Pay for Performance from Future Fund Flows: The Case of Private Equity

Lifetime incomes of private equity general partners are affected by their current funds’ performance through both carried interest profit sharing provisions, and also by the effect of the current fund’s performance on general partners’ abilities to raise capital for future funds. We present a learning-based framework for estimating the market-based pay for performance arising from future fundraising. For the typical first-time private equity fund, we estimate that implicit pay for performance from expected future fundraising is of approximately the same order of magnitude as the explicit pay for performance general partners receive from carried interest in their current fund, implying that the performance-sensitive component of general partner revenue is about twice as large as commonly discussed. Consistent with the learning framework, implicit pay for performance is stronger when managerial abilities are more scalable and weaker when current performance is less informative about ability. Specifically, implicit pay for performance is stronger for buyout funds compared to venture capital funds, and declines in the sequence of a partnership’s funds. The estimates suggest that total pay for performance in private equity is considerably larger, and exhibits much more cross-sectional variation, than implied by the carried interest alone. Our framework can be adapted to estimate implicit pay for performance in other asset management settings in which future fund flows and compensation depend on current performance. ∗For helpful comments and discussions, we thank Brent Goldfarb, Charlie Hadlock, Ulrich Hege, Josh Lerner, Andrew Metrick, Oguzhan Ozbas, Manju Puri, Morten Sorensen, Per Stromberg, and seminar and conference participants at the Argentum/SIFR/HHS Private Equity Conference, Duke University, Koc University, LBS Symposium on Private Equity Findings, Michigan State University, NBER Corporate Finance Meeting, Ohio State University, Rutgers University, University of Arizona, University of Georgia, University of North Carolina, and the Third Canadian Conference on the Economics of Innovation and Entrepreneurship. Please address correspondence to Berk Sensoy, Fisher College of Business, Ohio State University, 2100 Neil Avenue, Columbus, OH 43210, or e-mail at sensoy_4@fisher.osu.edu.