Pay for Performance from Future Fund Flows

Pay for Performance from Future Fund Flows

Michael Weisbach Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University, and his colleagues, Ji-Woong Chung, Berk A. Sensoy and Léa H. Stern, are looking at the effect of the pay for performance at private equity funds. One hand, there is the current income from management fees and a percentage of the profit earned by the fund. On the other hand, there is the potential future income from future funds.

A fund sponsor's lifetime income can be as dependent on the ability to raise capital in the future as it is for the income on capital currently under management. A fund sponsor's "total pay for performance equals the sum of pay for performance features of the explicit compensation contract and the implicit, market-based pay for performance caused by the relation between today's performance and future fundraising."

Weisbach takes a closer look at the magnitude of pay for performance for private equity fund managers.

  • For every extra percentage point of returns (or every extra dollar) earned for the current fund's investors, how much, in expectation, does the lifetime revenue to the fund's general partners change?
  • How strong is this implicit pay for performance sensitivity relative to the much-discussed explicit one?
  • Theoretically, how should implicit pay for performance vary across different types of partnerships and over time within a partnership? Do these predicted patterns appear true in the data?
  • More generally, how do today's returns affect the ability of partnerships to raise capital subsequently? How important is future fundraising to the total (explicit plus implicit) pay-performance relation facing private equity general partners, and for what types of partnerships and at what point in a partnership's lifecycle is it most important?

The results are not particularly surprising:

For all types of funds, both the probability of raising a follow-on fund and the size of the follow-on conditional on raising one are significantly positively related to the performance of the current fund. The magnitude of these relations varies with the scalability of the investments. Buyout funds, which are the most scalable, have the strongest relation, while venture capital funds, which are the least scalable, have the weakest relation.

We also find that these relations are stronger for funds that are earlier in a partnership's sequence of funds, that is, younger partnerships have stronger relations between future fundraising and current fund returns than older partnerships. This suggests that fund flows in the private equity industry reflect learning about ability over time, and that the strength of the market-based, implicit pay for performance facing a private equity partnership depends on the extent of its prior track record.

The paper does have some interesting data on private equity funds and their operations:

  • The mean (median) preceding fund size is $497.9 ($210.0) million for all funds taken together,
    • $866.4 ($380.0) million for buyout funds,
    • $217.7 ($125.0) million for venture capital funds, and
    • $501.0 ($314.9) million for real estate funds.
  • The mean (median) preceding fund performance is 15.1% (10.6%) for all funds taken together,
    • 16.5% (14.3%) for buyout funds,
    • 14.1% (5.8%) for venture capital funds, and
    • 14.6% (14.1%) for real estate funds.
  • The mean (median) follow-on fund size, conditional on raising one, is $792.2 ($314.0) million for all funds taken together,
    • $1,465.3 ($632.6) million for buyout funds,
    • $283.9 ($181.0) million for venture capital funds, and
    • $694.2 ($425.0) million for real estate funds.
  • The time between successive fundraisings averages 3.3 years for the entire sample,
    • 3.8 years for buyout funds,
    • 3.3 years for venture capital funds, and
    • 2.4 years for real estate funds.

In the end, they conclude that the implicit component of pay for future performance from future funds is on the same order of magnitude as the explicit component of compensation in the carried interest of the current fund. That sounds like a fund manager's interests are well aligned with the long term interest of the investors in its funds. That's something that public companies continue to struggle with.


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