In the paper, Incentives of Private Equity General Partners from Future Fundraising, which was recently published on SSRN, my co-authors (Ji-Woong Chung, Berk Sensoy, and Léa Stern) and I evaluate the importance of future fundraising to the incentives of private equity general partners. To do so, we formalize the logic by which good performance today could lead to higher future incomes for GPs.
We present a model in which a private equity partnership potentially has an ability to earn abnormal returns for their investors, but this ability is unknown. Given an observation of returns, investors update their assessment of the GP’s ability, and, in turn, decide how much capital to allocate to the partners’ next fund. We derive predictions about the relation between the performance of a particular fund and the fund’s partners’ abilities to raise capital in the future. Intuitively, the model implies that the more informative the fund’s performance is about GPs’ abilities, the more sensitive future fundraising should be to today’s performance. In addition, the way in which abilities can be “scaled” will affect investors’ willingness to commit higher quantities of capital for a given level of managerial ability. These larger funds will lead, in expectation, to higher compensation for the partners, since compensation agreements almost always change linearly with fund size. Given this setup, we derive an explicit formula calculating the effect of fund performance today on expected future GP compensation.
We test these predictions using a sample of 838 partnerships who manage 1,726 buyout, venture capital, and real estate funds. In particular, we evaluate the informativeness criterion, which suggests that performance of later funds (for example, a partnership’s third or fourth fund) should be less informative about ability and hence be less strongly related to future inflows of capital than would similar performance in a partnership’s first fund. In addition, the ability of managers to translate their skills to larger funds depends on the nature of the production process. Given Metrick and Yasuda’s (2010) finding that buyout funds are more scalable than venture funds, the model predicts that the future fundraising of buyout funds should be more sensitive to performance than that of venture funds.
Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund. This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees. Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability. Overall, the results suggest that implicit incentives from future fundraising have a substantial impact on general partners’ welfare and are likely to be an important factor in the success of private equity firms.
The full paper is available for download here.