Endowments invest in private equity funds through partnerships. They look for small teams of investors who have worked together and have made money together. Most of the time these small teams were part of an established private equity firm but depart to form their own fund.
A couple of Harvard Business School professors confirmed the reason why many of those partners leave an established firm: unequal pay.
In their working paper released in March, Pay Now or Pay Later? The Economics within the Private Equity Partnership, [Professor Victoria Ivashina] and [Professor Josh] Lerner found that a partner’s pay was often tied more to the person’s status than to performance. Previous success as an investor seemed to have little bearing on how much the partner earned. Founders in particular gobbled up a much bigger piece of the pie.
Senior partners who believe they aren’t compensated fairly are significantly more likely to leave a firm. These departures can give limited partners the impression that a private equity firm is unstable. That perception creates a wariness to invest, which means a PE firm often struggles in its attempts to raise the next fund.
So in essence, founding partners are damaging their own firms, in some cases beyond repair, by being greedy.
Although no one expects partnerships to be equal, they do expect them to be fair.
Our findings reveal that the inequality ratio is substantial for both carry and management company allocations. Moreover, the disparity between levels of compensation becomes even more pronounced when comparing senior to junior partners. Furthermore, we find that carry inequality increases as funds become progressively larger; when comparing funds with more than three senior partners to funds with more than eight senior partners, the carry inequality ratio increases significantly. On the other hand, we find that carry and ownership inequality falls as private equity organizations mature, as measured by the progression of inequality over successive funds. Next, we use regression analysis to examine the determinants of fund economics distributions and find that founder status is an important driver of compensation. Senior partners who are founders on average receive almost twice as much carried interest than a non-founder and have over twice the ownership stake of a non-founder. On the other hand, we find that the relationship between partners’ past performance and their share of economics is much less consistent.
You can find the research paper on SSRN.
Post by Marcelino Pantoja