Argentum, in cooperation with NHH and SIFR, will arrange the Argentum Conference and Symposium in Stockholm this September. One of the objectives is to highlight the latest in private equity research. Leading up to the conference, we will present an introduction to one of the papers that will be presented each week.

Berk Sensoy (Ohio State University): Incentives of Private Equity General Partners from Future Fundraising

Co-authors: Ji-Woong Chung, Léa H. Stern and Michael S. Weisbach

This paper evaluates the importance of the rewards stemming from the effect of current performance on the ability to raise larger funds in the future. These implicit incentives are evaluated in the context of a learning model in which investors use current performance to update their assessments of a general partner's ability. 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 carried interest, equal to a percentage of profits, aligns the incentives of General Partners with those of investors to a greater extent than in public companies. This explicit incentive to value-maximation is thought to be an important driver of the success of private equity firms.

But the explicit terms of the partnership agreements omits an important source of implicit incentives: The effect of the current performance on the ability of partnerships to raise larger funds in the future, and consequently to earn higher fees on those funds.

This paper evaluates the importance of future fundraising to the incentives of private equity general partners. Given an observation of returns, investors update their assessment of the general partner's ability and decide how much capital to allocate to the partners' next fund.

The model estimates a positive relation between the IRR of a partnership's current fund and the expected size of future funds. The magnitude of this relation varies with the scalability of the investments, where buyout funds have the strongest relation between IRR and future fund size.

Using these estimates, the authors are calculating the magnitude of general partners' incentives as the general partners expected incremental revenue from both an additional percentage point of returns to limited partners in the current fund and an incremental dollar of profits returned to limited partners.

The paper is also considering the sensitivity of future fundraising to the extent of which current performance adds incremental information about the general partners' abilities. They find that funds of younger vintages have greater sensitivities of fund growth to today's performance, and that this greater sensitivity leads to larger expected future profits per dollar of today's returns for these types of funds.

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