The greater the GP ownership, the more risk-averse fund managers are, a study from the Norwegian School of Business and Goethe University Frankfurt has found.
“GP ownership has direct implications on the portfolio company of choice. In particular, the GP selects the company by trading oﬀ the expected cashﬂow against the downside risk,” according to Carsten Bienz, Karin Thorburn and Uwe Walz, authors of Ownership wealth and risk taking: Evidence on private equity fund managers.
Analysing a sample of 62 portfolio companies acquired by 20 Nordic PE funds from 2000-10 and the taxable wealth of 120 investment professionals in these funds, the researchers found that GPs with a relatively high portion of their wealth invested in the fund tend to select firms with less risky cashflow.
GP commitment or skin in the game also affects how much debt is used to finance the acquisition. “Since lower risk ﬁrms have greater debt capacity, GP ownership also has an indirect eﬀect on leverage. That is, the higher the ownership, the more debt the GP uses to ﬁnance the firm.”
The average GP commitment in the sample was 3.7 percent and ranged from zero to 15 percent of the fund’s capital. The report also noted that investment professionals in Norway are generally required to put more money on the line in the funds they manage, with partners’ ownership averaging as much as 93 percent of their taxable wealth.
The average fund in the sample has committed capital of $942 million and three sample companies in its portfolio. Moreover, it has 16.6 investment professionals, of which 8.4 are partners.
The study found that the effect of GP ownership is not limited to characteristics of individual target firms and has a broader impact on the design of the fund portfolio. When GP ownership is higher, ticket sizes tend to be smaller.
“Within our own business, as well as for the GPs we prefer to back, having to write out a significant cheque yourself for every investment you make focuses the mind more than simply relying on carried interest incentivisation,” the head of European private equity at a UK-headquartered investment firm told Private Equity International.
Having a meaningful commitment size is fundamental to alignment of interests, the head added.
“The rule of thumb for a long period of time has been that you want your management team to be investing what is a meaningful sum to them – not so much as to keep them awake at night, but enough for them to really feel it if they lose that investment,” he said.
There may be some smoke and mirrors when it comes to skin in the game. The European PE head noted there are many situations where the GP commitment is effectively self-financed from the management fees. LPs should be looking closely at the profitability of the management company and total remuneration of key personnel, he said.