Private Equity Fund Investments: New Insights on Alignment of Interests, Governance, Returns and Forecasting

By Cyril Demaria

This book presents new, advanced, evidence-based guidance on investing in private equity funds: first by assessing the investor's environment and motivations, then by looking into the risks, returns and overall performance of funds and finally, by offering practical solutions to the illiquidity conundrum.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Apr 30, 2015
• ISBN: 9781137400390

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Private Equity Fund Investments

New Insights on Alignment of Interests, Governance, Returns and Forecasting

Cyril Demaria

© Cyril Demaria 2015

Foreword © Olivier Carcy 2015

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS.

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The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988.

First published 2015 by

PALGRAVE MACMILLAN

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ISBN: 978–1–137–40038–3

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A catalogue record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data

Demaria, Cyril.

Private equity fund investments : new insights on alignment of interests, governance, returns and forecasting / Cyril Demaria.

   pages cm. — (Global financial markets)

ISBN 978–1–137–40038–3 (hardback)

1. Private equity funds. 2. Investments. I. Title.

HG4751.D456 2014

332.63—dc23                                2014026511

Contents

List of Figures

List of Tables

Foreword

Olivier Carcy

Acknowledgments

List of Abbreviations and Acronyms

0 Introduction

0.1 Problem analysis

0.1.1 Limited partners: irrational investors subject to biases

0.1.1.1 Limited partners: irrational investors

0.1.1.2 Context of investment: intrinsic and extrinsic factors

0.1.1.3 Current regulations (until 2007)

0.1.1.4 New regulations (from 2007)

0.1.2 General partners are not subject to effective corporate governance

0.1.3 Declining marginal returns: the defining moment of LP-GP relationships

0.2 Research objective

0.3 Methodology

0.4 Terminology

0.4.1 Private equity: definition

0.4.1.1 Private equity: sectors included

0.4.1.2 Private equity: sectors excluded

0.4.1.3 Private equity funds

0.4.2 Limited partners: definition

0.4.3 Limited partners: categorization and motivations

0.4.3.1 Family offices and high net worth individuals

0.4.3.2 Foundations and endowments

0.4.3.3 Sovereign wealth funds and governmental agencies

0.4.3.4 Funds-of-funds and gatekeepers

0.4.3.5 Public and private pension funds

0.4.3.6 Insurance groups

0.4.3.7 Banks

0.4.4 General partners: definition

0.4.5 Corporate governance: definition

0.5 Framework

0.5.1 Market inefficiencies in private equity

0.5.1.1 General inefficiencies of the financial markets

0.5.1.2 Inefficiencies specific to private equity

0.5.2 Corporate governance in private equity

0.5.2.1 Moral hazards in private equity

0.5.2.2 Informal governance levers in private equity

0.5.2.3 Formal governance levers in private equity: LPA and other mechanisms

0.5.3 Selection of general partners and motivations of limited partners

0.5.3.1 General partners selection process and evolution

0.5.3.2 General partner selection: agency theory and critiques

0.5.3.3 Consequences: LPs motivation, GP selection and portfolio construction

0.5.4 Risks in private equity

0.5.5 Liquidity and time horizon

1 Suboptimal Risk–Return Profiles in Private Equity: The Case of Minority Business Enterprises Investing

1.1 Research question

1.2 Method

1.3 Results and discussion

1.4 Conclusion and further discussions

1.4.1 Anecdotal confirmation of the conclusions

1.4.2 Empirical confrontation of the conclusions, and rebuttal

1.4.3 Further discussion: investing in underprivileged markets

1.5 Summary and contribution to the research

2 Fee Levels, Performance and Alignment of Interests in Private Equity

2.1 Empirical framework and literature

2.1.1 Private equity returns: measures

2.1.1.1 Absolute measures of performances

2.1.1.2 Relative measures of performances

2.1.2 Private equity risks assumptions

2.1.3 Limits of current benchmarking methodologies and indexes chosen

2.2 Data and methodology

2.2.1 Drawdowns

2.2.2 Distributions

2.2.3 Data description

2.2.4 Selection of indexes

2.2.5 Data processing and methodology

2.3 Analysis and findings

2.3.1 Analysis of the paid-in to committed capital ratios

2.3.2 Analysis of the management fees and the carried interest

2.3.2.1 US VC

2.3.2.2 US LBO

2.3.2.3 EMEA VC

2.3.2.4 EMEA LBO

2.3.3 Top-quartile US VC, US LBO, EMEA VC, and EMEA LBO funds

2.3.4 Analysis of the performances of funds

2.3.4.1 The carried interest has no material impact on the relative performance of funds

2.3.4.2 Average American funds have better IRRs; indexes better multiples

2.3.4.3 EMEA funds show a very distinct performance landscape

2.3.4.4 Timing of cash flows can explain part of the performance of top-quartile fund managers

2.3.4.5 A partial confirmation of performance cycles in private equity

2.4 Conclusion, discussion and limits

2.4.1 Use for academic purposes

2.4.2 Use for practitioners

2.4.3 Limitations

2.5 Summary and contribution to the research

3 The Predictive Power of the J-Curve

3.1 Empirical framework and literature

3.2 Data and methodology

3.2.1 Interpretation of drawdowns

3.2.2 Interpretation of distributions

3.2.3 Data description and cycles identification

3.2.4 Data processing and methodology

3.2.4.1 First step: data retrieval

3.2.4.2 Second step: sorting data

3.2.4.3 Third step: data aggregation in fund categories (ideal types) and graphical illustration

3.2.4.4 Fourth step: determining the potential predictive power of the J-curve of performances

3.2.4.5 Fifth step: assessment of the reliability of the J-curves to predict future performances

3.3 Analysis and findings

3.3.1 Analysis of the paid-in to committed capital (PICC) ratios

3.3.2 Graphical analysis of the J-Curves

3.3.3 First predictor of performance: the time to breakeven

3.3.4 Ideal-type categories need to be adapted to each market

3.3.5 Reading graphical representations is insufficient for tentative performance predictions

3.3.6 Correlation analysis of the J-Curves

3.3.6.1 US VC

3.3.6.2 US LBO

3.3.6.3 EMEA VC

3.3.6.4 EMEA LBO

3.3.7 Correlations first eliminate categories and then indicate the closest comparable

3.3.8 The predictive power of the J-Curve

3.4 Conclusion, discussion and limitations

3.4.1 Use for academic purposes

3.4.2 Use for practitioners and regulators

3.4.3 Limitations

3.4.4 Further developments

3.5 Summary and contribution to the research

4 General Conclusion

4.1 Summary

4.2 Discussion

4.2.1 Consequences on extra-financial endeavors in private equity

4.2.1.1 Addressing the extra costs associated with additional extra-financial criteria

4.2.1.2 Addressing the signaling effect associated with additional extra-financial criteria

4.2.1.3 Addressing extra risks associated with additional extra-financial criteria

4.2.2 Consequences for the treatment of private equity under solvency and prudential ratios

4.2.3 Consequences on the relationship between LPs and GPs

4.3 Outlook

4.3.1 Consequences on the communication from GPs

4.3.2 Consequences on the behavior of LPs

4.3.3 Perspectives for further academic and empirical research

References and Bibliography

Index

List of Figures

List of Tables

Foreword

When it emerged in the United States in the late 1980s, private equity essentially consisted of investing in the capital of unlisted private companies to finance their growth, their transformation and their transfer of ownership. Over the past three decades, this investment strategy has progressed to become a full-fledged asset class in the allocation of institutional investors and sophisticated private investors. Private equity has formalized and professionalized itself with the emergence of specialized fund managers and the creation of adapted investment vehicles, which have become increasingly standardized.

Even though private equity aims to offer investors high absolute performance, adjusted risk and a relative lack of correlation with traditional financial assets, allocations to this asset class remain surprisingly low in most portfolios – often lower than 5 per cent of assets under management. Moreover, private equity is categorized as one of a number of ‘alternative’ (or ‘non-traditional’) investments – a group of asset classes loosely defined by its novelty and a relative lack of understanding, which prevent their being correctly classified. However, is private equity really an alternative investment? The history of capitalism exhibits a long tradition of investing over the mid- to long term in the capital of companies. Is this ultimately so different from investing in the shares of listed companies?

Compared with the stock exchange and listed shares, assets under management and volumes of investments in private equity are indeed modest. While the total global capitalization of listed companies has reached USD62 trillion (or close to 80 per cent of global GDP), private equity, at USD1.2 trillion, is equivalent to only 2 per cent of this figure. This is even more surprising when one considers that the number of unlisted companies and their estimated cumulative value are significantly higher than the figures for listed companies. Is there an under-allocation to private equity with regards to the depth and the potential of underlying markets?

Some would argue that the low rate of penetration of this asset class is related to its low liquidity. Investors theoretically prefer more liquid assets which can be valued daily. The relative illiquidity of this asset class is indeed a fact, even though there is a booming secondary market. But why look for daily liquidity for an investment whose horizon for value creation is multiple years?

Other investors put forward lack of transparency, confidentiality, limited access to information, the difficulty of interpreting performance or the complexity of contractual processes in private equity as explanations for this under-allocation. However, long-time investors in this asset class regularly provide the opposite feedback: satisfaction with the returns generated, strong conviction related to a proven model, transparency and increased alignment of interests. Another positive feedback is the feeling of having participated in the development of companies by capturing the value created without the pollution of the famous ‘beta’ of financial markets.

Why such a gap in perceptions? Why do so many asset allocation professionals, who are often great specialists in financial markets, not understand this asset class better in order to assign it some space in their portfolios? Surely it is only a question of understanding, education and thus training.

By comparison with the literature on the stock exchange, academic research on private equity is much more sparse. This asset class has not benefited from sufficient efforts to document its promise in terms of performance and risk management. Such research is required if we are to gain a good understanding of the attractiveness of private equity.

Investors in private equity have handled this asset class in a very empirical way, sometimes by chance, and very often taking an approach that follows that of other investors. Over the long term, the development of this asset class in a portfolio can happen only on the basis of a stronger conceptualization, information sharing, and empirical and academic studies on the strengths, advantages, risks and promises of private equity.

Cyril Demaria offers to reduce the knowledge gap with a work which is at the same time academic and practical. This book is thus without any doubt a new frontier in our knowledge about this asset class. It is an instrument for students, for professionals and for academics to better grasp what private equity is. By reinforcing our collective knowledge of the technical characteristics of this asset class, this book will contribute to its maturity and increase its presence in future asset allocations.

I wish you a good read.

Olivier Carcy

Global Head of Private Equity,

Credit Agricole Private Banking

Acknowledgments

Certain sectors of private equity remain terra incognita. While investing in small- and medium-size businesses, I witnessed numerous and significant gaps between financial theory (in general), the developing private equity academic corpus, and practice. The growing public attention to private equity widens the gaps and further generates noise, and often incomplete or incorrect perspectives on the sector.

The purpose of this research is to contribute to the practical and academic understanding of the private equity sector in one of its defining elements: the alignment of the interests of investors in private equity (a vast multitude) with those of the fund managers (rather limited in number, and single points of contact for investors in private equity funds). The resulting dynamics are shaping the sector, as well as the practice of investing in private equity.

I would like to thank my two academic supervisors, Prof. Dr. Andreas Grüner and Prof. Dr. Martin Hilb, for their support and constructive feedback.

This research was possible thanks to the enlightened support of my sponsor, Crédit Agricole (Suisse). I especially thank Olivier Carcy, whose belief in my work has provided me with the financial and critical means to achieve the results. I also gratefully acknowledge the advice and support of Thomas Meyer, Ivan Popovic, Xavier Gerardin, Daniel Hobohm, Jean-Christel Trabarel, Andreas Jäk, Laura Donovan, Gontran Duchesne, Julien Lobel, Michiel Dill, Corinna Traumüller, Michael Battey, Olivier Keller, Vivien Roussie and Ad van Ouweland. I would also like to thank the professionals and institutions which have participated in this study, and for their interest in supporting academic research. All errors and mistakes remain mine.

These acknowledgements would not be complete without the expression of my gratitude to my family for their enthusiastic support, and my wife Bada for her patience and her support, as well as Peter Baker and Gemma d’Arcy Hughes at Palgrave for their professionalism, kindness and patience.

Notice

The following text is based on a doctoral thesis undertaken by Cyril Demaria at University St. Gallen (Switzerland): ‘Alignment of Interests of Fund Investors and Fund Managers in Private Equity’.

Some of its content in the Introduction has been specifically developed and drafted for the extended readership of this book. It has therefore been neither graded nor evaluated by the Thesis Committee.

Zürich, May 2014

List of Abbreviations and Acronyms

0

Introduction

Private equity (PE) is a sector of the financial industry that stands out due to the fast growth of the assets allocated to it. It has evolved from a ‘cottage industry’ [Cornelius et al., 2011, p. 12] to an asset class over a period of forty years [Sensoy, Wang and Weisbach, 2013]. Some professionals have experienced this transformation over the course of their career [Perkins, 2007; Brooke and Penrice, 2009; Draper, 2011].

In the 1970s, the industry was shaped by a few investors (‘limited partners’, LPs) negotiating at arm’s length with a few fund managers (‘general partners’, GPs).¹ They were all based in the USA, with a single common language, culture and legal background. An LP of that time was likely allocating a few million dollars from a discretionary investment pool to funds managed by people situated just a few miles away from him. LPs knew GPs personally; not only were they informed of their reputation, but also LPs and GPs knew the same people. LPs may have even worked with GPs. The industry was made up of essentially personal connections, and represented a few hundred million dollars under management [Perkins, 2007; Draper, 2011]. This was a niche market, driven by long-term perspectives and the awareness that private equity investments could turn out to be a total loss.

In 2014, however, the Chief Investment Officer (CIO) of a financial institution is in charge of allocating hundreds of millions (if not billions) to the private equity sector as part of an overall investment strategy. PE is an official investment category, with target allocations to reach, and with a certain risk-return profile to achieve in different geographies, through different strategies and by delegating the management to GPs that the CIO and their staff do not necessarily know personally.

Today, the PE industry manages an estimated USD 3,000 bn and includes approximately 15,000 LPs and 4,000 to 6,000 GPs worldwide [Preqin estimates, 2012²]. The sector is structured by standardized contracts [Hobohm, 2010], specific time horizons for investments (which might differ from group to group) and the expectation that while this might generate partial/total losses with a given probability [Weidig and Mathonet, 2004], it would hopefully generate certain returns. LPs and GPs are now surrounded by a network of legal and tax advisors, placement agents, gatekeepers and consultants (the ‘ecosystem’) with specific roles and influence in the process.³

The context of PE investments has changed rapidly. New financial techniques have emerged (distressed debt investing, venture lending), and PE has contributed to the emergence of technologies that have triggered at least two post-industrial revolutions (information technologies and biotechnologies). It has also changed the face of capitalism, as monopolies and conglomerates have been drastically restructured through leveraged buy-outs (LBOs) [Brooke and Penrice, 2009]. Moreover, PE drives economic change, acting as an accelerator of the history of a corporation. Bernstein et al. [2008] state that

industries where PE funds have invested in the past five years have grown more quickly in terms of productivity and employment [ ... while there is no support] for claims that economic activity in [these] industries [ ... ] is more exposed to aggregate shocks.

0.1   Problem analysis

The emergence of modern PE was ultimately financed by the savings, donations, insurance premiums, retirement savings and taxes of American citizens (and later of other countries). However, in this process, it is not the citizens who have decided to allocate their contributions to PE,⁴ but the LPs: foundations, family offices, endowments, pension funds, insurance groups and banks. Thus, LPs are agents of the final capital provider [Allen, 2001], and they make decisions in the name and/or the account of the latter to invest in PE.

These LPs are not homogeneous in their expectations and behaviors (0.1.1), and their strategies have evolved over time. Moreover, GPs are not subject to effective corporate governance (0.1.2). The fact that multiple and heterogeneous LPs (principals) with different expectations (some of which might not be financial, see Chapter 1) have to control GPs (agents) in an ineffective governance relationship, drives the choice of whether or not to allocate capital to private equity.

Large institutional investors (pension funds, insurance groups and banks) allocation is dictated by the expected return and risk of PEFs: at the core of solvency and prudential ratios is the ‘standard method’, which relies on the idea of modeling private equity investments, using historical risks and returns of PEFs. The resulting ratios are artificially high (see EDHEC [2010], Studer and Wicki [2010] and Braun, Schmeiser and Siegel [2014] for European insurance groups, for example). In that respect, looking at past performances is helpful but not sufficient: this information falls short of helping investors to monitor and understand the behavior of active PEFs, and of the supporting performance predictions.

However, it is difficult to correct solvency and prudential ratio calculation to take into account specificities of private equity investing (Chapters 2 and 3). This analysis is set in the context of declining marginal returns, which has led to exposing the increasing tensions between LPs and GPs (0.1.3).

0.1.1   Limited partners: irrational investors subject to biases

LPs are irrational (0.1.1.1) investors, constrained by intrinsic and extrinsic factors (0.1.1.2), such as current and new regulations (0.1.1.3 and 0.1.1.4).

0.1.1.1   Limited partners: irrational investors⁵

Given the limited efficiency of the PE market, rational investors should exploit opportunities through arbitrage.⁶ However, there are limits to arbitrage, notably documented by behavioral finance (0.1.1.1.1). Investor psychology plays a significant role in the way risk (0.1.1.1.2) is handled and how it assesses probabilities (0.1.1.1.3).

0.1.1.1.1   Behavioral biases affecting limited partners

In a context of low, asymmetrical and incomplete information, noise [Black, in Thaler 1993, pp. 3–22] can have significant consequences on LP behavior. Unlike on listed financial markets, the informational issue for LPs is not an information overflow but a lack of information. If noise is the ‘opposite of news’, then private equity generates enough noise to fill the voids of information, especially via unfounded rumors, but also through outdated or partial information. As a matter of illustration, one of the consequences of the time-lag associated with the communication of formal performances of PEFs is the generation of ‘waves’ of investments in funds, in underlying assets and in returns [Higson and Stucke, 2012; for US Venture Capital (VC): Robinson and Sensoy, 2011]. These waves are fed by belated knowledge and understanding of past performances and allocation by LPs to capture these performances. Fashions and fads [Schiller, in Thaler 1993, pp. 167–218], as well as representativeness bias [Kahneman and Tversky, in Shefrin, 2002, p. 14] where LP judgments are based on stereotypes, and aversion to ambiguity [Shefrin, p. 2002, p. 21] drive choices, as LPs prefer the familiar to the unfamiliar, and fear the unknown.

This ‘wave’ phenomenon is compounded by the fact that predictions are not sufficiently regressive; recent information is usually over-weighted, and long-term trends are under-weighted [Thaler 1993, p. xix]. As recent information is rather patchy and usually requires more time to be confirmed by other facts and information, it could be assumed that long-term trends are better observed and taken into account by LPs. However, the private equity market is recent and has matured [Sensoy, Wang and Weisbach, 2013]; the distribution of returns has significantly changed over time. Specific skills that used to help certain LPs to capture more performance [endowments and foundations in Lerner, Schoar and Wongsunwai, 2007] appear later less differentiating and do not generate outperformances any more [Sensoy, Wang and Weisbach, 2013]. The consequences might be that LPs