Do Private Equity Fund Managers Earn Their Fees?

In our recent NBER working paper, Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance, we use a large, proprietary database of private equity funds to study the links between the terms of private equity management contracts and the subsequent cash flow behavior and performance of the funds. The database is the largest and most recent source of private equity compensation terms available to date, and is the first to provide information on manager ownership and to include cash flow information along with the terms of management contract.

We use these data to contrast two views of the state of managerial compensation practices in private equity. The first is that highly compensated GPs, or those with little skin in the game, extract excessive rents and have inadequate incentives, which ultimately spells poor returns for limited partners. The second view is that the management contracts we observe reflect (potentially constrained) efficient bargaining outcomes between sophisticated parties, and that management contracts reflect the productivity of GP skills and the agency problems that LP’s face.

The evidence in this paper supports the latter view. To be sure, during fundraising booms, percentage management fees increase and GP’s compensation shifts toward the fixed component, consistent with greater GP bargaining power and a preference for fixed compensation. Moreover, GPs who receive fees on invested capital tend to exit investments (and thus lower their fee basis) more slowly, while GPs tend to accelerate the pace of exit immediately after they become eligible to receive carried interest. These findings indeed suggest that the fundamental information asymmetry between GPs and LPs allows GPs to game the contractual provisions that are partially in place to protect the LP’s return, and they certainly illustrate that GP’s earn more in boom periods. However, we find no evidence that high-fee funds underperform an on a net-of-fee basis.Management fees and carried interest are generally unrelated to net-of-fee cash flow performance. This suggests that private equity GPs that receive higher compensation earn it in the form of higher gross returns. When we examine the relation between GP ownership and performance, our evidence flatly contradicts the argument that GPs with low skin in the game demonstrate poor performance.

Thus, even though the asymmetric information problem between LPs and GPs may sometimes give rise to a misalignment of incentives between GPs and LPs in private equity, the management contracts that facilitate investment in the private equity industry are not so bad at providing incentives (or so confusing) that these conflicts lead LPs to suffer low returns on average. The fact that GP compensation goes up in boom periods does not mean that they capture an undue proportion of the rents from private equity investing; instead it means that the overall rents on average increase during private equity booms. The fact that contractual provisions designed to protect LP returns are subject to gaming by GPs does not mean that LPs are any the worse for having them; it simply reflects the fact that, in equilibrium, such contractual provisions come with costs as well as benefits.

Our results on the relation between fees and net-of-fee performance in private equity stand in marked contrast to what is known about the mutual fund industry. There, net-of- fee performance is strongly negatively correlated with management fees. Of course, limited partners who invest in private equity are different from mutual fund investors in a number of important respects. First, because they are typically large institutions committing large sums of capital, they presumably are more sophisticated than most retail investors. But perhaps more importantly, the inability to withdraw their commitments without incurring substantial costs creates much stronger incentives to screen GPs ex ante and to guarantee that management contracts optimally reflect their agency concerns. In this regard, private equity investors also differ from investors in hedge funds, who are able to withdraw their capital periodically, with advance notice given to the fund. Our results suggest that under- standing how monitoring,oversight and the matching process between LPs and GPs affect the equilibrium effort and performance of intermediated capital is an important question for future research.

The full paper is available for download here.