Private Equity Fund Returns: Do Managers Actually Leave Money on the Table?

Evidence indicates that private equity funds, unlike mutual funds, deliver persistent abnormal returns and that top performing funds are often oversubscribed. Why do private equity funds appear to leave money on the table, rather than, say, increasing fund size and/or fees? We argue that private equity funds are fundamentally different from mutual funds because their success is contingent on matching with high quality entrepreneurial firms, and these firms are looking to match with high ability managers. In the presence of asymmetric information about managerial actions or fund attributes, we show that fund managers limit fund size and fees and deliver persistent excess returns to investors. They do this in order to manipulate entrepreneurs' beliefs about managerial ability to add value, even though firms are not fooled in equilibrium. The model provides several novel time series and cross sectional predictions about performance persistence, fees and size, in addition to addressing the questions raised above.