Pay for performance from future fund flows: the case of private equity, Review of Financial Studies, forthcoming

Lifetime incomes of private equity general partners (GPs) are affected by their current funds’ performance not only through direct carried interest profit sharing provisions, but also indirectly by the effect of the current fund’s performance on GPs ’ abilities to raise capital for future funds. We estimate the magnitude of this market-based indirect pay for performance in the context of a rational learning model, which we show better matches the empirical relations between future fundraising and current performance than behavioral alternatives. The estimates indicate that indirect pay for performance from future fundraising is of the same order of magnitude as direct pay for performance from carried interest. Consistent with the learning framework, indirect pay for performance is stronger when managerial abilities are more scalable and weaker when current performance is less informative about ability. Specifically, it is stronger for buyout funds compared to venture capital funds, and declines in the sequence of a partnership’s funds. Our findings suggest that total pay for performance in private equity is both considerably larger and much more heterogeneous than implied by the carried interest alone. Our framework can be adapted to estimate indirect pay for performance in other asset management settings in whic