PeFees - VCPE fee structures and orphan funds Mark...

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Unformatted text preview: VCPE fee structures and orphan funds Mark Humphery-Jenner * This version: March 15, 2011 Abstract This article documents and analyzes the creation of orphan ven- ture and private equity funds. Orphan funds are funds that extract management fees on funds-under-management despite making few in- vestments. They account for up to 13% of all VCPE funds and each fund extracts around $12.25m in management fees for capital that they do not invest. I show that an explanation for orphan funds is the imposition of a threshold IRR that the fund must meet on all in- vestments (not just individual projects) before a performance bonus is payable. This discourages poorly performing funds from making further investments even if these investments are value-creating. This is the first paper to document presence of orphan funds or to explain why they occur. Keywords: Venture Capital, Private Equity, Orphan Funds, Perfor- mance Fees JEL Classifications: D21, D86, G11, G24, * Tilburg University and University of New South Wales. Email address: . I thank Mark Carnegie, Doug Cumming, Deon Jou- bert, and Sian Owen. 1 1 Introduction This article shows that the traditional VCPE fee-structure explains the ex- istence of orphan funds. The traditional fee structure comprises a fixed management fee and a performance fee (carry) that is payable if the funds overall IRR (not just that on an individual investment) exceeds a threshold. Orphan funds plague the VCPE industry. These funds fail at one investment and cannot earn carry. Thus, they are abandoned; the VCPE manager does not draw-down any further capital, makes no further investments. The VCPE manager effectively abandons the fund but continues to draw management feeds. VCPE funds can stimulate corporate development. 1 However, prior lit- erature suggests that VCPE funds earn relatively low net returns on a risk adjusted basis. Phalippou and Gottschalg (2009) find that private equity funds under-perform the S&P 500 by 6% on a risk-adjusted basis. I find, using a sample of 3895 VCPE funds raised after 1980, that funds earn a net IRR of 9.49%, on average. 2 Some studies have examined the fund- characteristics that influence performance. 3 Another approach is to examine 1 This has received significant coverage in the literature. Not all studies find that VCPE funds create corporate value. See for example: Aggarwal and Hsu (2009); Fitza, Matusik, and Mosakowski (2009); Rind (1981). 2 The sample is from Preqin. It includes all funds whose vintage (date of first draw down) is after 1980. 3 See for example: Cumming and Dai (2011); Cumming, Fleming, and Schwienbacher (2009); Cumming and Walz (2010); Hochberg, Ljungqvist, and Lu (2007); Phalippou (2010)....
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This note was uploaded on 03/30/2011 for the course FIN 5514 taught by Professor Jaffe during the Three '11 term at University of New South Wales.

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PeFees - VCPE fee structures and orphan funds Mark...

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