Outside investors don't know if the original investors failed to renew because they had other needs for the money — a "liquidity shock" — or because the fund is a lemon, said Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Cambridge. Ms. Schoar and Mr. Lerner co-wrote "The Illiquidity Puzzle: theory and evidence from private equity," a paper that will be published in the April edition of the Journal of Financial Economics. The market generally interprets the failure of an incumbent to invest in a subsequent fund as a signal that the funds are bad, Mr. Lerner said.
Regarding the bans on transferring interests, the study found that when limited partnership agreements do contain these restrictions, they are often stricter than those required by securities and tax laws.
"The presence of these curbs is particularly puzzling, given that partnership interests are very illiquid to start with because of the large stakes held by each limited partner," the paper said.
What the professors found in their study of 250 U.S. private equity partnerships is that these contract provisions are used as a screening device to deter less desirable investors. These restrictions help the general partners find investors who are more likely to invest in future funds. Restrictions on transfers of limited partnerships are less common in a private equity firm's later funds because by then the private equity firm has established a track record. Moreover, private equity funds that invest in industries with longer investment cycles, like biotechnology funds, have more constraints on transferring limited partnerships than do funds in industries with shorter cycles, like software and Internet funds.
"Investors who expect to face many liquidity shocks in the future would find these restrictions especially onerous and therefore would avoid investing," the paper noted.
Most of the contracts — 89% — indicated the general partner must approve any transfer, and 73% said the general partner must approve a new limited partner, and 33% gave other limited partners the right of first refusal.