Carry bias impacts future fundraising

Harvard research warns that inequality in carry and ownership at private equity firms leads to partner-level departures that have negative effects on future fundraising.

The difference in share of carry taken home by founders compared with other partners in a firm increases the likelihood of partner departures, with negative future impact on fundraising, according to research from Harvard University.

“Pay Now or Pay Later?: The Economics within the Private Equity Partnership,” a survey of 717 private equity partnerships conducted by Harvard Business School professors Victoria Ivashina and Josh Lerner, found that the founder of the firm on average receives 19.2 percent of carried interest, whereas a non-founder takes a 11.3 percent share in the carry.

The average founders’ ownership stake is 21 percent, the study found.

It also found that the average senior partner receives 15 percent of the fund’s carried interest and 21 percent of the firm’s ownership.

Meanwhile, junior partners receive on average 7 percent of carry and 3 percent of ownership. Most junior partners, even as partners, however, had no carry at all.

This divide was more evident among North American firms and venture funds, with Europeans having significantly lower carry and ownership per partner.

In turn, having a lower share of carry and ownership increases the chances of an individual leaving the fund. In the study’s data, one standard deviation increase in the difference in carry shares raised the departure rate by 2.2 percent.

It was even more notable for ownership inequality. A one standard deviation widening in difference between ownership stakes increased the departure rate by 3.7 percent. These rates are significant, considering the average departure rate of a senior partner was 9 percent, the study said.

A private equity professional told the study authors: “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.”

These departures make it harder for firms to raise future funds, partly because sophisticated investors view team stability as a key prerequisite to investment success, the research noted. Whenever partners leave, there are inevitable challenges faced by general partners and limited partners working together for the very first time.

Not surprisingly, the negative effect on fundraising is stronger after the departures of senior partners and top-performing partners. More specifically, one senior partner’s departure at an average-sized firm of four senior partners leads to a 17 percent decrease in the size of the next fund, the study said.

While the carry and ownership bias at a firm might be good for the founders, the consequences from it are not in the interest of the LPs, who want to build long-term relationships with stable, high-performing funds, the study said.