Pay Now or Pay Later?: The Economics within the Private Equity Partnership

Victoria Ivashina is Professor of Finance at Harvard Business School and Josh Lerner is Jacob H. Schiff Professor of Investment Banking at Harvard Business School. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

Partnerships—a business venture in which a small group of individuals shares the profits and liabilities—were the dominant organizational form of businesses for several millennia and, even today, remain critical to the way in which the professional service and investment sectors are run. Much of the existing literature and theories suggest that partnerships continue to be prevalent because they address the difficulty of attributing individual contributions to a partnership. Two dominant hypotheses emerge regarding profit sharing in partnerships. The first proposes that compensation within the same tier of partners should be compressed to provide partners an incentive to monitor each other and ensure productivity. Alternatively, compensation should correspond to performance and would therefore vary in a group with heterogeneous talent. In this article, we suggest a third possibility: that founders of partnerships may not appropriately reward other contributors, and instead claim a disproportionate share of the economics generated by the firms for themselves.

To conduct our analysis, we look at data from over 700 funds compiled by a limited partner (LP) in the course of its due diligence process. Investment proposals submitted to the LP by fund managers contained details of the distribution of firm economics among partners. These economics come primarily in two forms: distribution of carried interest (“carry,” or the share of fund profits claimed by the fund manager) and allocation of ownership of the management company. To measure potential inequalities in these distributions, we distinguish between senior and junior partners. We define the measure “inequality” as the ratio of the carried interest or ownership share of the individual with the largest such allocation to the average share. We use this data to examine four topics: the nature of compensation in private equity funds, the determinants of fund economics distributions, the relationship between fund economics and departures of partners, and the consequences of such departures.

Our findings reveal that the inequality ratio is substantial for both carry and management company allocations. Moreover, the disparity between levels of compensation becomes even more pronounced when comparing senior to junior partners. Furthermore, we find that carry inequality increases as funds become progressively larger; when comparing funds with more than three senior partners to funds with more than eight senior partners, the carry inequality ratio increases significantly. On the other hand, we find that carry and ownership inequality falls as private equity organizations mature, as measured by the progression of inequality over successive funds. Next, we use regression analysis to examine the determinants of fund economics distributions and find that founder status is an important driver of compensation. Senior partners who are founders on average receive almost twice as much carried interest than a non-founder and have over twice the ownership stake of a non-founder. On the other hand, we find that the relationship between partners’ past performance and their share of economics is much less consistent.

In examining the relationship between fund economics and the decisions of partners to leave their firms, we first establish that the departure of a partner is not correlated to his or her past performance to a statistically significant degree. Next, we find that senior partners are statistically significantly more likely to stay with a firm that has lower carry inequality, while the inverse is true for junior partners. Our analysis shows that high-performing partners are more likely to leave firms with higher inequality of economics distribution. In determining the effects of such departures, we find that the departures of senior partners are associated with a decrease in the size of the next fund.

Our findings suggest that the inequalities we observe in private equity partnership models are the results of founders acting in their own private best interests, potentially at the expense of their firms’ abilities to raise future capital. This raises potential agency issues between founders, their firms, and the LPs, as founders may find it more personally profitable to have a larger share of a smaller fund, whereas the private equity firm as a whole and its LPs would prefer stable, long-term relationships.

These issues have implications beyond academia, as well. The topic of succession has increasingly become of interest to both fund managers and their LPs and has historically been a source of grief to both groups. Multiple news accounts have attributed private equity firms’ inability to raise new capital, and their subsequent dissolution, to disputes over succession, ownership of the firm, and distribution of economics. In Coller Capital’s Global Private Equity Barometer, 2011, a survey of 110 LPs showed that over 60% named succession or continuity issues a likely reason not to commit to a new fund. Clearly, the equitable distribution of firm economics and its effects on employee turnover (and by extension, the longevity of the firm) represent pressing issues in the private equity industry. However, our data show that the current partnership model may exhibit an overallocation of value to founders. This leads to an observable degree of compensation inequality that contributes to the departures of high-performing partners and negatively effects firms’ ability to raise capital.

The complete article is available for download here.

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