broad conspiracy claims are unfounded. But this sort of arrangement is troubling and, from speaking to private equity sources, quite common. In other words, this goes way beyond Bain and Blackstone.

The standard defense is that PE executives have far more money invested in their own funds than they do in those managed by others, so there is no conflict. Moreover, these third-party commitments are extremely small compared to a PE executive's overall net worth.

Those excuses may be how private equity executives justify such behavior to themselves, but it doesn't work for me. If the commitments are so small, so insignificant, why make them in the first place? Do they also walk around the neighborhood on trash pickup day, looking for aluminum cans?

To me, it seems to be about sleeping better at night. It hurts to lose, and this is a way to mentally minimize the sting. But if I'm a limited partner, I don't want any salve on that wound. I want it fresh and raw, so that my fund manager wins the deal next time out. And maybe it's time for limited partners to begin demanding such 100% attention when negotiating their next fund agreements...

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