Better Alignment of Financial Interest in Private Equity

Abstract

The carried interest received by private equity fund managers, or general partners (GPs), generates some controversies. The three most debated claims are that carried interest (1) aligns financial incentives, (2) should be treated as a capital gain for tax purposes, and (3) should not be reported as a fee charged to investors. The existence of two key principal agent relationships within the private equity model might lie at the root of these controversies. One relationship links the GP as the principal with the portfolio company management team as the agent. In this first contract, the three claims hold true. The other relationship links the fund investors, or limited partners (LPs) as the principal with the GP as the agent. This article shows that modifying that second contract (carried interest) by introducing a first-loss feature and reducing the catch-up rate makes the two contracts equivalent. Hence, the benefits of the limited partnership structure can coexist in a setting where the three claims about carried interest hold true. However, currently, these three claims are at odds with how the carried interest is computed.

TOPICS: Private equity, legal/regulatory/public policy, equity portfolio management, portfolio management/multi-asset allocation, real assets/alternative investments/private equity, fundamental equity analysis

Key Findings

• • The private equity model aligns the interest of management with that of fund managers.

• • The private equity model does not have the same alignment between fund managers and fund investors.

• • It is possible to change the fund manager—investor contract to be like the management—fund manager contract and thus achieve incentive alignment between fund managers and investors.