Optimal ownership structure in private equity

• Date: 01 January 2018
• Published date: 01 January 2018
• DOI: http://doi.org/10.1111/eufm.12130

DOI: 10.1111/eufm.12130

ORIGINAL ARTICLE

Optimal ownership structure in private equity

Bo Liu

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Yang Liu

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Jinqiang Yang

2

1

School of Management and Economics,

University of Electronic Science and

Technology of China, No.2006, Xiyuan

Ave, West Hi-Tech Zone, Chengdu,

611731, China

Email: Liub@uestc.edu.cn

2

School of Finance, Shanghai University

of Finance and Economics, No.777

Guoding Road, Yangpu District,

Shanghai, China 200433

Emails: liuyangbread@yeah.net;

yang.jinqiang@mail.sufe.edu.cn

Abstract

We develop a tractable model to analyse the valuation of a

general partner (GP) and the ownership allocation in a

private equity (PE) fund. Our results indicate that holding

ownership will increase GP’s value. We further explore the

influential factors that affect GP’s optimal ownership

decision. Our model predicts that GP’s managerial skill has

positive effects on GP’s shareholding choice. Factors such

as leverage, unspanned risks, GP’s compensation have

negative impacts on GP ownership decision. The fund’s

maturity has a non-monotonic and concave influence.

Moreover, the widely used performance measures implied

by our model are consistent with empirical findings.

KEYWORDS

illiquidity, incomplete market, managerial compensation, ownership

structure, private equity

JEL CLASSIFICATION

G11,G23,G24

The authors are especially grateful to John Doukas (the Editor) and two anonymous referees for very helpful suggestions.

Bo Liu acknowledges support from the National Natural Science Foundation of China (#71373036 and #71573033) and the

Science and Technology Support Program of Sichuan Province (#2013GZ0116). Yang Liu acknowledges support from the

Natural Science Foundation of China (# 71472117) and Shanghai University of Finance and Economics Postgraduate

Innovation Funds (CXJJ-2014-315). Jinqiang Yang acknowledges support from the National Natural Science Foundation of

China (#71202007 and #71522008), Innovation Program of Shanghai Municipal Education Commission (#13ZS050) and

‘Chen Guang’Project of Shanghai Municipal Education Commission and Shanghai Education Development Foundation

(#12CG44).

Eur Financ Manag. 2018;24:113–135. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

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INTRODUCTION

A private equity (PE) fund is a closed-ended, finite partnership whereby the limited partner (LP) and

general partner (GP) share the residual profits after paying debt holders. To establish the ownership

allocation, PE contracts usually involve items about the GP’s shareholding. Robinson and Sensoy

(2013) examine 837 PE funds and find that 79% have GP ownership above 0.99%. Given the huge

amount of global PE investment, the issue of ownership allocation is significant and requires

theoretical explanation and support. Incentive-based compensation is a common explanation for GPs

owning a significant share of PE funds, as the LP attempts to align the GP’s interests with the

underlying project. The traditional view is that ownership holding, as well as carried interest, are used

to reduce the principal-agent problems. However, there exist two potential limitations. First, under the

traditional view, ownership holding and carried interest have the same effect. Therefore, it is unclear

why the GP should be awarded with ownership if carried interest has already been adopted. Second, it is

difficult to quantify the effects of the GP’s ownership holding on the principal-agent problem, and

hence, one cannot accurately analyse the issues surrounding the GP’s compensation structure.

PE fund assets are illiquid, and their risk exposure is difficult to hedge with publicly traded

securities due to PE funds’unique characteristics. PE fund shares are not as easily tradable as public

securities since the secondary market is inactive and there are tremendous discounts when selling PE

fund shares. Kleymenova, Talmor, and Vasvari (2012) report an average bid discount of 25.2% on PE

secondary transactions over the 2003–2010 period. Nadauld, Sensoy, Vorkink, and Weisbach (2016)

report discounts of slightly more than 50% in the 2009 crisis period. The discounts are significant and

large, even as an alternative investment. Sorensen, Wang, and Yang (2014) (SWY hereafter) calculate

the illiquidity cost due to the unspanned risks of the underlying assets and lock-up period resulting from

PE being a closed-end fund, with the main result being that the GP must generate sufficient risk-

adjusted excess return to compensate the LP for bearing the idiosyncratic risks. SWY mainly define

and solve LP’s valuation problem with non-GP’s ownership holding.

To overcome the limitations of traditional explanations for a GP’s ownership levels, we develop a

tractable model to theoretically analyse the GP’s valuation with ownership holdings based on the SWY

model. We improve on their model by allowing the GP to hold positive shares and solve GP’s

optimality problem. In our model, the GP can take on firm-level idiosyncratic risks except those that

must be borne by the LP. The GP’s will be increased relative to the case in which the GP has no

ownership. For a risk-averse GP in our model, the improvement in marginal valuation from risk-benefit

sharing outweighs the cost when the GP’s shareholding ratio is relatively low. When the GP holds more

shares, the illiquidity discount from bearing idiosyncratic risks becomes noticeable, and the trade-off

between the utility increase and illiquidity discount determines the GP’s optimal ownership preference.

Our numerical results indicate that risk-benefit sharing means that GPs will benefit from holding some

shares. Compared with the traditional view of incentive compensation, which treats shareholding by

GPs as an effective way to reduce the principal-agent problem, our model shows that increase in value

for the GP offers another reasonable explanation for why a GP would like to hold an ownership stake in

a PE firm.

In addition to the utility improvement resulting from risk-benefit sharing, the ownership allocation

arrangement will also increase the GP’s value via an earlier earnings realisation. Following the

waterfall compensation structure, the carried interest would be realised only if the liquidation value of

PE assets exceeds the sum of debt repayment and investors’preferred return. The distribution

clustering around the carried interest threshold is a result of this mechanism. There exists an incentive

for the GP to time distributions such that they cluster at and just after a fundamental asset’s value

exceeds the catch-up region in which carried interest takes effect. By doing so, the GP immediately

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