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Rewarding risk-taking or skill? The case of private equity fund managers

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  • Buchner, Axel
  • Wagner, Niklas F.

Abstract

We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components.

Suggested Citation

  • Buchner, Axel & Wagner, Niklas F., 2017. "Rewarding risk-taking or skill? The case of private equity fund managers," Journal of Banking & Finance, Elsevier, vol. 80(C), pages 14-32.
    • Handle: RePEc:eee:jbfina:v:80:y:2017:i:c:p:14-32
    DOI: 10.1016/j.jbankfin.2017.03.014
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    2. Karpavičius, Sigitas & Yu, Fan, 2018. "The impact of dividend-protected CEO equity incentives on firm value and risk," Economic Modelling, Elsevier, vol. 71(C), pages 16-24.
    3. Lu, Shuai & Li, Shouwei & Chen, Ning, 2022. "Robust return efficiency and herding behavior of fund managers," Finance Research Letters, Elsevier, vol. 46(PA).

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    More about this item

    Keywords

    Fund manager compensation; Risk-taking incentives; Managerial skill; Abnormal return; Private equity; Buyout funds;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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