Private Equity Incentive Contracting and Fund Leverage Choice When Investors Only Care About Meeting Return Targets

We show how the standard PE compensation contract is used to create incentives for GPs to utilize leverage so that LP investors can meet their return targets. A theory of fund capital structure is developed in which investors trade off alpha with costs of financial distress. We then show how carried interest is used to fine-tune leveraging incentives, where there is a one-to-one mapping between the carried interest return hurdle and fund leverage. The fixed asset management fee and promote percentage are used to ensure fees meet or exceed the minimum fee required for GP participation. When costs of financial distress are sufficiently large relative to alpha, limits will exist on the ability to leverage a fund to meet LP return targets. Three different fee regimes are considered to analyze net-of-fee PE returns, where we show that fees generally increase incentives to leverage the fund. This analysis highlights pension fund investment behavior when there is a focus on absolute returns without close reference to risk considerations.