The Politics of Pay in Private Equity

Profit sharing at private equity firms is more closely tied to tenure and seniority than to actual investment performance, finds Harvard Business School.

Limited partners (LPs) should already be aware of how fees paid to private equity firms affect their own cut of the performance. But how those fees are allocated within firms can also have relevant impacts for LPs, according to new research.

Division of carried interest and ownership stakes at private equity firms is closely linked to turnover among senior partners, which in turn is linked to a firm’s future performance, wrote Harvard Business School professors Victoria Ivashina and Josh Lerner.

“Distributions of carried interest and ownership appear to substantially affect the stability of the partnership,” they wrote.

Ivashina and Lerner’s research, based on data collected from the due diligence reports of one of the world’s largest limited partners, found that profit sharing at private equity firms often has little to do with individual performance. Instead, allocation of performance fees and ownership stakes was based heavily on seniority and tenure, with founding partners taking home significantly more than other senior employees regardless of their contributions to the fund.

The less equal a senior partner’s compensation, the more likely that partner was to depart from the firm.

These departures can in turn signal trouble for the larger firm, as turnover of top-level employees has “real consequences for funds’ ability to access capital,” with LPs often shying away from staffing volatility.

“Sophisticated LPs often argue that team stability is an important prerequisite to a partnership’s enduring investment success,” Ivanshina and Lerner explained. “Even when a departing GP is replaced by a comparable investor, performance frequently suffers, because of the challenges that investment professionals working together for the first time frequently encounter.”

But while unequal profit sharing among private equity firm partners can be bad news for LPs, the beneficiaries of distorted compensation structures are unlikely to push for change anytime soon, they added.

Founders “may prefer to have the proverbial larger share of a smaller pie, especially if there is considerable income to be gleaned from management and transaction fees,” the Harvard professors concluded. “Such outcomes are unlikely to be in the interest of the LPs.”

Read the full report, “Pay Now or Pay Later?: The Economics Within the Private Equity Partnership.”

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