This morning a “must read” Pulse email caught my eye before my finger could enter the “default mode” and hit the delete key on my phone. The word science, spotted in the title, won my curiosity, sneaking in through my Galilean inclination. I am not sure I’ll buy the book that the piece promotes but I am happy I read it. My take-away was learning about the “Hawthorne Effect”, a concept that I thought applies to the dynamics of the alternative investments and private equity industries.
In its more common interpretation, the Hawthorne Effect (also known as the observer effect) refers to a phenomenon whereby individuals improve or modify an aspect of their behavior in response to their awareness of being observed.
Alternative investments practices, in particular with regards to fees and net performance, are increasingly questioned. Calpers’ decision to dump its hedge funds portfolio cites cost, among other reasons. At the same time, the SEC is probing private equity performance figures and investigating other fee charges.
It is not difficult to draw a parallel between the Hawthorne experiment and the current context of increased “observation” concerning the alternative investments industry, to speculate about the results that it may bring about.
In Hawthorne experiment’s terms, Calpers’ decision may yield beneficial improvements, not directly to them because of the divesture, but possibly at industry level allowing rebalanced negotiation powers. Fellow institutional investors may now be able to use Calpers’ pull-out threat and try and negotiate down fees, ultimately inducing an immediate and certain improvement in net performance. In addition, Calpers’ decision breaks the paradigm of being “in for the long term” implying that also “exclusive access” asset classes have to compete for capital on the ground of relative value.
Similar observer effects may benefit investors in the private equity industry, with the U.S. Securities and Exchange Commission boosting its scrutiny of performance calculation practices. By addressing performance transparency matters, the regulator seems to be creating conditions for investors to move away from a “fideistic” approach to private equity and allocating capital more scientifically.
More rational flows of capital driven by more transparent secondary prices, a marked to market counterbalance to fair value expectations, should accompany the industry through its next phase of growth.
Questioning fees and performance figures, negotiating for a more balanced principal-agent relation does not necessarily mean denying the potential of alternative investments in a well-diversified portfolio. But it is up to investors to perpetuate Hawthorne effects observing, measuring and deciding whether to stay in or to leave an asset class based on own expectations and objectives, not because “they’ll not let me in next time”.
Because, the Hawthorne experiment shows, improvements end if observations cease.
The DARC Room 
Excellent–thanks, Massimiliano. There’s a ton of evidence that transparency (along with liquidity and strong governance) helps prevent investment managers from making poor investments and wasting their investors’ capital. That’s the Hawthorne Effect in practice.
Excellent–thanks, Massimiliano. There’s a ton of evidence that transparency (along with liquidity and strong governance) helps prevent investment managers from wasting investors’ capital by making poor investment decisions. That’s the Hawthorne Effect in practice.