a model of private equity strongfundstrong compensation.pdf

A Model of Private Equity Fund Compensation! Wonho Wilson Choi Andrew Metrick Ayako Yasuda KAIST Yale School of Management University of California at Davis September 15, 2011 Abstract: This paper analyzes the economics of the private equity fund compensation. We build a novel model to estimate the expected revenue to fund managers as a function of their investor contracts. In particular, we evaluate the present value of the fair-value test (FVT) carried interest scheme, which is one of the most common profit-sharing arrangements observed in practice. We extend the simulation model developed in Metrick and Yasuda (2010a) and compare the relative values of the FVT carry scheme to other benchmark carry schemes. We find that the FVT carry scheme is substantially more valuable to the fund managers than other commonly observed (and more conservative) carry schemes, largely due to the early timing of carry compensation that frequently occurs under the FVT scheme. Interestingly, conditional on having an FVT carry scheme, fund managers’ incremental gains from inflating the reported values of the funds’ un- exited portfolio companies would be negligible. JEL classification: G1, G2, G3, G17, G24, G34 Keywords: private equity; venture capital; fund managers; managerial compensation; corporate governance ! This paper was previously titled as “Expected Carried Interest for Private Equity Funds”. All errors and omissions are our own. ! 1. Introduction Private equity funds are typically organized as limited partnerships, with private equity firms serving as general partners (GPs) of the funds and i