Pay for Performance from Future Fund Flows: The Case of Private Equity
Korea University Business School
The incentives of private equity general partners to create value for their investors (limited partners) are often questioned by investors, industry observers, and academics alike. Critics allege that pay-for-performance incentives from the carried interest profit share (typically 20%) are muted when funds fall short of their hurdle rates, and because fixed fees alone represent a substantial source of income for many private equity groups.
In this paper, we point out that the direct incentives from carried interest are only part of the total pay-for-performance incentives that general partners have. The other part is the indirect, market-based incentives that arise from the fact that general partners’ ability to raise capital for new funds in the future, and so to earn income from managing that capital, depends on the performance of their current funds.
To better understand general partners’ motivations, it is essential to have a complete picture of their total pay for performance incentives, which is the sum of the direct effect of current performance on earnings from carried interest, and the indirect effect of current performance on earnings from managing future funds.
Our goal is to quantify the latter effect, and compare its magnitude to the former. To do so, we present a rational learning model that formalizes the logic by which good performance in the current fund could lead to higher future incomes for general partners through an effect on expected future fundraising.
The model provides us with an explicit formula for indirect pay-for-performance from future fundraising as a function of i) expected sizes of future funds, consisting of the probability of raising a future fund and its expected size if there is one, ii) the sensitivities to current performance of the likelihood of a general partner raising another fund, and its size if there is one, and iii) expected general partner compensation per dollar of fund size.
The model also provides us with several cross sectional predictions about the magnitude of the sensitivity of future fundraising to current performance that have not been previously tested in the private equity literature, and that in our framework translate directly into cross-sectional differences in indirect pay for performance incentives. The first prediction is that for a given assessment of a general partner’s ability to generate returns, the more ‘’scalable’’ abilities are, the more investors are willing to put money into a following fund. To the extent that buyout funds are more scalable than venture capital funds, future fundraising-performance sensitivity should be greater for buyout funds than for venture capital funds. The model also predicts that as a partnership ages, so its ability is known with more precision, performance in a given fund should have less incremental impact on the market’s overall assessment of the partnership’s ability. This means that future fundraising should be more sensitive to performance for younger partnerships than for older ones. Finally, the model predicts that for a given performance, a manager is more likely to raise a subsequent fund if the prior assessment of his ability is better. It implies that later sequence funds should be more likely to raise a follow-on fund because the average assessment of ability will be higher in later sequence funds than in earlier ones, for the simple reason of their survival.
Using a sample of buyout, venture capital, and real estate private equity funds from Preqin over 1993-2010, we find support for all of these predictions. Importantly, there are three main takeaways from the estimates of direct and indirect pay-for performance. First, indirect pay for performance is sizeable and of the same order of magnitude as direct pay for performance from carried interest. Second, indirect pay for performance is much stronger for buyout funds than for venture capital funds, with real estate in between. Third, it becomes weaker as a partnership ages and manages more funds. The magnitude is reduced by more than half for a fifth-fund buyout partnership compared to a new partnership, and for venture capital there is essentially no indirect pay for performance beyond the fourth fund.
Review of Financial Studies, Volume 25, Issue 11, pp. 3259-3304, November, 2012