Pay Now Or Pay Later? the Economics Within the Private Equity Partnership

Pay Now or Pay Later? The Economics within the Private Equity Partnership The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Ivashina, Victoria, and Josh Lerner. "Pay Now or Pay Later? The Economics within the Private Equity Partnership." Journal of Financial Economics 131, no. 1 (January 2019): 61–87. Published Version https://doi.org/10.1016/j.jfineco.2018.07.017 Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:41845080 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Open Access Policy Articles, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#OAP Pay Now or Pay Later?: The Economics within the Private Equity Partnership Victoria Ivashina Harvard University and NBER Josh Lerner Harvard University and NBER First draft: March 9, 2016 This draft: March 1, 2017 Abstract The economics of partnerships have been of enduring interest to economists, yet it is not clear what profit sharing within a private partnership should look like. We examine over seven hundred private equity partnerships, and show that the allocation of fund economics to individual partners varies drastically even among the most senior partners and appears divorced from past success as an investor, being instead related to status as a founder. A smaller share of carried interest and ownership—and inequality in fund economics more generally—is associated with departures of senior partners, which, in turn, is negatively related to the funds’ ability to raise additional capital. Keywords: Partnerships, venture capital, leveraged buyout. JEL classification: G24, J33, L26 We thank participants at the American Finance Association 2017 Annual Meeting, CalTech/USC Private Equity Finance Conference, London Business School Private Equity Symposium, London School of Economics, and UNC Private Equity Research Consortium Conference, as well as Ashwini Agrawal (discussant), Yael Hochberg (discussant), Anna Kovner, Edward Lazear, Ludovic Phalippou, Elena Simintzi (discussant) and a number of seminar participants at various schools and practitioners for helpful comments. Grace Kim, Andrew Green, Lucy Zhang, Yulin Hswen, and Kaveh Motamedy provided remarkable assistance with the analysis. Harvard Business School’s Division of Research and the Private Capital Research Institute provided support for this project. One of the authors has advised institutional investors in private equity funds, private equity groups, and governments designing policies relevant to private equity. All errors and omissions are our own. Electronic copy available at: https://ssrn.com/abstract=2757039 Pay Now or Pay Later?: The Economics within the Private Equity Partnership Abstract The economics of partnerships have been of enduring interest to economists, yet it is not clear what profit sharing within a private partnership should look like. We examine over seven hundred private equity partnerships, and show that the allocation of fund economics to individual partners varies drastically even among the most senior partners and appears divorced from past success as an investor, being instead related to status as a founder. A smaller share of carried interest and ownership—and inequality in fund economics more generally—is associated with departures of senior partners, which, in turn, is negatively related to the funds’ ability to raise additional capital. Keywords: Partnerships, venture capital, leveraged buyout. JEL classification: G24, J33, L26 Electronic copy available at: https://ssrn.com/abstract=2757039 I. Introduction Partnerships—a business venture in which a small group of individuals shares the profits and liabilities—were the dominant organizational form of businesses for several millennia and, even today, remain critical to the way in which the professional service and investment sectors are run. Most of theories explaining the prevalence and persistence of this ownership form build on lack of observability of partners’ effort. The classic formulation of Alchian and Demsetz (1972) suggests that in settings where employees are difficult to monitor, a partnership structure may provide optimal incentives for hard work.1 Alternatively, Morrison and Wilhelm (2004, 2008) suggest that it may serve as a commitment device, ensuring that the senior partners properly monitor and train successors. In this context, what should we expect profit sharing within a private partnership to be? Levin and Tadelis (2005) argue that partnerships with equal sharing rules can actually overcome their clients’ concerns about the lack of the observability of partner effort: because of the equal sharing rule, partners have a powerful incentive to closely monitor each other and ensure that they are productive. At the same time, dividing profits according to any kind of a set formula may lead to moral hazard problems, where partners’ awareness that they are only capturing a portion of the profits that they are generating reduces their motivation to work hard (Alchian and Demsetz, 1972; Holmstrom, 1982). This hypothesis has been empirically supported in a variety of settings, from Gaynor and Gertler’s (1995) study of medical practices to Abramitzky’s (2008) analysis of Israeli kibbutzim. Yet, several mechanisms had been shown to be effectivein alleviating this free-riding problem, including the peer pressure posited by Kandel and Lazear (1992) and the relational 1 Literature on executive compensation has also emphasized the benefits of the partnership structure, such as the ability to screen for optimistic employees and increased retention (e.g., Oyer and Schaefer, 2005). Electronic copy available at: https://ssrn.com/abstract=2757039 contracts studied in the partnership setting by Rayo (2007). More broadly, labor literature establishes the importance of peer compensation for job satisfaction and job turnover. Notably, Card, et al. (2012) develops a theory and presents empirical evidence on why information on peer compensation may affect worker’s utilities. The importance of ensuring that employees’ wages are similar to those of their peers is a frequent explanation for the wage compression (i.e., the tight distribution of compensation) often observed in the work places.2 As the previous paragraph suggests, two key hypotheses emerge from the existing literature. First, due to monitoring incentives and/or peer issues, compensation within the same tier of partners should be compressed. Alternatively, compensation should respond to performance and therefore would vary in a group with heterogeneous talent. There is a third possibility that we put forward: because of the opaqueness of partnerships and the difficulty of determining individual contributions—the very reasons that the literature suggests partnerships exist in the first place—the founders of partnerships may not appropriately reward other contributors, and instead take for themselves a disproportionate share of the economics generated by the firms.3 An extensive practitioner literature suggests that when non-founding partnersleave to begin their own funds, they frequently find it difficult to attract capital due to concerns about “attribution”: whether their past performance was really due to their effort, or to the reputation of their former firm and its founding partners. For instance, Probitas Partners notes: Even with emerging mangers, few investors are willing to back groups unless they have an attributable track record of successful private equity investing. However, the process of vetting such a track record for an emerging manager can be much more difficult… Since private equity investing is a collaborative effort, it is often 2 It should be noted that the workers in much of the earlier literature on this topic have substantially lower levels of compensation and autonomy than those examined here. 3 This is akin to the “information monopoly” problem observed for bank borrowers (Rajan, 1992). 2 difficult to sort out responsibility for individual transactions and the issue can be very contentious.4 Due to this “lock-in” effect, we would expect that in settings where founders extract a large portion of the rents, the rate of departure of other partners would still be small. Nonetheless, it should be higher than in an alternative settings without such rent extraction. To the degree that such departures reveal flawed incentive structures to the limited partners (LPs), and lead them to anticipate further departures, we would expect it to be reflected in reduced subsequent fundraising. Founders may anticipate these detrimental consequences of commanding a large share of the rents. Nonetheless, it may be privately optimal for the founders to extract a “larger slice of a smaller pie”: i.e., it may be individually wealth maximizing for them to do so. In this paper, we analyze these issues in the context of private equity funds. In particular, we examine approximately 700 partnerships analyzed in the course of the due diligence process by a major institutional investor. In each case, we have detailed data on how the economics of the fund—in particular, the carried interest (the profit share) and ownership of the management company—is split between the individual partners. We link this information to that on the past performance of individual partners’ investments, the characteristics of the current, subsequent, and prior funds raised by the

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