We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components.

In this study, we explored the presence of correlated investment choices (i.e., herd behaviour) among international buyout funds by distinguishing among the contemporaneous and the following herding of smaller funds towards the top market players (i.e., the top quartile in terms of the fund size). In our analyses, we found that the industry herding towards the largest ones is common in private equity (PE) but mostly during market contractions or the deterioration of general market conditions. Moreover, we also found that as capital inflows into the PE industry slow down, herding occurs more often. This finding is consistent with the increasing competition for new capital fundraising in downturns, which can induce PE funds to herd more. We also found that both types of herding generate higher fund returns and lower risk for funds that are capable of herding. Additionally, we documented the persistence in herding.

In this paper, we investigate whether fund-specific risk helps explain performance persistence in private equity funds, using detailed deal-level cash flow information at both the fund and deal levels. We further extend existing findings to international evidence on buyout and venture capital (VC) by testing the impact of various risk measures. We find that risk is an important driver of performance persistence and helps explain such persistence. We also find persistence in risk in private equity, in particular persistence in downside volatility for both buyout and VC funds. Finally, we document that fund performance is more strongly affected by fund managers able to minimize downside losses than selecting outperforming portfolio companies. This effect is strongest for buyout but, to a weaker extent, also holds for VC. Our results are further robust to controlling for legal factors at the country level.