Interaction between the dry powder of private equity buyout funds, their remuneration structure and their performance

Abstract

Over the past decade, private equity has evolved from a small alternative investment asset class to a well-established investment industry that raised $555 billions in 2019 to reach $3.7 trillion of assets under management (McKinsey & Company, 2020). This growth of investment flows towards private equity, and more specifically towards buyout funds, has raised concerns about the potential agency conflicts that exist between the general partners (GPs) and the limited partners (LPs). The dry powder, which is the capital committed to buyout funds but not yet invested, has also reached record amounts, potentially exacerbating the agency conflicts in the current remuneration structure. In the context of a booming private equity buyout fund industry, this master thesis shows the agency costs generated by dry powder and the resulting negative impact it can generate in the light of the fund managers’ remuneration structure. This paper, using a large sample of US buyout funds with vintage years from 1980 to 2019 retrieved from Preqin, investigates the interaction between the dry powder of private equity buyout funds, the remuneration structure and the performance. Thanks to a theoretical approach combined with an empirical analysis, the various agency costs generated by the dry powder can easily be identified and its impact on the funds’ performance can also be studied. The results of this analysis illustrate the pressure that GPs can face when the level of dry powder is high approaching the end of the investing period. This phenomenon is detailed in a fee decomposition model over the life of the fund. Furthermore, the empirical analysis, based on OLS regressions, allows to identify the causal impact of the dry powder on the funds’ performance. The outcome shows a statistically and economically significant negative impact of the dry powder on funds’ performance especially among the funds that are under pressure to invest. The rationale behind this result is that if when approaching the end of the investing period, the dry powder ratio is above the optimal level, which will be approached in the theoretical model, GPs will be under pressure to spend money. The pressure arises from the remuneration structure which is mainly composed of fixed management fees and variable performance fees. GPs can face a tradeoff between performance fees and management fees which could result in investing in less performing deals which require less time to evaluate and execute, in order to maximize the total fees collected during the life of the fund. It is also shown how the different remuneration components impact the level of the dry powder. There is a positive relationship between the dry powder and the hurdle rate and a negative one between the dry powder and the management fee and the carry interest rate. Furthermore, this paper shows that there is a true negative causal effect of the dry powder on the performance when GPs are under pressure.