So You Think You Can Dance? Lessonsfrom the US Private Equity Bubble

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Citation Turco, Catherine, and Ezra Zuckerman. “So You Think You CanDance? Lessons from the US Private Equity Bubble.” SocScience 1(2014): 81–101.

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So You Think You Can Dance? Lessons from the U.S. PrivateEquity BubbleCatherine J. Turco, Ezra W. ZuckermanMassachusetts Institute of Technology

Abstract: This article develops a sociologically informed approach to market bubbles by integrating insights fromfinancial-economic theory with the concepts of voice and dissimulation from other cases of distorted valuation studiedby sociologists (e.g., witch hunts, unpopular norms, and support for authoritarian regimes). It draws on unique data—longitudinal interviews with private equity market participants during and after that market’s mid-2000s bubble—to testkey implications of two existing theories of bubbles and to move beyond both. In doing so, the article suggests a crucialrevision to the behavioral finance agenda, wherein bubbles may pertain less to the cognitive errors individuals make whenestimating asset values and more to the sociological and institutionally driven challenge of how to interpret complexsocial and competitive environments.

Keywords: financial markets; bubbles; valuation; private equityEditor(s): Jesper Sørensen, Olav Sorenson; Received: September 16, 2013; Accepted: October 27, 2013; Published: March 24, 2014

Citation: Turco, Catherine J., and Ezra W. Zuckerman. 2014. “So You Think You Can Dance? Lessons from the U.S. Private Equity Bubble.” SociologicalScience 1: 81-101. DOI: 10.15195/v1.a7

Copyright: c© 2014 Turco and Zuckerman. This open-access article has been published and distributed under a Creative Commons Attribution License,which allows unrestricted use, distribution and reproduction, in any form, as long as the original author and source have been credited.

Avexing question for both social scientists andpolicy makers is why public valuations (the

majority’s publicly enacted preferences) often be-come wildly disjointed from objective conditions.Well-known examples include moral panics likewitch hunts, in which fantastical beliefs are widelyendorsed; the cult of personality in authoritar-ian regimes, where millions of people proclaimallegiance to a cruel leader or bankrupt ideology;norms that are broadly enforced despite question-able social value; and financial market bubbles,when prices greatly exceed valuations justified bythe economic fundamentals.

A common account of such episodes is thatpeople have succumbed to mass hysteria or delu-sion. However, sociological and political sciencestudies highlight mechanisms of exit and voice(Hirschman 1970). That is, support for author-itarian regimes often depends less on citizens’delusion about how the regime governs and moreon restrictions on speech and assembly that si-lence their dissent, and on social pressure thatmotivates them to dissimulate (publicly feign al-legiance) (Wedeen 1999). Similar logic holds inless extreme cases like moral panics and ques-tionable norms (Centola, Willer, and Macy 2005).There, actors may be highly committed to a par-

ticular community, thus limiting their use of exit,and voicing dissent may be socially risky, even ifformally permissible.

From this perspective, though, financial mar-ket bubbles are hard to explain. After all, finan-cial markets are defined by vehicles for exit andvoice, with such vehicles eliminating distortionsin prevailing public valuations (prices). Considerthe stock market. If investors believe stocks areoverpriced, they can exit by selling their shares,thus lowering prices. Also, investors can publiclyquestion the inflated prices with no attendantsocial risk, both informally and through variousforms of arbitrage. Because such arbitrage gen-erates high returns when skeptical investors areright, significant gaps between price and valueshould never endure. Accordingly, the orthodoxfinancial-economic view of bubbles—as summa-rized in the efficient market hypothesis (EMH)—argues that the mechanisms supporting exit andvoice in markets are so powerful, and the incen-tives for using them so high, that bubbles areeffectively impossible (Garber 2000).

Yet bubbles do occur. Examples include Dutchtulips in the 1630s, shares of the South Sea Com-pany in 1720, the U.S. stock market of the 1920s,Internet stocks in the late 1990s, U.S. housing

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in the 2000s, and the subject of this article—the mid-2000s U.S. private equity bubble, whenasset prices rose far above historic levels. Echo-ing accounts of other distorted public valuations,heterodox scholars have adopted one of two ap-proaches when explaining these phenomena.

Collective DelusionThe most prominent heterodox approach assumesthat bubbles inflate when a majority of investorsbecome collectively deluded about asset values.1By some accounts, investors are driven to un-reasonable estimates of value when they con-vince themselves that “this time is different”—that inflated prices make sense because of fun-damental economic changes invalidating “the oldrules of financial valuation” (Reinhart and Rogoff2009:xxxiv). Some argue that inflated valuationsare especially likely when investors can obtaincapital (in particular credit) cheaply because in-vestors often ignore the cost of financing whenestimating asset values (Minsky 1975, 1992). Ingeneral, behavioral economists focus on cognitivebiases that lead investors to make mathemati-cal errors or factual mistakes when estimatingasset values (Lamont and Thaler 2003; Rashes2001), whereas sociologists emphasize investors’reliance on flawed theories of value that renderthem oblivious to major mispricings (MacKenzie2011; Zuckerman and Rao 2004). Yet whetherascribed to “animal spirits” (Akerlof and Shiller2009), “euphoria” (Kindelberger [1978] 2005:13),a “fieldwide delusion” (Fligstein and Goldstein2010:34), or a “miasma of irrationality” (Pozner,Stimmler, and Hirsch 2010:5), all such accountssuggest that bubbles are driven by widespreaddelusion about asset values.

Institutionalist PerspectiveIn contrast, a second approach suggests that bub-bles can form without widespread delusion. In-vestors may recognize a mispricing, but institu-tional conditions prevent them from voicing dis-sent and correcting the distortion. Two variantsof this perspective propose two distinct strate-

1 By “majority of investors,” we mean the majority ofcapital in the market.

gies that dissenting investors adopt and that fuelbubbles.

Silenced Voice through RationalSittingDuring a bubble, short selling is the key way skep-tical investors can dissent from prevailing publicvaluations and correct market distortions. It isthe market equivalent of standing in the commonsquare and proclaiming that the authoritarianregime is bankrupt or the witch hunt overblown.Specifically, it involves an investor borrowing asecurity the investor thinks is overpriced andselling it at that inflated price, then buying itback later after the price has fallen to repay theoriginal owner and keep the profit. When ortho-dox theory assumes that bubbles are impossiblebecause price–value distortions are immediatelyeliminated, it explicitly assumes this sort of arbi-trage is unrestricted and riskless.

In reality, short sellers risk massive losses ifprices continue to rise before correcting (De Longet al. 1990a; Shleifer and Vishny 1997). Riskaside, short selling opportunities are often quitelimited too. For example, the small float of In-ternet stocks prevented dissenters from shortingthe 1990s bubble (Ofek and Richardson 2003),and before 2006, there were no institutional vehi-cles whatsoever for shorting the U.S. real estatemarket (Gorton 2008; Zuckerman 2009).

Accordingly, rational sitting models observethat when prices rise, skeptical investors whowould otherwise short sell are often unwilling to(because of risk) or unable to (because of marketconditions), and so instead they sit on the side-lines (Miller 1977; Zuckerman 2012b). This cedesthe market to more optimistic investors, and bub-bles can inflate unchallenged. A key implication—and one that distinguishes this perspective fromcollective delusion accounts—is that significantprivate dissent can be contemporaneous with abubble: bubbles may be driven not by a deludedmajority but by a deluded minority and silencedmajority.

Dissimulation through OptimalDancingSharing this expectation of widespread dissent,

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dancing models suggest that dissenters them-selves may fuel a bubble by participating in—notsitting out of—the inflated market (Harrison andKreps 1978). The logic comes originally fromKeynes’s ([1936] 1960) observation that in liquidmarkets—where investors can move in and outof positions quickly and without affecting prices—paying inflated prices may be rational if investorsexpect to resell at even higher prices. This strat-egy is the market equivalent of dissimulation inother cases of distorted valuation: investors’ be-havior suggests they endorse the public valuation,yet they privately dissent from it.

Investors often call such dissimulation “danc-ing until the music stops,” and we label this setof related theories optimal dancing models be-cause they portray dancing as an optimal strategy,where dancers profit from their speculation, exit-ing the market just before it crashes (e.g., Abreuand Brunnermeier 2003; Brunnermeier and Nagel2004; De Long et al. 1990b; Temin and Voth2004).

Crucially, though, dancing is only predictedin liquid markets. Keynes ([1936] 1960:149–54)and all modern optimal dancing models assumethis necessary condition, for without a high levelof liquidity, dancers run the risk of holding over-priced assets when the “music stops,” and this riskoutweighs the potential benefits of riding the bub-ble. In illiquid markets, optimal dancing modelsreduce to rational sitting models: investors whosee that the market is in a bubble are expectedto withdraw.

Agenda: Testing andDeveloping Heterodox TheoryThis article begins by testing key implications ofthe heterodox approaches reviewed earlier againstunique data—longitudinal interviews with pri-vate equity (PE) participants during and afterthat market’s mid-2000s bubble. First, we testcompeting predictions about investor sentimentduring the PE bubble. The collective delusionperspective expects optimistic investors to pre-dominate, whereas the institutionalist approachexpects significant private dissent. This test isimportant because even though the institutional-

ist perspective seems compelling, it has receivedlittle direct empirical validation. In fact, we findevidence of widespread investor recognition dur-ing the PE bubble that asset prices far exceededany reasonable estimate of fundamental value,and this constitutes the first direct evidence thata bubble can persist despite significant privatedissent from prevailing prices. While collectivedelusion about value may drive other bubbles,this test strongly suggests that bubbles do notdepend on such delusion.

Second, we test institutionalist theories’ com-mon prediction about investor behavior in illiq-uid markets. Both rational sitting and optimaldancing models assume that investors who aresophisticated about value (who know prices areinflated) are also sophisticated in reading themarket environment so as to know whether to sitor to dance—and, if they dance, that they knowhow to time their exit before a crash. There isno precedent, then, for our finding that in theilliquid PE market, most dissenters danced. Post-bubble evidence we present indicates this was aflawed investment strategy and the reason thePE bubble inflated to such heights.

These findings lay the groundwork for a pro-posed theoretical revision. We argue that bub-bles can inflate even when there is no collectivedelusion about value but, instead, when there iscollective error in the investment strategies pur-sued. Such errors are unanticipated by existingtheory, and we draw on in-depth qualitative datafrom the PE market to probe their nature. Thedata reveal how misperceptions about marketliquidity and peers’ strategies can make dancingseem viable even when it is not, and our analysismoves beyond institutional restrictions on voiceto identify the crucial importance of institutionalrestrictions on market visibility as well.

Taken together, this article’s findings suggestthat the errors fueling bubbles may pertain less tothe cognitive and behavioral challenges of ascer-taining asset values and more to the sociologicaland institutionally driven challenge of how tointerpret one’s social and competitive landscape.This calls for a revision to the current behav-ioral finance agenda and offers a sociologicallyinformed path forward for research on financialmarkets.

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The Private Equity MarketThere are approximately 600 PE firms in theUnited States.2 Together they possess more than$1 trillion in capital and own and control compa-nies that employ more than 8 million Americanworkers.3 Although the few largest firms employ100 or more investors, most have staffs of 20 orfewer.

PE firms purchase companies with the goalof reselling them at a profit. Purchases are struc-tured as leveraged buyouts (LBOs), meaning theyare financed using not only equity but also debtraised from third-party lenders (e.g., commercialor investment banks).4 The debt is secured bythe assets of the acquired company. The equity isdrawn from PE funds—10-year limited partner-ships for which the PE firm serves as general part-ner and its capital providers serve as limited part-ners (LPs). LPs are generally large institutions,including public and corporate pension funds,university and foundation endowments, and in-surance companies.When a PE firm raises a fund,LPs commit a set amount of capital. The PEfirm is then responsible for investing the fund’scapital. As it finds companies to purchase overthe ensuing years, it calls down LPs’ capital com-mitments to finance the purchases. Upon sellinga company, the PE firm returns to LPs the orig-inal capital plus 80 percent of any profit, andretains 20 percent (called carried interest).

When evaluating prospective investments, PEinvestors engage in months-long due diligence tovalue a target company. Two common methodsof valuation are (1) a discounted cash flow analy-sis, whereby a company is worth its future cashflows discounted by time and risk, and (2) theapplication of historical, industry-specific pur-

2Unless otherwise specified, quantitative data on thePE market concern U.S., leveraged-buyout-focused PEfirms and were obtained from Pitchbook, a commercialdata set focused on this market. Complete, reliabledata on the PE market are notoriously difficult to ob-tain (Stucke 2011), but comparison of alternative datasources (based on Harris, Jenkinson, and Kaplan [2011])suggested that Pitchbook offered at least as completedata as alternative sources. We extensively cross-checkedPitchbook’s data against other sources.

3 Employment data from Private EquityGrowth Council website, accessed May 7, 2012:http://www.pegcc.org/education/pe-by-the-numbers/.

4 This section draws from Kaplan and Stromberg(2009:123–30) and Tuck (2003); also industry reports,trade press, and our extensive interviews.

chase multiples to a company’s recent operatingprofit, whereby a dollar of operating profit isworth the same across time and within industry.PE prices typically reflect multiples of earningsbefore interest, tax, depreciation, and amortiza-tion (EBITDA)—that is, the price, or purchasemultiple, for the investment is the total capitalused to purchase the company (in equity anddebt) divided by the company’s operating cashflow.

The Mid-2000s Bubble

The earliest PE firms were founded in the late1960s and 1970s, and the market experiencedits first bubble in the 1980s. From $1 billionin transactions in 1980, the market soared tomore than $60 billion in transactions by 1988,then crashed, contracting to $4 billion by 1990(Kaplan and Stein 1993). During the 1990s andearly 2000s, the industry retrenched, then grewslowly. In the mid-2000s, an even larger bubbleemerged.

Figure 1 shows the total value of all U.S. LBOdeals from 1990 to 2012. Between 2005 and 2007,PE firms invested approximately $960 billion,far more than they had invested over the entireprevious decade. This run-up was characterizedby an unprecedented number and size of LBOs.The median LBO deal averaged $51 million inthe 10 years prior to 2005 but grew to $59 millionin 2005 and $100 million by the bubble’s 2007peak. Importantly, these larger deals reflectedthe fact that PE investors were paying higherprices for the same fundamentals than they hadhistorically. For the 5 and 10 years prior to 2005,median purchase multiples in PE averaged 6.6times EBITDA, but they rose considerably duringthe bubble, reaching a record high of 11.4 timesEBITDA in Q4 2007 and Q1 2008.

With the broader economic collapse in 2008and 2009, the PE bubble popped and the marketcrashed. By 2009, the industry had returned toits early-2000s size, with only $58 billion in LBOs,a median deal size of $40 million, and medianpurchase multiples of 5.9 times EBITDA. Sincethe depths of the downturn, multiples and dealactivity have increased somewhat, but the PEmarket remains far below its 2007 peak. Todaythere is widespread consensus among analysts and

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Figure 1: Aggregate LBO Deal Value by Year

market participants that this period constituteda bubble of historic proportions.5

Both to understand how this happened andto develop more robust general theory, we testexisting theories of bubbles against evidence fromPE. Several conditions make this an ideal settingto pursue this agenda.

Conditions Suggesting WidespreadDelusionCollective delusion is a plausible explanation forthis bubble given capital market dynamics at thetime. Just as the first PE bubble occurred duringthe 1980s’ junk bond craze, this one occurredduring an unprecedented surge in the credit mar-kets. In the early 2000s, lenders began syndi-cating a portion of LBO debt, packaging it intocollateralized loan obligations to trade in the sec-ondary market. This shifted originating lenders’incentives and encouraged more aggressive lend-ing practices, meaning PE investors could ac-cess more debt at cheaper rates than ever before(Acharya, Franks, and Servaes 2007). Concur-rently, equity capital from LPs also spiked (Figure2).

Orthodox theory would argue that price in-creases merely reflected these exogenous changes

5 In our interviews in 2010 and 2011, PE investorsunanimously reported that the mid-2000s had been amassive bubble. Numerous industry reports and pressarticles discuss the unprecedented run-up in PE duringthose years (e.g., Pitchbook Data Inc. 2011).

in the cost of capital. However, the qualitativedata we present later cannot be reconciled withthis. For now, it is sufficient to note that suchan account is inconsistent with the fact that mid-2000s PE investments have performed consider-ably worse than those of other times: estimatedaverage returns for PE funds raised during thebubble are 52 percent of the historical average.6

In fact, over the industry’s history, priceshave risen and returns have suffered during pe-riods of cheap and abundant capital, suggest-ing bubbles are particularly likely at just thesemoments (Kaplan and Stein 1993; Kaplan andSchoar 2005; Axelson, Jenkinson, and Strömberg2013; Robinson and Sensoy 2011a). The surgingcapital markets, combined with poor investmentreturns, specifically suggest PE may have experi-enced the sort of capital-fueled collective delusionbubble Kindelberger (1978) described—that is,perhaps PE investors unwittingly paid inflated

6At the time of this writing, current Pitchbook esti-mates of the median internal rate of return (IRR) for PEfunds raised from 2005 to 2007 average 8.37 percent, com-pared to 16.07 percent for funds raised from 1980 to 2004.This may overstate returns during the bubble becauseIRR calculations for those years are based, in part, on PEinvestors’ own estimates of as-yet unrealized returns (i.e.,companies bought during the bubble but not yet resold).A method of calculating PE returns that avoids this issueis the “realization multiple,” that is, the capital actuallyreturned from investments thus far divided by the totalinitial capital invested. For funds raised from 1994 to2004, the median realization multiple five years after afund was raised averaged 0.56; for funds raised in 2005 to2007, it is 0.23.

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Figure 2: Limited Partner Capital Commitments to Private Equity

prices because abundant debt and equity blindedthem to the actual cost of this capital.

A contemporaneous market development mayhave reinforced such value delusion. Historically,PE firms found LBO targets through proprietarynetworks. By the 2000s, however, target compa-nies were increasingly retaining investment banksto run formalized auctions in which PE firmsbid against one another. Auctions often induceparticipants to overpay (Thaler 1988), and be-cause investment banks receive a percentage ofthe winning bid, they have an incentive to elicitthe highest valuations possible regardless of fun-damentals (cf. Ho 2009; Perrow 2010).

Conditions Suggesting WidespreadDissentBut could a majority of PE investors really havebeen so deluded about asset values? While theuntrained “noise” traders driving many collec-tive delusion stories may fall prey to behavioralbiases and collective euphoria (see Akerlof andShiller 2009; Barberis and Thaler 2005; Black1986), PE is composed entirely of the type ofinvestors and incentives thought to rationalizemarkets. Specifically, both PE firms and theirLPs are sophisticated institutional investors, andthe market has been explicitly structured to mo-tivate PE investors to overcome behavioral biasesand value target assets accurately (Jensen 1989).

For example, PE investors are required toco-invest alongside LPs, with at least 1 percentof any PE fund’s capital coming from its ownpersonal capital (Kaplan and Strömberg 2009).They also share in their investments’ long-termprofits through the 20 percent carried interest.This carried interest is itself typically contingenton factors that further motivate them to pay fairprices in pursuit of long-term returns—for ex-ample, LPs are often guaranteed a “hurdle rate,”meaning PE investors receive no carried interestuntil LPs reach a preset return on their capital;and PE firms face “clawback” provisions allowingLPs to recall carried interest from earlier dealsif later investments perform poorly (Metrick andYasuda 2010). Given this set of incentives, insti-tutionalist theories that explain bubbles in theabsence of widespread value delusion seem likepromising candidates for explaining the PE bub-ble.

Conditions Leading to TestablePredictionsThough compelling, institutionalist theories havereceived little direct empirical testing or valida-tion, and collective delusion theories remain themost prominent account of bubbles. Two condi-tions, however, make PE ideal for testing institu-tionalist predictions.

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Short selling constraints. Testing institution-alist theories requires a market with short sellingconstraints, the mechanism assumed to silenceeven widespread dissent. PE certainly meets thiscondition: short selling is not just limited be-cause of costliness or riskiness (as it is, say, in thepublic stock market) but rather it is outright im-possible here. The assets being traded are privatecompanies, so there are no freely traded securi-ties to short. Moreover, the entire investmentthesis is to go “long,” not short, and LPs contrac-tually bind PE firms to limit their investmentactivities to LBO-like transactions. The strictmandate is to use LP capital to purchase compa-nies, increase their value by driving operationaland strategic improvements, then resell them at ahigher price. Finally, just as PE investors cannotshort the market, neither can industry outsidersshort the equity of privately owned companies.7Because few PE firms are publicly traded andonly a portion of their capital comes from thepublic market, there are insufficient freely tradedshares for outsiders to exercise an effective shortselling strategy.

The complete absence of short selling meanswe can test theoretical predictions about investorsentiment during the PE bubble: institutionalisttheories predict considerable silent dissent on ac-count of the restrictions on voice, whereas collec-tive delusion theories expect widespread delusion.

Market illiquidity. Because PE is a highlyilliquid market, we can also test institutional-ist predictions about investor behavior duringthe bubble. Entire companies—not shares onan exchange—are bought and sold in this mar-ket. PE firms hold investments for an averageof six years (Kaplan and Strömberg 2009), and,when they finally do exit an investment, theymust sell the company to another company orPE firm or via public offering on the stock market.These exits—like the initial LBO itself—are long,complex transactions that take months and some-times years to complete given financial, legal, andregulatory issues. This, and the industry’s long

7 Some hedge funds have considered shorting the debtof PE-owned companies by buying credit default swapprotection on public companies that PE firms could con-ceivably take private in the future (ZeroHedge 2010). Thisis highly indirect, and public company LBOs are a frac-tion of all PE investments, so such trades have minimalimpact.

holding periods, mean investors cannot expect tosell assets readily, any time they wish.

Consequently, we should not expect PE in-vestors to adopt a speculative orientation whereinthey determine what price to pay today basedon where they expect prices to move in the shortterm. Because they cannot liquidate holdingsquickly, PE investors should be willing to payonly what they estimate the asset’s intrinsic valueto be. In short, given PE’s illiquidity, institution-alist theories carry a clear common prediction inthis market: dissenters should sit out of a bubble,not dance.

This hypothesis is compelling, but given thebubble and market conditions just described,there is reason to doubt it will be supported in PE.If PE investors are sophisticated and motivatedto recognize when prices have risen above funda-mental value, and if illiquidity makes dancing apoor strategy, then we should never see bubblesin this market. Yet PE experienced a massivebubble in the mid-2000s. This implies the marketwas dominated by one or two kinds of investorsnot easily reconciled with existing institutionalisttheory and intuition: (1) those who are actuallydeluded into overestimating value despite theirsophistication and incentives and/or (2) thosewho recognize that prices are inflated, yet opt todance even though it is a poor strategy. Giventhis, we will not only test the predictions of col-lective delusion and institutionalist accounts forPE but also use our data on investor sentimentand strategies to move beyond these existing ac-counts.

MethodsThis agenda necessitates capturing investors’ pri-vate beliefs about value during a bubble as wellas their investment strategies. Our data andmethods—interviews with PE market partici-pants (N=82) in 2005 and re-interviews withthose same participants in 2010 and 2011—areuniquely suited to obtaining such evidence.

The 2005 Sample: Capturing MarketSentiment in a Rising BubbleIn 2005, the lead author conducted 43 interviewsin the PE industry as part of a larger multi-year

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study on the nature and structure of PE investing.The author entered the industry with no previousawareness of—nor intent to study—a PE bubble,and no interview questions asked directly aboutthe issue. Rather, the interviews included severalopen-ended questions, such as, “Is there anythingelse I need to know about the current PE mar-ket as I begin to study it?” and “Are there anyrecent trends in the industry I should be awareof?” In response to these and other questions,respondents routinely volunteered their personalopinions on valuation levels in the current mar-ket. These responses reveal market participants’beliefs about public valuations, but, crucially,without priming the idea of a bubble.

PE firms were randomly selected from a strat-ified sampling frame. First, the author compileda comprehensive list of all PE firms. Because in-dustry participants and observers regularly iden-tify three distinct market segments—PE firmswith small funds (several hundred million dollarsor less), medium funds (several hundred millionto a few billion dollars), and large funds (multi-billion-dollar funds, the largest of which are calledmega-funds)—and because the dozen or so largestfirms represent a sizable portion of all capital inthe market, it was important to stratify the listof firms by size to gain a representative sampleof both perspectives and capital in the market.PE firms were then randomly selected from eachstratum.8

Interviews with PE investors (N=21 individ-uals; N=18 firms)9 were then used to build atheoretical sample of other key PE market par-ticipants, including LPs (N=6) that invest innumerous PE firms; major investment banks(N=7) that interact with hundreds of PE firmsas lenders, advisors, and auctioneers; consultants(N=6) who advise PE firms on due diligence;and trade journalists (N=3) who cover the en-tire industry. Given the industry’s reputation forintense secrecy, the author initially relied on keyinformants and personal contacts to gain accessto the randomly selected PE firms and other mar-ket participants. However, response rates proved

8 The first author also interviewed two non-randomlyselected firms, where personal contacts enabled deep ac-cess and early background discussions.

9 Because the author conducted interviews with severalinvestors at each of the non-randomly selected firms, theNs for firms and PE investors differ slightly.

high (90 percent overall) regardless of method ofaccess.

Re-interviews in 2010 and 2011: Iden-tifying Investment Strategies duringa BubbleFollowing the crash, we re-interviewed the orig-inal sample, asking directly about respondents’views of the mid-2000s market (which could becompared to their earlier statements) and abouttheir firms’ specific investment strategies duringthose years. We later used a range of sources (in-dustry reports, coverage of PE investments in thetrade press, firms’ own press releases during thebubble) to validate these self-reported investmentstrategies.

The second wave contains 31 re-interviews (72percent re-interview rate), where we interviewedeither the original respondent from 2005 or some-one from the original firm. During re-interviews,respondents consistently identified several PEfirms and LPs known for particularly good orbad performance during the bubble as well as aconsulting firm that actively advised firms dur-ing the bubble. Because these institutions couldoffer useful analytical traction and insight intodynamics during the bubble, we added them tothe sample.

In total, the 2010 and 2011 sample contains 39interviews. A supervised research assistant con-ducted the majority; the lead author conductedthe remainder. Table 1 presents each wave’s sam-ple structure.

Test 1: 2005 Market Sentiment–Collective Delusion or Unvoic-ed Dissent?

Our first result is straightforward. Despite factorsin the capital markets and auctions that couldhave fed delusion, during the bubble, there wassignificant investor dissent from market prices,not widespread delusion that these prices re-flected assets’ true value.

In 2005, 16 of 18 (89 percent) PE investors inour sample reported that the market was cur-rently in a bubble with prices inflated above

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Table 1: Qualitative Sample

2005 2010 2010Interviews Reinterviews New

Private Equity InvestorsaLarge (>$2bn) 8 6 4Medium ($500m−$2bn) 7 5 −Small (<$500m) 6 4 −

Total 21 15 4

Limited partners 6 4 3Investment bankers 7 6 −Consultants to industry 6 5 1Journalists 3 1 −

Total interviews (N=82) 43 31 8a Because of multiple interviews at several firms, N=18 distinct PE firms in 2005.

fundamental values.10 Reports were consistentacross all market segments. A PE investor froma small firm commented, “The fundamental frus-tration within PE these days is the prices. . . Ifyou’re buying a $12 million EBITDA business,historically you’d have to pay 6 to 7 times forit. . . [Now] people are willing to pay 8 to 9 timesfor that business. Valuations are getting crazy. . .We are seeing businesses we know a lot about gofor stupid prices.” Another small-firm investorechoed this, saying, “Today’s prices are outra-geous,” and “It’s just crazy in terms of valuationsnow.” A mega-fund investor spoke of inflatedprices, then observed, “There are a lot of dumbdeals being done.”

Consistent with their sense of a market bub-ble, such investors predicted a crash. An investorfrom a medium-sized firm insisted, “It’s a cycle. . .There will be a correction.” He elaborated, “PEfirms are paying more for equivalent deals thanthey did in the past,” and, consequently, “pri-vate equity will blow up. You don’t have towrite about it. It will happen.” Another warned,“Things have been going up for a while. They

10 Using Kindelberger’s several definitions of a bubble,we coded respondents as dissenters (those who recognizedthe market’s mispricing) when they used the term “bub-ble” to describe the current market, reported that priceswere in excess of asset values (apart from changes in thefinancing environment), and/or said current prices wereunsustainably high and going to “correct” or “crash” inthe future. We used the 2010 and 2011 re-interviews tovalidate coding of 2005 data where possible.

will come down at some point too. . . There willbe some spectacular failures.”

In the full 2005 sample, 27 of 40 (68 per-cent) respondents reported that PE was in abubble. Four of six LPs expressed skepticismabout current prices. The manager of a univer-sity endowment was definitive that the marketwas in a bubble, drawing analogies between thecurrent LBO market and previous bubbles else-where: “It’s not unlike the venture [capital] worldin the late-90s. People see that the venture guyswere nowhere near as clever as they thought theywere. Same thing is going on in the buyout worldtoday.” LPs do not directly evaluate the compa-nies being purchased, however, and perhaps as aresult, three expressed uncertainty about whatthese high prices meant exactly, puzzling whetherprices were high because of an asset bubble orbecause of structural change in the industry.

Trade journalists and industry advisors work-ing directly in the market (e.g., helping PE firmsevaluate target companies) were considerablymore adamant. Like most PE investors, theybelieved prices were inflated: two of three jour-nalists, five of seven investment bankers, andthree of six consultants in our sample reportedthat the market was clearly in a bubble. In 2005,one banker observed, “PE firms are overpayingnow. . . To close a deal, they pay the extra multi-ple.”

Like the skeptical PE investors, these advi-sors predicted a crash. Explaining that he was

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“suspect of the market,” a consultant warned, “Atsome point, the market will have a correction.”Another said, “We worry about what happenswhen the music stops.” Note that trade journal-ists cover hundreds of firms and cultivate sourcesacross the entire industry, and any one invest-ment bank or consulting firm works with numer-ous PE firms. So, the fact that these respondentsbelieved public valuations were inflated furthervalidates that skepticism was prevalent across theentire market, not just our sample. Furthermore,as early as 2005 and continuing throughout thebubble, there was public speculation about theexistence of a PE bubble both in the nationalnews and trade press as well as among industryleaders at major PE conferences (e.g., Primack2005; Dixon 2007).

The foregoing evidence constitutes the firstcontribution of our article. Across all categoriesof respondents, there was widespread dissent fromprevailing public valuations in 2005. Commentsthat prices were “crazy,” “outrageous,” “stupid,”and bound to “crash” cannot be reconciled withan orthodox account, which assumes prices accu-rately reflect value conditional on the financingenvironment; nor can they be explained by a col-lective delusion account. Instead, they representthe first, direct evidence in support of the keyprediction of institutionalist accounts that mar-kets with restricted short selling can experiencebubbles despite widespread recognition of themarket’s mispricing.

Test 2: 2005 to 2007 DissenterBehavior–Rational Sitting orOptimal Dancing?

But what did these dissenters (investors who be-lieved current prices were inflated) do during theensuing bubble years? As noted, existing institu-tionalist theories predict that, in markets wherethere are limits to arbitrage, the degree of liq-uidity in the market determines how dissentersbehave. When markets are liquid, the optimalstrategy is often to dance, buying assets at to-day’s inflated prices to resell at higher prices priorto the market’s correction (Abreu and Brunner-meier 2003). However, when markets are illiquid,

as in PE, such investors should sit out until pricescorrect (Miller 1977).

Our data are surprising, then. While 4 of the16 PE investors who recognized the bubble in2005 curtailed investment activity over the nextfew years, the majority—9 of 16—participatedactively in the inflating market.11 Three of thefirms added in 2010 did the same. These investorspurchased more companies, at a faster pace andin larger transactions than ever, paying pricesthey knew to be in excess of the companies’ un-derlying values. We classify these investors as“dancers” because, as in optimal dancing models(e.g., Abreu and Brunnermeier 2003), they spokein terms of Keynesian speculation, that is, payinghigh prices today with the intention of selling ateven higher prices tomorrow. An investor whosefirm danced during the bubble explained, “We’dproject out the price that we felt we could getwhen we sold the business, and we felt we werebasing this [the price they paid] on appropriateassumptions of sales prices.”

Such behavior was not just limited to our sam-ple. The prevalence of dancing across PE actu-ally inspired what has become the most infamousquote of the broader financial market excessesof that time. In 2007, Chuck Prince, CEO ofCitibank (a lender in many PE deals), told hisemployees that so long as PE investors wantedto keep dancing—as they were widely believed tobe doing—then Citibank should keep providingthem with debt to finance their deals: “Whenthe music stops in terms of liquidity, things willget complicated. But as long as the music isplaying, you’ve got to get up and dance. We’restill dancing.” Moreover, given the prevalence ofskepticism about price levels both in our sampleand in the broader PE market dialogue of thetime, the sheer volume of PE investment activ-ity in 2005 to 2007 implies considerable dancing(Figure 1).

Our 2005 interviews reveal specific examplesof investor dancing at the time, offering directevidence of this strategy. For instance, the in-vestor who called prices “outrageous” and “crazy”explained in the same interview that his firm was

11 Given data limitations, we were unable to classifythree firms in our 2005 sample as either a sitter or adancer. Even if all three had sat out (which anecdotalevidence suggests is not the case), dancing still wouldhave been the majority strategy in our 2005 sample.

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nevertheless highly focused on “closing deals” (inthe homebuilding product sector, one of the mostoverpriced). Other investors who said prices wereinflated spoke similarly about being highly “pre-occupied” (in the words of one) with finding evermore investments to make in the current market.

Post-crash interviews provide further evidenceof dancing and additional insight into the strat-egy. Dancers admitted knowingly paying highprices that were unjustified by the underlyingfundamentals. An investor whose firm dancedarticulated the logic, “We knew we were payingprices above average for historical LBOs. . . Webelieved ‘we can justify paying x times [EBITDA]because we’ll get x plus times on the way out.” ’Across all market segments, dancers made similaradmissions:

We all recognized that we were get-ting to a point where—let’s just sayto an unsustainable pace. . . [But] wewere active. . . We made a lot of in-vestments then. It’s absolutely notthe case that we said, “Let’s stay outof market.” (PE investor, mega firm)

We were fully aware we were in abubble. . . We did some deals at thepeak. (PE investor, medium firm)

There was a collective belief thatthings were at relatively highprices. . . The idea that people didn’tknow there was a bubble didn’texist. People knew these were frothytimes. . . We definitely overpaid forthe [deals] we did then. (PE investor,small firm)

A trade journalist who had identified thebubble in his 2005 interview reflected back in2011, “PE had a bubble. Prices were risingunsustainably. . . I thought for the most partthey [PE investors] agreed with me intellectu-ally [that prices were inflated] but ultimately itdidn’t change their behavior.” That it didn’t—that many investors continued to invest despiterealizing the market was overpriced—leaves uswith a puzzle. Although we observe that dancingoccurred and fueled the PE bubble, and although

this finding is consistent with the sociologicaland political science literature that says “dissim-ulation” can drive distorted valuations (Wedeen1999), such behavior occurred in the absence ofthe key condition existing institutionalist theoryassumes is necessary for observing it: liquidity.As one PE investor remarked, “We are not publicmarket investors who can get in and out of themarket by picking up the phone to a broker whenwe see things start to turn. We’re dealing withsizable companies, transformative transactionsthat take weeks and months and sometimes yearsto line up.” Given this, theory tells us that danc-ing would be suboptimal and therefore avoided.The finding of prevalent suboptimal dancing inthe absence of theory to explain it constitutesour article’s second contribution.

It appears that the PE bubble would not haveoccurred had all the investors who recognized thatprices were too high sat out of the market. Welearn from this that bubbles can be fueled byinvestors who are sophisticated in their approachto value but nonetheless err in the investmentstrategies they pursue. This calls for developmentof new theory. To do so, we must first addresstwo key questions: Was dancing really suboptimalfor PE investors? If so, why did some investorsnevertheless adopt it?

Was Dancing Suboptimal?The puzzle of PE dancing would be resolved ifdancing were suboptimal only for LPs, not PEinvestors. Indeed, PE investors receive signifi-cant short-term economic benefits from dancing,irrespective of long-term returns. They collecttransaction fees every time they buy or sell acompany and annual monitoring fees from eachportfolio company (Metrick and Yasuda 2010).For each fund, they also collect an annual man-agement fee of 2 percent of the fund’s committedcapital. Because they cannot raise a new fund un-til their existing one is mostly invested, they maydisregard prices and invest quickly to raise thatnext fund and collect more management fees.

Given recent examples of financial marketmalfeasance (cf. Perrow 2010), we must askwhether these short-term incentives alone can ex-plain PE dancing during the bubble. Careful con-sideration suggests a more nuanced perspective,though, and the data demonstrate that despite

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its short-term benefits, dancing was suboptimalfor PE investors, not just LPs.

First, these short-term incentives are alwayspresent in PE, so they cannot alone explain whyinvestors would knowingly pay inflated prices dur-ing some periods but not others. Also, if dancerswere simply exploiting LPs’ capital for short-termpersonal gain during the bubble, why admit tous in 2005 that prices were too high? They couldhave obscured the malfeasance by claiming pricesreflected robust economic fundamentals.

Most important, the data overwhelminglydemonstrate that dancing was simply not op-timal for PE investors. In our 2010 and 2011interviews, we asked PE investors what had beenthe best strategy for a PE firm to adopt duringthe bubble, and all but one (regardless of whatstrategy they had adopted) acknowledged thatdancing had been wrong and that the first-beststrategy was to have remained disciplined andsat out of the market by refusing to overpay fordeals.12

The issue is that although there are short-term incentives to dance, there remain powerfulcountervailing incentives to care about long-terminvestment returns. Recall that PE investorsinvest their own capital—not just LPs’—to pur-chase assets, meaning they are not simply agents.In economists’ principal–agent models, havingsuch “skin in the game” (as one respondent putit) is the key mechanism for counteracting short-term temptations to exploit. Moreover, PE in-vestors share in the long-term investment profitsthrough carried interest, and such profit shar-ing can dwarf fee-driven compensation.13 Yetdancing did not optimize such returns. Returnsfrom investments made during the bubble havebeen poor relative to historical returns. As ofmid-2013, PE firms still held $776 billion worthof unsold assets, the majority of which were pur-

12 By contrast, Brunnermeier and Nagel (2004) andTemin and Voth (2004) describe dancing as the optimalstrategy in the bubbles they study.

13 In 2011, the three founders of the Carlyle Group, alarge PE firm, each made $134 million from their shareof the firm’s investment profits as well as approximately$70 million from returns on each founder’s own personalinvestments in the firm’s funds, compared to $250,000 insalary and $3.5 million in bonus (i.e., the two fee-drivencompensation components). That year, each also putbetween $97 million and $164 million of their own capi-tal back into Carlyle’s funds (Zuckerman and Dezember2012).

chased during the bubble and were now valuedeither below cost or below the hurdle-rate return,meaning dancers will receive no carried interestfrom them.

Furthermore, investors appeared quite awarethat lasting financial success in PE is achievedby raising a sequence of increasingly larger funds(not by playing a one-shot game of maximizinga single fund’s fees) and that this depends uponbuilding a track record of strong returns for LPs.They further recognized that dancing was incon-sistent with that. Numerous dancers echoed oneinvestor’s sentiment that “I’d not have invested asactively and would have waited it out,” preserv-ing capital to invest after prices corrected. (Also,whereas sitters took advantage of the bubble’sinflated prices to sell existing companies, dancerstended to hold theirs, believing they could sellat even higher prices later. Because transactionfees are paid when companies are bought or sold,this further suggests dancers were not just tryingto maximize fees.)

In our 2010 and 2011 interviews, dancersfeared a “judgment day,” “shakeout,” and “catas-trophic consequences” for the most egregiousdancers, predicting that such firms would diewhen LPs refused to invest in their subsequentfunds. Indeed, LPs significantly reduced theircommitments postbubble (Figure 2), and dancershave had considerable difficulty raising new capi-tal relative to sitters.14

To be sure, just because dancing might jeopar-dize LP relationships and suboptimize long-termreturns does not mean PE investors kept thesefactors in mind. Research on hyperbolic discount-ing demonstrates that actors often struggle toavoid short-term temptations even in the pres-ence of powerful long-term incentives. However, abedrock principle in that literature is that invest-ment in illiquid investments is the key mechanismfor disciplining actors to discount the future ap-propriately (Laibson 1997). Because PE is anilliquid market, PE investors should have been

14 Four PE firms in our sample raised new funds atapproximately the same time in 2005. Two danced; twosat. By 2011, one dancer had given up on fund-raisingand appeared to be winding down operations. After adifficult fund-raising process, the other ultimately raiseda new fund that was considerably smaller than the firm’sprior fund. The two sitters (who invested the majority oftheir 2005 funds postcrash) had both raised new, largerfunds.

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highly attuned to the future consequences of danc-ing and recognized that this was a suboptimallong-term strategy, both for themselves and LPs.In fact, when we examine why respondents choseto dance, we are led directly to their beliefs aboutliquidity and their LPs’ likely response.

Misperceptions SupportingSuboptimal Dancing

Our data suggest that two misperceptions aboutthe market environment made dancing seem rea-sonable at the time and that dancers held thesemistaken beliefs, whereas sitters did not. Giventhe nature of interview data, a causal link be-tween these misperceptions and suboptimal danc-ing should be regarded as preliminary. Never-theless, the qualitative evidence highlights theirimportance in investors’ decision to dance.

False sense of liquidity. During the bubble,one-third of the dancers in our sample seemedto believe PE’s liquidity environment had perma-nently changed to now support dancing. To besure, PE was experiencing relatively high levelsof liquidity, in that debt was cheap and plentiful.In 2005, sitters and dancers alike mentioned thisas a major environmental factor. A mega-fund in-vestor commented, “Capital is a commodity now,”whereas one from a medium-sized firm observed,“Capital is one of the least difficult things in thisspace.”

Sitters were appropriately skeptical of this sit-uation, noting the debt markets were in a “crazy”and “cyclical” moment that would not last. Theylinked the current availability of capital to in-creased liquidity in PE but were clear that anyincreased liquidity was only as long-lived as thiscredit cycle. Some dancers, however, interpretedthe increased availability of capital as “sustain-able,” reflecting the long-term “institutionaliza-tion” of PE investing. A banker who advisedmany dancers during the bubble captured thissentiment in 2005, saying, “This [liquidity] willnever dry up. . . [PE] has gone from an illiquidcowboy-type environment where a small group ofreally bright people made money, to a very liquidenvironment.” Respondents’ postcrash commentsprovide further insight into such thinking. Adancer recalled internal meetings during the bub-ble in which he and his colleagues decided to pay

prices they knew to be above fundamental valuebecause they believed “all the now obviously falsearguments” that conditions in the market hadpermanently changed and they would be able tosell at even higher prices later. According to anLP, dancers like this one “fundamentally believedthe world had changed” and operated with “theassumption the capital markets would be there”to support dancing.

Not all dancers in our sample believed liq-uidity had permanently changed, however. Likesitters, another third of the dancers recognizedthat the capital markets were in a cyclical peakand any increased liquidity in PE was only tempo-rary. In 2005, an investor from a mega-fund thatdanced said, “I feel like this will last as long asinterest rates stay low, but once the cycle turns,it will be harder to get deals done. . . Interestrates aren’t low forever.”

The mistake of these dancers was to overes-timate their firms’ ability to navigate it success-fully.15 The investor quoted earlier as sayingthat “PE will blow up” reported in 2005 that thesuccess of dancing “all depends on the credit men-tality,” which he readily acknowledged was tem-porary. Yet in his 2010 interview, he recountedmeetings where he and his colleagues had decidedto dance for a while longer, believing there wouldstill be time to sell their assets at higher prices.Another dancer summed up the basis for suchthinking: “Everyone stayed in. . . People are goingto dance as long as the music plays. . . Everyonewas suffering from the same illusions. It was abubble mentality. . . People’s elevated view of self,‘I know what I’m doing, I can lead us throughthe treacherous waters.” ’

False sense of safety in numbers. An addi-tional misperception supported dancing by re-assuring investors that, even if dancing provedsuboptimal, LPs were unlikely to punish them.

15A particular strategy that facilitated such thinkingwas the increased use of dividend recapitalizations (“re-caps”) whereby a PE firm refinances the debt of an ac-quired company based on a higher valuation and extractsa dividend. This strategy may have made it appear thatit was easier to exit investments quickly at a profit, butrecaps do not provide a level of liquidity sufficient to jus-tify dancing (see Grant 2008). Two reasons are that (1)recaps take at least several months to complete and (2)they depend on an increase in the company’s valuationfrom the time of acquisition, and so they depend on ei-ther value-enhancing operational improvements or furtherprice increases, both of which take time to transpire.

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Specifically, dancers assumed they had “safetyin numbers” (Zwiebel 1995; cf. Keynes [1936]1960:158). In 2005, all of the respondents whowent on to dance through the bubble indicatedthat they believed everyone else was also partici-pating in the bubble. Most believed everyone wasknowingly dancing like themselves, though somesuspected there were a few “fools” in the markettoo, unwittingly paying high prices. Post-crash,respondents observed that a “pack mentality” hadoperated during the bubble. Such herding is rele-vant in PE because when LPs decide whether toinvest in a new fund, they typically focus less ona firm’s overall past performance and more on itsrelative performance.16

By this logic, if there was a chance dancingmight be successful (because one believed theliquidity environment could possibly support it),then not dancing was risky. A dancer explained,“You definitely knew you were in a boom, butyou’re worried about being left out.” Moreover, ifdancing failed, the negative consequences wouldbe minimal and mistakes easy to justify becauseeveryone else’s returns would also be poor. Char-acterizing the logic he believed some dancers used,an LP said, “It was absolutely clear. Everyoneknew it was insanity but you participate. If you’regoing to fail, do it with a lot of company. . . Peo-ple [who danced can] say ‘We all drank the Kool-Aid. . . We all made the same mistakes. Nowwe’re getting back to business.” ’ Consistent withthis, an investor in our sample justified his ownfirm’s dancing, saying, “We were in the same fishtank as everyone else. . . Most funds were hurt,right?”

Note that with a sense of safety in numbers,it then becomes reasonable to take advantageof the short-term incentives to dance (i.e., fees),

16 Two reasons for this are as follows: (1) It is unclearwhether average PE returns exceed those of the publicmarkets and thus whether LPs should allocate as muchcapital as they do to this risky, illiquid asset class (seeHarris et al. 2011; Kaplan and Schoar 2005; Robinson andSensoy 2011b). Nevertheless, there is general consensusthat returns within PE vary considerably and that, atany given time, the best-performing funds outperformother asset classes. Consequently, LPs try to identify “top-quartile” funds, a strategy that makes relative performancecentral. (2) Individual LP managers are evaluated on arelative basis themselves. Overall returns often matterless for their job security than do returns relative to “peer”institutions. Managers thus focus on investing in betterPE funds than their peers, again making relative PEperformance salient.

regardless of investments’ long-term prospects.So, although we argued earlier that fee-basedincentives alone were insufficient for explainingdancing, once investors mistakenly believed thatthey had safety in numbers and/or that the liq-uidity environment might support such a strategy,the temptation to exploit short-term fees likelyadded fuel to the inflating bubble. One sitterexplained, “I guess it’s the Chuck Prince phe-nomenon. You’ve gotta keep dancing. Plus theywere rewarded handsomely to keep playing. Theoptimal strategy [in their minds] was to raiseas much money as you could think of, spend itas quickly as possible and take whacking greatfees. . . But the strategy was flawed. It all camecrashing down.”

Our data suggest that the reason it “all camecrashing down” was because dancers’ perceptionsof liquidity and safety in numbers were wrong.When the market crashed, dancers had overpricedinvestments they could not unload and dissatis-fied LPs, whereas sitters had preserved both cap-ital and LP favor. Had dancers read their marketenvironment correctly, they would have antici-pated this outcome and sat out, and the bubblewould never have occurred. Thus, although ourdata do not allow us to speculate about why sit-ters avoided these misperceptions when dancersdid not, these data strongly suggest that the PEbubble was directly fueled by suboptimal dancingand that this dancing was predicated on investorshaving misread key environmental conditions. Inthe next two sections, we develop the generalimplications of this finding for theory.

I. Theory Development: Mis-takes about Market LiquidityTo appreciate this finding’s novelty, contrast itwith two well-known collective delusion theories.Reinhart and Rogoff (2009) attribute bubbles tothe widespread belief that “this time is different”and fundamental valuations have permanentlyincreased. But in PE, we saw investors invokesuch language with regard to liquidity to jus-tify dancing, even while recognizing that thistime was not different with regard to valuations.Akerlof and Shiller (2009:152) contend that in-vestors’ animal spirits make them overconfidentin both their own estimates of value and their

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estimates of others’ estimates, such that they be-lieve prices “will always go up strongly.” But inPE, we find investors who are overconfident abouttheir ability to navigate a complicated liquidityenvironment. PE dancers had an accurate senseof value and even a good sense of one another’sestimates of value (no one believed the marketwas dominated by deluded fools who had overes-timated value), but they had an inaccurate senseof market liquidity. This warped their investmentstrategies but not their valuations (dancers knewprices were inflated).

This is a subtle but crucial difference, andit leads to a new understanding of the condi-tions driving bubbles. A bubble fueled by valuedelusion should become increasingly fragile asit inflates because even previously optimistic in-vestors become skeptical after a point. This iswhy massive bubbles, which inflate well beyondany seemingly reasonable estimates of value, areso hard to understand in retrospect. By contrast,a bubble fueled by delusion about liquidity can beself-sustaining. As investors believe the marketis more liquid, dancing seems more viable, andas investors dance, the market seems more liquid.Given this dynamic, collective liquidity delusionmay explain the extent and duration of manymajor financial market bubbles better than valuedelusion.

The notion of a liquidity delusion also movesbeyond existing institutionalist theories. Bothoptimal dancing and rational sitting models as-sume one-to-one correspondence between skillin estimating asset values and skill in readingthe market environment: that is, investors whospot the market’s mispricing are assumed to readthe liquidity environment correctly and so knowwhether it is better to sit or dance—and if theydance, they are assumed to know where pricesare going and when they will crash. To appre-ciate what is distinct in our findings, consider amemo that leaked throughout the PE industryand trade press in 2007.

William Conway, the co-founder of one of thelargest PE firms, the Carlyle Group, wrote amemo to his staff in January 2007. Like manyof our respondents, he directly linked the “enor-mous availability of cheap debt” to liquidity anddancing in PE: “There is so much liquidity in theworld financial system that lenders (even ‘our’lenders) are making very risky credit decisions.

This debt has enabled us to do transactions thatwere previously unimaginable. . . and has resultedin (generally) higher exit multiples than entrymultiples.” He acknowledged, “This liquidity en-vironment cannot go on forever. I know that thelonger it lasts, the greater the pressures will beon all of us to take advantage of this liquidity.And I know that the longer it lasts, the worseit will be when it ends. . . But I do not knowwhen it will end.” Nevertheless, he wrote (in allcapital letters) that he expected it “will con-tinue for at least the next 12–24 months.frankly, i see no catalyst that will leadto a quick, large, or dramatic change inglobal liquidity.”

This memo is telling for two reasons. First,existing institutional theories suggest that if aprominent player publicly broadcasts that pricesare inflated, such broadcast will act as a “co-ordinating event,” causing the bubble to burst(Abreu and Brunnermeier 2003). The logic isakin to a child announcing that the emperorhas no clothes (Centola et al. 2005): once itbecomes common knowledge that prices are in-flated, dancers close out their positions becausethey expect others to do so. Yet Conway’s memowas clear that market prices had become inflated,and the PE bubble did not burst immediatelyin response. This seems to reflect the fact thatPE dancing was fueled by erroneous beliefs aboutliquidity, and on this score, the memo did notclarify matters (and, in fact, liquidity evaporatedmuch sooner than Conway forecasted). Investorsalready widely believed the emperor was naked(there was a bubble), and they assumed theirpeers were equally aware; but given the erro-neously perceived environmental conditions ofhigh debt–fueled liquidity into the foreseeablefuture, they reasoned it was best to dissimulate(dance). Had Conway’s memo challenged thisperception, it might have occasioned a crash.

In short, it was not enough for investors toappreciate, as Conway and many dancers in oursample did, that the market’s debt-fueled liquid-ity could not support dancing indefinitely; theyalso had to recognize that they would be unable totime their exits before that liquidity evaporated.This distinction between debt-fueled liquidity andthe more transactional sense of it constitutes thesecond lesson we can draw from Conway’s memoand our foregoing findings: mistakes about liq-

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uidity may be especially likely given the complexnature of the phenomenon. The ability to movein and out of positions in a market is a func-tion of both (1) conditions in the broader capitalmarkets and (2) the nature of the transactionsthemselves. A large supply of cheap capital canmake transactional liquidity seem higher for aperiod of time, but visibility into when—and howquickly—the capital markets will turn is notori-ously difficult, for it depends on highly complex,systemic activity outside one’s own market. Andwhen the capital markets do turn, the nature ofthe market’s transactions ultimately determineswhether dancers can exit in time.

II. Theory Development:Mistakes about Peer BehaviorA second theoretical implication of this studypertains to the crucial role of market visibility inbubbles. Recall that although one-fourth of oursample curtailed investment activity, the dancersbelieved everyone was participating in the bubble.When we examine why they developed this falsesense of safety in numbers, we uncover a constella-tion of institutional factors that obscured others’sitting. We do not identify one single factor asdirectly responsible because sitting’s invisibilityis actually overdetermined in PE. Rather, ouranalysis suggests how a range of institutionalconditions can impact market visibility and thuswhere scholars and policy makers might directtheir attention when seeking to study and managefuture bubbles.

Start with short selling constraints. A previ-ously unappreciated implication of short sellingconstraints is that they not only silence dissentingvoices but also obscure sitters’ strategy. The PEcase reveals that in the absence of countervail-ing mechanisms to support visibility, investorswho stay in the market see only those investorswho are also actively participating, not those whohave departed, and this can skew their perceptionof peers’ investment strategies, thus motivatinga decision to dance.

Of course, sitters’ behavior could still becomevisible via social networks. After all, awareness ofpeer strategies often spreads through formal andinformal ties, like those observed among some

traders (e.g., Preda 2012; Simon et al. 2012).However, the presence of networks has not pre-vented past bubbles, perhaps because social net-works do not necessarily promote trust. (If aninvestor hears that some peers have sat out, howcan the investor know this is not just a strategicdecoy?)

In fact, and in contrast to what others havefound in public markets, our interview data sug-gest that PE investors rarely communicate withone another directly about current investmentactivities. This is unsurprising as PE firms his-torically sought proprietary deals of which theircompetitors were unaware and now participatein blind auctions. Participants sign legal docu-ments forbidding communication with the otherPE firms in the auction, and they can see neitherwhich firms those are nor their bids. Such restric-tions aim to prevent PE firms from colluding tosuppress prices, but they also obscure visibilityinto one anothers’ strategies.

The dominance of auctions also means thatPE investors gain market information (e.g., over-all investment activity and pricing levels) only ifthey participate. This is how they gain access tocompany financials and can compare their ownestimates of value to ultimate sale prices. Con-sequently, PE firms rarely ever withdraw com-pletely from the market. One sitter explained,“No PE firm will tell you they stepped out of themarket. You can’t afford to. You still want tosee deals, stay in the flow.” In a sense, sittersthus engage in their own form of dissimulation.To remain informed of market conditions (and inhopes of winning a deal at a fair price if ever pos-sible), sitters continued to participate in auctionsduring the bubble, conducting due diligence andsubmitting bids. But in contrast to dancers, theyonly bid their estimate of a company’s under-lying value, meaning they consistently lost andeffectively sat out.

To the extent sitters were visible, then, theylooked like dancers. Cultural dynamics in PElikely encouraged this reading. Although sittingout can prevent future loss of capital, it does notgenerate returns and so garners little attention,whereas “doing deals” carries the prospect of re-turns and is more culturally salient as reflected inindustry vernacular (Turco 2010). Accordingly,the trade press covers deal activity (who is doingwhat deals), not its absence.

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Such dynamics may also help explain why LPsapparently failed to transmit information aboutsitting to dancers. While some sitters explainedtheir strategy to LPs, most did not advertisetheir inactivity. (As discussed, LPs in our samplewere unsure how to interpret the heated market,and they do not make money from PE sitting.)Nevertheless, PE investors did receive marketinformation from some third parties—their in-vestment bankers, lenders, and consultants. Butthese actors are paid per transaction, profitingfrom high levels of market activity, and by 2010and 2011, some PE investors speculated that suchadvisors may have hyped deal activity and down-played the extent of sitting to serve their owninterests.

Taken together, the foregoing observationssuggest that even when investors are directly orindirectly connected to one another, they maynot have good visibility into peer strategies. Tothe contrary, the institutional context may ob-scure peer behavior, not reveal it. While existinginstitutionalist theories have overlooked this, re-cent work in the sociology of distorted valuationoffers some relevant insights. Consider two re-cent contributions. In Strang and Macy (2001),managers over-adopt faddish business practicesbecause they lack visibility into peer firms’ be-havior, relying instead on business press and con-sultants who overstate the overall adoption andefficacy of those practices. Similarly, in Centolaet al.’s (2005) analysis of unpopular norms, actorswho cannot see the full distribution of peer be-havior (e.g., conformity, deviance, enforcement)are more likely to engage in false adoption andenforcement.

Although neither model speaks directly tothe PE bubble, each is consistent with the ideathat institutional features of markets can obscurethe full range of peer strategies, and that thiscan lead actors to pursue suboptimal strategiesthat drive distorted valuations, just as we sawin PE. Our evidence also points to a key buthidden assumption in these models: actors areoften unaware of, and thus fail to adjust for, insti-tutional limits on visibility (see also Zuckerman2012:228). More generally, if past institutional-ist theories of bubbles imply that short sellingconstraints act like restrictions on freedom of ex-pression in other cases of distorted valuation, ourcase demonstrates that a market’s institutional

features can also act like restrictions on freedomof assembly, preventing investors from comingtogether and observing one another’s strategiesdirectly, and that this can fuel a bubble.

ConclusionWe began by noting that collective delusion andinstitutionalist accounts make distinct predictionsabout the extent of dissent during bubbles. Ourfirst finding lent strong support to an institution-alist explanation of the PE bubble. Thereforewe should no longer presume that collective delu-sion on valuation is necessary to drive bubbles.Nevertheless, our second finding of suboptimaldancing and our analysis of the false assumptionsunderlying it suggest that the PE bubble wasindeed fueled by a form of collective blunder, justone unanticipated by existing theory. Specifi-cally, we documented a case of collective error oninvestment strategy and identified the mistakesinvestors made in reading their environment thatled to that.

This has potentially far-reaching consequencesfor financial market research. All heterodox the-ory seems to assume that the key errors investorsmake pertain to valuation and that conditionalon arriving at a given valuation, investors fol-low the appropriate investment strategy. Thisassumption is core to behavioral finance in itsexamination of the cognitive and behavioral trapsthat lead actors to misestimate asset values (seeBarberis and Thaler 2005; Hirshleifer 2001). Italso appears in institutionalist models of sittingand dancing, where investors who are smart aboutvaluation are assumed to be smart about read-ing the market environment and selecting theoptimal investment strategy for it. On its face,this assumption seems reasonable, because in-vestors who are motivated and able to accuratelyassess an asset’s fundamental value would seemmotivated and able to determine an appropriateinvestment strategy relative to that asset. Casesof successful dancing suggest it is sometimes anaccurate assumption (Brunnermeier and Nagel2004; Temin and Voth 2004). Yet our resultssuggest that we can better understand financialmarket dynamics if we relax this assumption.

A key implication of our study is that thecognitive challenge of accurately valuing tangible

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assets may pale in comparison to the more so-ciological challenge of understanding a market’scomplex social and competitive dynamics to selectthe appropriate investment strategy. Althoughparticular aspects of this challenge are salient inPE, the more general challenge of navigating anenvironment that is collectively constructed bymarket participants—and thus seemingly moreor less liquid—is generic. And if the highly mo-tivated, sophisticated PE investors collectivelyfailed at this challenge, it is quite likely that otherbubbles are driven by similar failures.

Finally, by highlighting the role of collectivedelusion about liquidity and institutional limitson visibility, our study has important policy im-plications. First, we find that dancing can fuel abubble even when there is widespread recognitionof the bubble and even when the sustainabilityof liquidity is publicly questioned. Perhaps theonly measures to defuse such a bubble, then, arelimiting the supply—or raising the cost—of capi-tal. Accordingly, policy makers should be vigilantwhen the cost of capital is so low that it may pro-mote liquidity delusion even when there is novalue delusion.

A second lesson is that, just like other casesof distorted valuation, bubbles should be seenless as the product of intractable behavioral ten-dencies and more as the product of institutionalfailure and thus amenable to institutional solu-tions. When the environment is highly complexand presents participants with a biased pictureof one another’s strategic behavior, there is asignificant likelihood of collective error in thestrategies that are adopted. This results in whatwe have seen in the PE bubble—an episode ofdistorted valuation, whereby the “smart money”was too smart by half—that is, with limited vis-ibility into the market, they applied the wronginvestment strategy despite knowing the rightvaluation. Future research should examine howinstitutional conditions that create transparencymay promote more accurate interpretations ofthe complex social and collective environmentthat is the market.

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Acknowledgements: Laurel Grassin-Drake pro-vided valuable research assistance on thisproject. Earlier versions of this article bene-fited from the generous advice of Sarah Halpern-Meekin, Kate Kellogg, and Ray Reagans andfrom the feedback of audiences at the HBSEntrepreneurial Management Seminar, the In-ternational Network of Analytical Sociologists’2012 Conference at Columbia University, theBrandeis University Sociology Department, andMIT Sloan’s Organization Studies Group. Di-rect correspondence to Catherine J. Turco,Sloan School of Management, MassachusettsInstitute of Technology.

Catherine J. Turco: Sloan School of Management,Massachusetts Institute of Technology.E-mail: cturco@mit.edu.

Ezra W. Zuckerman: Sloan School of Management,Massachusetts Institute of Technology.E-mail: ewzucker@mit.edu.

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