Private Equity Fund Returns: Do Managers Actually Leave Money on the Table?

Abstract

Evidence indicates that private equity funds, unlike mutual funds, deliver persistent abnormal returns and that the top performing funds are often oversubscribed. Why do private equity funds appear to leave money on the table, rather than increasing fund size? We argue that private equity funds are fundamentally different from mutual funds because their success is contingent on their matching with high quality firms (entrepreneurs). Firms also want to match with managers that have higher estimated value adding ability. This gives managers an incentive to manipulate firms' beliefs about their ability by providing higher returns. Managers limit fund size, fees or both even if firms are not fooled in equilibrium. The model explains the puzzle and provides several new time series and cross sectional predictions about fund performance, fees and size. For example, venture capital funds should have stronger performance persistence and lower sensitivity of size to past returns compared to that of buyout funds.