Risk-Shifting and Compensation in the Private Equity Industry

Edoardo Marchesi, Finance PhD student

The aim of this project is to investigate whether the compensation schemes enjoyed by private equity (PE) fund managers induce funds to tilt investments towards riskier acquisitions (risk-shifting). Given that PE fund managers are compensation packages include a pay-for-performance component—which is triggered whenever the fund delivers a pre-specified rate of return (hurdle rate) to investors—managers have incentives to increase the volatility of the fund’s underlying assets. At the same time, incentives to risk-shift are exacerbated by the fact that PE funds have a pre-determined fund life, which puts additional pressure on the managers to achieve the pre-specified rate of return. In this paper I test whether funds which are close to the hurdle rate select relatively riskier assets whenever the fund is approaching the date of dissolution