Incentives of Private Equity General Partners from Future Fundraising

Incentives from the explicit fee structure ("two and twenty") of private equity funds understate the actual incentives facing private equity general partners because they ignore the rewards stemming from the effect of current performance on the ability to raise larger funds in the future. We evaluate the importance of these implicit incentives in the context of a learning model in which investors use current performance to update their assessments of a general partner's ability, and, in turn, decide how much capital to allocate to the partners' next fund. Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund. This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees. Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability. Overall, the results suggest that implicit incentives from future fundraising have a substantial impact on general partners' welfare and are likely to be an important factor in the success of private equity firms.