Rewarding risk-taking or skill? The case of private equity fund managers |
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| Institution: | 1. University of Passau, Department of Business and Economics, 94030 Passau, Germany;2. Cranfield School of Management, College Road, Cranfield MK43 0AL, United Kingdom;3. Univ. Lille - SKEMA Business School, SKEMA Business School, Lille Campus, Avenue Willy Brandt, 59777 Euralille, France;1. Fuqua School of Business, Duke University, Durham, NC 27708, USA;2. National Bureau of Economic Research, Cambridge, MA, USA;3. Fisher College of Business, The Ohio State University, Columbus, OH 43210, USA;1. University of Virginia, Darden School of Business, USA;2. University of Oxford, Said Business School, UK;3. University of Chicago, Booth School of Business, USA;4. Warburg Pincus, LLC ,USA;1. Toulouse School of Economics, University of Toulouse-Capitole, France;2. Department of Finance, HEC Paris, France;3. Department of Finance, Arizona State University, USA;4. ECGI, France;1. Technical University Munich, Arcisstraße 21, 80333 Munich, Germany;2. Saïd Business School, University of Oxford, Park End Street, Oxford OX1 1HP, UK |
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| Abstract: | We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components. |
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