Academic journal article Fordham Journal of Corporate & Financial Law

The Evolution of Private Equity and the Change in General Partner Compensation Terms in the 1980s

Academic journal article Fordham Journal of Corporate & Financial Law

The Evolution of Private Equity and the Change in General Partner Compensation Terms in the 1980s

Article excerpt

INTRODUCTION

Private equity funds, such as Kohlberg Kravis Roberts & Co. (KKR) and Forstmann Little, first entered public consciousness in the late 1970s.1 While the business model has remained largely the same, private equity today is very different from what it was during the 1970s and 1980s. Most evidently, private equity has transformed from a niche investment strategy to an asset class and industry. In 1980, there were only about fourteen leveraged buyout funds.2 Today, there are thousands of private equity funds internationally, with the number having doubled from 2004 to 2014.3 As of June 2016, private equity funds managed a total of about $2.49 trillion in assets.4

Not only has the private equity industry grown significantly, but its profitability and reputation also have changed since its earliest days. In the 1980s, private equity was both highly controversial5 and highly profitable.6 Frequently, in the 1980s, it was described as excessively risky, illogical, and bad for the economy.7 The president of Chemical Bank, for example, wrote in 1985 that he worried leveraged buyouts were "simply . . . a perverse result of greed and not a logical, rational thing."8 While the private equity industry remains the subject of criticism-most notably, when Mitt Romney ran for President in 20129-today, it is not only much less controversial, but also frequently celebrated as an ideal investment strategy.10 Many of the disastrous effects that analysts predicted private equity would cause have not come to fruition.11 In addition, many key insights of private equity funds regarding management compensation incentives and disciplinary effects of debt are now textbook in the business community.12 As an illustration of its institutional acceptance, in 2017, Preqin reported that "[eighty-four percent] of investors have a positive perception of private equity, the greatest proportion among alternative asset classes."13

Yet, as private equity has become more mainstream, its average returns have declined significantly. Although the average returns of private equity funds net-of-fees in the early 1980s far exceeded the returns of the market, Steven Kaplan and Antoinette Schoar in 2005 found that leveraged buyout funds raised after 1986, "weighted by committed capital" and net-of-fees, have, on average, not "outperformed] the S&P 500."14 Chris Higson and Rüdiger Stucke, using a different dataset, found that buyout funds from vintage years since 1980 "have outperformed the S&P 500," but that there has been a "significant downward trend in absolute returns over all twenty-nine vintage years."15

This paper will tell the story of how private equity evolved from controversial and extraordinarily profitable to an accepted asset class and much less profitable. It will discuss the factors that affected the private equity industry in the 1980s that led to each of these changes, particularly the steep decline in private equity returns.

This paper also will identify another important change to the private equity industry that occurred around the late 1980s which the academic literature has largely ignored: the change in the way incentive compensation was calculated.16 In an attempt to better align the incentives of fund managers and investors, institutional investors requested that private equity compensation terms change to be theoretically more investor-friendly and to eliminate certain conflicts of interest faced by fund managers.17 The most important change was the evolution from a deal-by-deal calculation of carried interest to the aggregation method, which requires that profits and losses across individual portfolio deals be aggregated before a general partner (GP), the manager of the fund, is allowed to receive incentive compensation.18

We argue that although this change in GP compensation is seemingly positive for investors and designed to deal with one agency cost problem, it has had several negative effects for private equity fund investors. …

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