By: Blakely Blackford.

Historically, many limited partners in private equity have voiced concerns that the limited partner agreements they sign with general partners are bad deals. Among the litany of concerns, two that come up most often are that general partners earn excessive fees, and that they earn carried interest on strong exits even if this exit follows a string of poor past returns. As the sector has cooled, the contracting pendulum has swung in favor of limited partners, and increasingly they have come to insist on what are called “whole-fund” carry provisions, which stipulate that GPs cannot begin to earn carried interest until the limited partners have earned a preferred return on their entire capital commitment. (The alternative would be to offer “deal by deal” carry, which allows GPs to earn carry out of each investment as it is exited: the concern is that under these contracting terms a GP could earn carry on a successful exit even if they owed money to limited partners from losses on past exits.) Essentially, under whole-fund LPAs, LPs are served first. The idea that a general partner should only earn carried interest after they have returned capital to limited partners strikes most people as so obviously fair-minded towards limited partners that these contracts therefore are widely considered the LP-friendly option. Indeed, in its Private Equity Principles, the Institutional Limited Partners Association (ILPA) puts carry provisions at the top of its concerns, positing that whole-fund provisions help align GP with LP interests.

While it seems obvious that LP-friendly contracts seem fair to LPs, no empirical evidence has ever demonstrated that limited partners are actually better off under this contracting scheme. Fuqua researchers David Robinson and Niklas Hüther, along with a team of German researchers, were able to obtain data to study this question. Their work asks the simple question: “Are LPs actually better off with LP-friendly contracts?”

Their answer? No. Using a proprietary dataset of contracts and fund performance for 85 VC funds, they consider underlying dynamics tied to deal-by-deal and whole-fund carry provisions and look closely into how carry structures affect fund performance. Their findings reveal that deal-by-deal contracts are tied to better returns for LPs on both a gross and a net-of-fee basis. Across their dataset, which includes over 3,500 investments by funds raised between 1992 and 2005, the funds with whole-fund provisions performed on average 18% below index funds, while the deal-by-deal funds exceeded public market performance by 24% (PME of 1.24). Also, gross IRR was “14 percentage points higher among the set of deal-by-deal contracts.”

The authors see two explanations for why deal-by-deal contracts are associated with better returns and overall fund performance. One is obvious. GPs with better track records can demand GP-friendly LPAs, while GPs with less experience or success may prompt LPs to shy from offering deal-by-deal carry.

The other is maybe not so obvious: changing from deal-by-deal to whole-fund carried interest affects the incentives that GPs have to exit investments, and in a manner that is detrimental to LPs interest.

“Paying LPs first only makes sense if you think that nothing else in the contract is changing, but when you move from a deal-by-deal to a whole-fund compensation structure for GPs, past failures cast a shadow over current investments. This can be especially bad in venture capital, where you need GPs to really swing for the fences,” says Hüther.

Recognizing the influence of carry provisions on fund management, the researchers compare the exit behavior of GPs with deal-by-deal and whole-fund LPAs. Whole-fund provisions are connected with grandstanding, the practice of “posting early returns to investors […] to send a signal of the fund’s underlying quality,” and thus the quality of the GP. While such signaling takes place early in a fund’s life, the lack of carried interest provided before the breakeven point on the entire fund gives GPs little incentive to move aggressively on individual exits. In contrast, deal-by-deal carry payments encourage GPs to maximize the value of each exit, an incentive that robustly strengthens overall fund performance.

By providing GP incentives for nimble fund management, LPs empower them to perform at their best, which means that both groups stand to profit more with deal-by-deal carry provisions. When it comes to LPAs, it turns out that the GP-friendly contract is also the most LP-friendly.

“We have a lot of discussion about taxing private equity differently, about encouraging long-term investment behavior, but most of this discussion implicitly assumes there is a one-size-fits-all answer: An answer that works for the entire industry. Our research shows that one-size-fits-all contracts don’t work in private equity. We need room for different kinds of contracts so that different types of investment funds with different types of investment opportunities all have the right incentives. The concern I have with the current discussion swirling around private equity circles is that we’re losing that,” concludes Robinson.

BACKGROUND INFORMATION: Venture capital and private equity funds are intermediaries: the fund managers use other investor’s capital to build investment portfolios of privately held firms. Limited partner agreements are the legal contracts that support this activity. These documents specify the fees that the VC fund managers receive, they specify the types of firms they can invest in and set limits on how long the fund manager has to invest capital, and they specify how the investment returns are shared between the General Partner (i.e., the fund manager) and the limited partner (i.e., the ultimate provider of capital). This sharing rule provides for GPs to earn “carried interest”—typically 20 to 25% of the net return—as compensation for generating investment returns.

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