Rewarding Risk-Taking or Managerial Skill? The Case of Private Equity Fund Managers

58 Pages Posted: 24 Apr 2015

See all articles by Axel Buchner

Axel Buchner

University of Passau; CEPRES - Center of Private Equity Research

Niklas Wagner

Passau University

Date Written: 2015

Abstract

Compensation of private equity fund managers typically consists of a fixed management fee and a performance related carried interest which entitles managers to option-like payoffs. We consider whether this structure tends to reward excessive risk-taking rather than managerial skill. Our model of manager compensation is based on risk-neutral pricing techniques in an equilibrium framework where investors earn zero abnormal returns net-of-fees. When the model is calibrated to a set of buyout funds, our results demonstrate that managers indeed have an incentive for excessive risk-taking in case only fee income from the current finite lifetime fund is considered. In the more realistic setting where managers take into account potential compensation from follow-on funds, the risk-taking incentives will depend on the manager’s level of skill. Our model illustrates that the typical contractual arrangements can serve as a means of limiting possible risk-shifting behavior during fund lifetime. Also, skilled managers in this setting even have an incentive to reduce fund risk. Based on our sample of buyout funds we further show that the typical compensation structure is costly. Managers must generate substantial alpha in order to compensate investors for bearing the given fee components. Based on a standard compensation contract, annual break-even alphas amount to around 7 percent, and the present value of total compensation equals about 20 percent of committed capital.

Keywords: Private equity, venture capital, buyout funds, fund manager compensation, risk-taking incentives

JEL Classification: G13, G23, G24

Suggested Citation

Buchner, Axel and Wagner, Niklas F., Rewarding Risk-Taking or Managerial Skill? The Case of Private Equity Fund Managers (2015). Available at SSRN: https://ssrn.com/abstract=2598113 or http://dx.doi.org/10.2139/ssrn.2598113

Axel Buchner (Contact Author)

University of Passau ( email )

Innstraße 27
Passau, 94030
Germany

CEPRES - Center of Private Equity Research ( email )

Max-Joseph-Strasse 7
Munich, 80333
Germany

Niklas F. Wagner

Passau University ( email )

Innstrasse 27
Passau, 94030
Germany

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