Not Quite a Piece of Cake: Theory and Evidence of Compensation in U.S. Venture Capital Partnerships
66 Pages Posted: 18 Mar 2012
Date Written: March 15, 2012
Using a novel dataset including limited partnership agreements (LPAs) and corresponding funds’ cash in- and out-flows in every portfolio company, we analyze incentive effects induced by different distribution rules of general partner (GP)-friendly (deal-by-deal) versus limited partner (LP)-friendly (fund-as-a-whole) compensation contracts on the return and risk characteristics of U.S. venture capital (VC) funds. So far there is little research on performance and related compensation schemes, still only focusing on two components, i.e., 1) carried interest and 2) management fee (e.g., Gompers and Lerner 1999a, Robinson and Sensoy 2011). Through our precise treatment of legal terms, we are able to examine this third key component of venture capital contracts, i.e., the distribution rules, as introduced by Litvak (2009) which sets out in which priority investment profits will be paid out. As VC funds last for ten or more years and are characterized by restricted liquidity, distribution rules can be seen as the driving force for inducing incentives. The empirical results are consistent with our theoretical model predictions that GP-friendly rules lead to higher gross fund returns and higher risk, despite this risk is borne by the GP attributable to clawback provisions. Furthermore, being provided with all internal data regarding each deal our findings are robust to an extensive battery of robustness checks including a comprehensive set of control variables and using various econometric techniques. For example, we control for carried interest and management fee arrangements and confirm studies by, e.g., Gompers and Lerner (1999a) or Robinson and Sensoy (2011), that both contract terms are not associated with fund performance. Finally, we discuss the implications of our findings for researchers and investors regarding compensation schemes.
Keywords: executive compensation, venture capital , partnership, deal-by-deal, fund-as-a-whole
JEL Classification: G24, M12
Suggested Citation: Suggested Citation