How does the contract of the fund manager influence the performance of a private equity fund? A team of reseachers, including Sönke Sievers, investigated this question. Their empirical analysis shows that the timing of the fund’s manager’s payment has a measurable impact on the fund’s performance. If the payment timing is rather favorable for the fund manager, the fund tends to offer higher returns for the investors, as Sievers explains below.
The compensation terms of general partners (GP) in private equity are defined by limited partner agreements, contracts between general partners – fund’s managers – and their investors, limited partners. Usually, these contracts specify three aspects of compensation: management fees, the carried interest, and when general partners get paid. In fact, the timing is a major determinant of the value of compensation that general partners receive, as I will explain below. Despite the economic importance of the timing, there was no empirical evidence connecting the timing of the general partner’s payment to the actual cash flows that limited partners receive. We aimed to shed light on that important aspect of venture capital compensation: How does the actual fund performance vary according to the compensation practice the fund’s manager faces?
Two approaches to compensation timing
Historically, there are two approaches for paying carried interest – the share of the profits of an investment that fund managers receive in addition to the amount that they contribute to the partnership – to general partners: deal-by-deal or whole-fund.
Deal-by-deal or “American” carry provisions allow the general partners (GP) to earn carried interest on each deal as it is exited, even if the fund as a whole has not returned sufficient capital to limited partners for them to break even. This approach allows general partners to earn carried interest more often and in larger amounts. Therefore it is considered „GP-friendly“.
An example may illustrate why: A fund has exited two investments, meaning it sold the shares in which they had invested, the first at a gain and the second at a loss, so that the combined return of the two exits is zero. A deal-by-deal contract allows the general partner to earn carried interest on the initial strong exit even though the combined return on the two investments was zero. Although deal-by-deal contracts often contain clawback provisions, the standard clawback provisions typically do not cover the entire return of principle.
In contrast, whole-fund, or “European” carry provisions, require that invested capital and fees are returned to limited partners (LP) before the general partner earns any carried interest. Hence, this approach is regarded as „LP-friendly“. In our example, a general partner in the whole-fund approach would not yet be eligible to receive carried interest on the strong initial exit because the fund as a whole had not yet earned a positive return on total invested capital.
„GP-friendly“ contracts lead to higher returns
The „GP-friendly“ compensation practices have been criticized. Many industry observers, for example the Institutional Limited Partner Association (ILPA), have argued that limited partners in private equity should insist on LP-first compensation structures. But would this really lead to higher returns for limited partners?
In short, the answer is no. We show in our analysis that so-called GP-friendly contracts are associated with better performance on both a gross and net-of-fee basis. The numbers are clear, whole-fund contracts are associated with net present value losses of nearly 11 cents per dollar of invested capital, whereas in deal-by-deal funds the present value of distributions exceeds that of contributed capital by about 39%.
While fees and carried interest percentages are typically higher for deal-by-deal funds, limited partners earn higher net returns in deal-by-deal funds than in funds with whole-fund carry provisions. In other words, we observe better investment performance for limited partners among the deals supported by „GP-friendly“ contracts than among deals supported by „LP-friendly“ contracts, which is surprising while initial economic intuition might suggest the opposite.
„GP quality effect“ and beyond
How can these differences be explained? Of course, we have to be cautious with causal claims. But one reason surely is what we call the „GP quality effect“: general partners with more industry experience and a better past performance command better compensation on average. They are more likely to operate under „GP-friendly“ contracts.
Yet, the large difference in performance cannot completely be explained by this. Our analysis suggests that there is another aspect: the terms of the contract apparently cause general partners to behave differently than they would have otherwise. A number of potentially competing mechanisms may be behind this finding. For example, we observed differences in exit behavior. General partners under LP-friendly contracts appear to begin by generating early exits in relatively less risky deals so that they can begin earning carried interest. This suggests they have a motive to “play it safe”.
All in all, we show that deal-by-deal contracts outperform whole-fund contracts. But then, why do both types of contracts exist simultaneously on the market? The answer is: they offer different cost-benefit trade-offs. When concerns about avoiding overcompensation are the greatest, the added security of the whole-fund structure outweighs other effects of this structure. When providing incentives for risk-taking is the more salient consideration, the deal-by-deal structure dominates. It is important to recognize that both contract forms have potentially different welfare implications for limited partners.
Therefore, we argue that policy makers should proceed with care when prescribing changes to the contractual environment of private equity investment. Changes that may seem desirable for limited partners at first glance are not obviously better.
Read the Publication “Paying for Performance in Private Equity: Evidence from Venture Capital Partnerships” by Niklas Hüther, David T. Robinson, Sönke Sievers, Thomas Hartmann-Wendels. Management Science, published online in Articles in Advance: https://doi.org/10.1287/mnsc.2018.3274
For our study, we examined 85 venture capital funds raised between 1992 and 2005 including due diligence data, limited partnership agreements and cash flow payments. The data were provided to us by one of the largest international limited partners in the world on an anonymous and confidential basis. Although they are a global investor, we restricted our attention to U.S. venture capital partnerships to narrow the scope of the investment strategy to startups.
We have detailed contract data along with information on all 3,552 portfolio companies in which the venture capital funds (GPs) invested. Our data allow us to measure precisely the timing and size of all cash flows exchanged between each of the 85 funds and the 3,552 portfolio companies.