Optimal Carried Interest: Adverse Selection in Islamic and Conventional Venture Capital and Private-Equity Funds

ABSTRACT

In an optimal carried interest model with adverse selection, the optimal profit-loss sharing ratio (PSR) explains how the risk aversion of the two parties can affect their bargaining powers by allowing investors to detect the true risk aversion of fund managers and not their true skills. The higher the management fee, the higher is the PSR. Our simulation exercise shows that when the fund manager is more risk averse than the investor for a higher invested capital and weaker expected net profit, the optimal negotiated profit-sharing ratio will be higher.

KEYWORDS:

• Adverse selection
• hidden skill
• optimal compensation
• profit-sharing ratio
• risk aversion

JEL CODES:

• G2
• G17
• G23
• G24
• F51.

Notes

^1. An independent Islamic law board monitors the compliance of Islamic fund investments with the sector and financial screening criteria. Indeed, in the process of selection, the Islamic fund manager has to proceed at two levels. The first level of screening is sector screening, which consists in systematically excluding the shares of companies involved in activities considered impermissible by Islamic law. At a second level, the fund manager has to make a financial screening to exclude shares from companies with financial ratios incompatible with Islamic investment guidelines.

^2. We have to note that there is a lack of research on Islamic carried interest; that’s why we use conventional private-equity’s references.

^3. The Wall Street Journal (May 6th, 2014): http://online.wsj.com/news/articles/SB10001424052702303417104579546213365623096

^4. The net profit is the periodic profit of the fund investments after deducting all expenses.

^5. In private equity, the fund managers are general partners and institutional or other wealthy investors are limited partners who provide the capital.

^6. Typically, this compensation is known as performance fees in the case of hedge funds.

^7. This is the highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager compensation, which is performance based. The high-water mark ensures that the manager does not get paid large sums for poor performance. So if the manager loses money over a period, he/she has to get the fund above the high-water mark before receiving his/her carried interest. For instance, say after reaching its peak a fund loses 150,000USD in year one, and then makes $350,000 in year two. The fund manager therefore not only reached the high-water mark but exceeded it by $200,000 ($350,000–$150,000), which is the amount on which the manager gets paid the performance bonus (according to his carried interest). Source: http://www.investopedia.com/terms/h/highwatermark.asp

^8. The profit-sharing ratio is the net profit share of the investor.

^9. This negotiation stage is inspired from the Islamic Profit and Loss Sharing contracts (Standards of AAOIFI).

^10. The management fees are not included in our model as variable to simplify the reasoning.

^11. This hypothesis is inspired from the models of Manove, Padilla, and Pagano (2001); Stiglitz and Weiss (1981)