In a first-ever look at the internal economics driving private equity partnerships, Harvard Business School researchers have found that many of these funds can be torn apart by greed among founding partners who take home a much bigger share of profits than other senior partners, even when their performance doesn’t merit higher rewards.
This creates a ripple effect, where other senior partners become resentful, disenchanted, and leave their jobs, causing instability that spooks potential investors and could lead to a firm’s collapse.
“Short-term greediness is affecting the long-term stability and continuity of the firm”
This pattern of unequal pay was much more extensive than anticipated among the 717 private equity partnerships studied by HBS finance professor Victoria Ivashina and Josh Lerner, the Jacob H. Schiff Professor of Investment Banking.
These rifts, far from being uncommon, are the average experience in PE partnerships, Ivashina says.
In their working paper released in March, Pay Now or Pay Later? The Economics within the Private Equity Partnership, she and 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.
Founding partners who shave off what is considered excess pay for their efforts can destabilize private equity firms. Source: Nic McPhee (CC 2.0)
“Short-term greediness is affecting the long-term stability and continuity of the firm,” Ivashina says. “If you perceive you’re talented and you believe there is an unfairness in terms of compensation, you are likely to move on. It’s an important element that could trump the continuity of the firm.”
It’s interesting, she continues, because you might think that founders would care about legacy and the firm continuing beyond one generation. “But many firms seem to be missing the consequences and longer-term effects.”
UNEQUAL PAY FALLOUT
Partnerships remain key to the way the professional service and investment sectors are run. Previous research has shown that the partnership structure has many advantages, including encouragement for senior partners to mentor successors.
The divide among partners has played out in the media in recent years.
For example, Weston Presidio reportedly suspended its fund-raising in 2014 after a group of partners left the company to start a new investment firm.
Doughty Hanson fell apart in 2015, according to one investor, because “historically there was an issue with the top guys having all the power and the economics, so there were quite a few spinouts in the past.” Another investor who decided not to invest in the firm’s funds said, “One of the things that we never got comfortable with was the economics between the two founders and the rest of the team, and as far as I’m concerned that did cause [staff] turnover to a large extent.”
Also in 2015, Charterhouse was said to be “a scene of frictions, involving both how its earnings are divided among the staff and how to hand power to a new generation.”
PARTNERS FLEE AND FIRMS STRUGGLE
Ivashina and Lerner studied 2,577 senior partners and 1,394 junior partners, as well as 1,032 investment professionals who were classified as founders. They looked at a variety of detailed data on the partners and the funds, including performance information, as well as the split of ownership and carried interest—or profit share.
The average founding partner grabbed a much larger share of the carried interest than the average non-founder: 19.2 percent compared with 11.3 percent. Similarly, a founding partner had an average ownership stake of 30.8 percent, compared with the average non-founder’s stake of only 13.6 percent.
The researchers also took note of partners’ departures, which in general are uncommon. For the average fund, the probability that a given senior partner will depart was 9 percent, and for junior partners, 12 percent. But senior partners were significantly more likely to leave a firm that had higher pay inequality; partners on the shorter end of the profit stick were the ones leaving.
The paper notes that senior partners who stay have much higher carry stakes than those who leave—16 percent versus 9 percent. The difference in ownership stake is even higher: Senior partners who stay until the next fund have 23 percent of the ownership, whereas those who leave have only 13 percent.
Ivashina says that although senior partners’ departures were strongly related to pay inequality, this was not the case with junior partners, who also earn less.
“The junior partners will be paid less, and it doesn’t really matter,” Ivashina says. “The fact that as a junior partner you don’t make as much as a senior partner, that could be justified. The junior partners are willing to endure a lot until they get to that status of a senior partner. But when you become a senior partner, it matters.”
When senior partners walk, it often has very real consequences for the performance of funds. Even when partners are replaced by comparable investors, the team may be viewed as less stable due to the challenges investment professionals often face when working together for the first time. With the stigma that comes with staffing changes, the partnership may struggle to drum up ongoing investments.
Junior partners can come and go without affecting the ability of a PE firm to raise the next fund. But that’s not the case with senior partners: The more senior partners leave, the smaller the next fund is.
That’s because limited partners often take the time to look at the partnership makeup at private equity firms when deciding which ones to invest in.
Limited partners “have a lot of private conversations and collect a lot of information. They look at the partners and how they have performed in the past,” Ivashina says. “If someone left and they believe this person is important, there is likely to be a very serious conversation about that.”
GREED IS THE NORM
The researchers naturally expected greed to surface at some private equity firms, but found it notable that this pattern of unequal pay played out among so many of the firms they studied.
“There are several firms that do think about this issue very seriously: They think about how to pass senior rights to next generations and make sure there is continuity to the firm. It’s not that there are not good exceptions out there,” Ivashina says. “But the result we observed in a large sample—with [certain] senior partners taking away most of the economics—seems to be the average experience. The average experience is more in line with the stories we hear in the news about unstable firms. People are frustrated.”
The research conducted by Ivashina and Lerner was made possible through collaborating with one of the largest limited partners, which provided what Ivashina calls “unprecedented data” about how people are compensated, with a promise from the researchers that information about individual firms would be kept confidential.
“We are sworn to secrecy,” she says. “Many of these firms are very curious [about the findings]. Private equity firms are quite interested, but there is especially huge interest among limited partners who have a choice about whether to allocate money to firm A or firm B. They may be the agent of change here.”