Private equity’s pitch to avoid compensation regulation

Here’s a letter to congress from the private equity industry. Its purpose is to avoid regulation of compensation at private equity firms. Regardless of your opinion on the issue, it is a good primer on how private equity firms are structured – which is quite similar to how venture capital firms are structured. There’s a good description of the model, including the relationships between General Partners, Limited Partners, Funds, and Firms, as well as different aspects of compensation including management fees and carried interest as well as the timing of payments and clawbacks. If you’re interested, take a look here.

I’ll also share a few thoughts on compensation regulation. There are two potential drivers for compensation regulation: incentives which may increase systemic risk, and social equity. I’ll talk about the first here; I’ll skip the second as I don’t think its likely to generate a particularly useful online discussion.

Systemic risk is typically generated by entities which use a lot of leverage. To the extent that private equity is making un-leveraged investments and its LPs are not using leverage to invest in the funds, it should be free to adopt whatever compensation policies are agreeable to the parties directly involved. To the extent that they are borrowing large amounts of capital from our banking system, there is a public interest in ensuring that pay practices do not promote excessive risk taking. That said, I believe the clawback provisions in most private equity firms are generally effective mechanisms for avoiding excessive risk taking, so even if there is some leverage involved I don’t know that compensation regulation is helpful.

— Max

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