Incentives of Private Equity General Partners from Future Fundraising

Michael Weisbach is Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University.

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.

Post a comment or leave a trackback: Trackback URL.

Post a Comment

Your email is never published nor shared. Required fields are marked *


You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

  • Subscribe

  • Cosponsored By:

  • Supported By:

  • Programs Faculty & Senior Fellows

    Lucian Bebchuk
    Alon Brav
    Robert Charles Clark
    John Coates
    Alma Cohen
    Stephen M. Davis
    Allen Ferrell
    Jesse Fried
    Oliver Hart
    Ben W. Heineman, Jr.
    Scott Hirst
    Howell Jackson
    Robert J. Jackson, Jr.
    Wei Jiang
    Reinier Kraakman
    Robert Pozen
    Mark Ramseyer
    Mark Roe
    Robert Sitkoff
    Holger Spamann
    Guhan Subramanian

  • Program on Corporate Governance Advisory Board

    William Ackman
    Peter Atkins
    Joseph Bachelder
    John Bader
    Allison Bennington
    Daniel Burch
    Richard Climan
    Jesse Cohn
    Isaac Corré
    Scott Davis
    John Finley
    David Fox
    Stephen Fraidin
    Byron Georgiou
    Larry Hamdan
    Carl Icahn
    Jack B. Jacobs
    Paula Loop
    David Millstone
    Theodore Mirvis
    James Morphy
    Toby Myerson
    Morton Pierce
    Barry Rosenstein
    Paul Rowe
    Rodman Ward