Coller Institute of Private Equity

FindingsINSIGHTS FROM THE WORLD’S BEST PRIVATE EQUITY RESEARCH

ISSUE 3 WINTER 2010 / £25 $40 €30

INSIDE THE SHAPE OF THINGS TO COME How and VC funds will -emerge from the crisis IMPLICIT INCENTIVES -Why carry counts less than we think MANAGEMENT, MANAGEMENT, MANAGEMENT -Is this private equity’s trump card? CALLING TIME ON CAPTIVES Should banks be principal -investors in private equity? COLLER INSTITUTE PE Masterclass: Lives up to its name

INCLUDING CONTRIBUTIONS FROM: LONDON SCHOOL OF ECONOMICS l HARVARD BUSINESS SCHOOL l MIT SLOAN SCHOOL OF MANAGEMENT l INSEAD l OHIO STATE UNIVERSITY l STANFORD UNIVERSITY 4 By the numbers Diminishing returns. Emerging markets VC blossoms. The harsh fundraising environment. IPOs pulled; secondary boom.

6 Analysis: Where next for private equity? Josh Lerner, Martin Halusa and Sandra Pajarola on the chances of a cyclical recovery, the persistence of disparity of returns and what the industry will look like in 10 years’ time.

10 Head to head: Today’s fund, tomorrow’s reward? Limited partners tend to focus on as the main way of incentivising managers. But the prospect of raising larger funds is as much, if not more, of a driver of performance, according to new research.

12 Roundtable: Why management counts How important are management practices to improving performance in companies? And how much of a difference can individual managers make? A panel of experts discusses.

17 Beyond the abstract: The end of the captive? The risks stemming from banks’ principal investing activities have historically been unquantified. But recent research into the area sheds new light on the way in which captive private equity arms behave across cycles. 22 Coller Institute of Private Equity News The Masterclass in Private Equity continues to attract a large and diverse group of participants. Plus, a round-up of past and future events.

2 Private Equity Findings

Editorial Board he financial crisis has affected the private equity industry in many ways – exit and fundraising Jeremy Coller conditions remain tough, leverage has not been availableT and the increasing regulatory focus has induced Professor Eli Talmor Professor Francesca Cornelli uncertainty. Issue 3 of Private Equity Findings starts by looking

at the state of the industry and its future prospects. Josh Professor Professor Eli Talmor Lerner of Harvard Business School, a keynote speaker at the Francesca Cornelli Coller Institute of Private Equity’s 2010 Symposium, kicks off the debate, presenting a number of scenarios of what the Special acknowledgements future will hold for private equity as it emerges from the crisis: cyclical recovery or a broken industry? and thanks to We proceed by looking at some of the most contentious issues concerning the future of private equity and examine what insights the world’s best private equity research provides. Hans Holmen, First, Issue 3’s Head to head explores the question of general partner incentives. One of the key issues Coller Institute of Private Equity, currently being discussed is alignment of incentives for GPs and LPs. We present research about GP Executive Director incentives which points out that managers are motivated not only by explicit incentives from fees and carry on their current funds but also by implicit incentives. This is because a successful performance today enables GPs to raise larger funds in the future and therefore to earn further fees. Another issue presently the subject of debate is whether private equity creates value. If leverage is not going to be easily available in the future, the general opinion of LPs is that the successful private equity firms will be the ones that are best at restructuring and improving managerial capability. In this issue’s Roundtable, we ask whether management practices are important in creating value. How can management practices affect corporate behaviour and returns and how much is attributable to the personal characteristics of individual managers? We also ask whether firms owned by private equity display better management practices. Finally, Beyond the abstract delves into the area of captive funds, a highly relevant subject with the banking industry facing regulatory pressure regarding the future of their PE arms. Will we continue to see captive funds in the future, and should we want to? We explore the role that banks’ principal investing activities have played in the PE market and we debate whether such activities constitute a systemic risk. As a leading forum for debate, the Coller Institute of Private Equity hopes that this edition of Private Equity Published by Bladonmore (Europe) Limited Findings continues to stimulate a healthy exchange of views. Whether you concur with the points raised or Editor: Vicky Meek not, we would appreciate your feedback. Continue the debate by emailing us on [email protected] or via Managing Editor: Sean Kearns our new website at www.collerinstitute.com by responding to our blog. Sub-editor Lynne Densham As academic research in the field continues to expand, we look forward to featuring more leading Creative Director: Nigel Beechey research going forward. We thank all contributors to this issue. Art Editor: Ivelina Ivanova Production Manager: Andrew Miller Publisher: Siân Mansbridge Publishing Director: Sophie Hewitt-Jones Steve Dell Group Managing Director: Richard Rivlin T: +44 (0)20 7631 1155 Professor Eli Talmor Professor Francesca Cornelli

Illustrations: E: [email protected] Chair, Coller Institute Academic Director, Coller Institute

3 50 50 By the numbers 30 30

40 40 25 25

30 30 20 20

15 15 20 20

10 10 Diminishing10 10 returns 5 5 Figure0 1: LPs with net0 returns of 10% or less from their PE portfolios Figure 2: LPs with net returns of 16%+ from their PE portfolios 0 0 since they began investing since they began investing

50 50 50 50 n Summer 2006 n Summer 2006 n Summer 2008 n Summer 2010 n Summer 2007 40 40 40 40 n Summer 2008 30 30 30 30 n Summer 2009

20 20 20 20 n Summer 2010 Respondents % Respondents %

10 10 10 10

0 0 0 0 IRR Negative 0% - 5% 6% - 10% IRR 16%+

Source: Coller Capital, Global Private Equity Barometer, Summer 2010 Source: Coller Capital, Global Private Equity Barometer, Summer 2010 l The effects of the financial l Only around one in five (22%) l Despite this, 20% of LPs are l Nearly two-thirds are also crisis are showing in LPs’ now has returns of 16% or more, expecting to increase their expecting to accelerate their portfolios, as more than 50% of compared with well over a third allocations to private equity commitments to GPs over 2010 respondents to the Coller Capital in summer 2009. The peak year over the next 12 months, up and 2011, which will be welcome Summer 2010 Barometer was 2007, when nearly half from 17% in summer 2009. news for funds in the market or reported lifetime private equity (45%) reported 16+% returns. The number expecting to reduce planning to be so in the coming returns of 10% or less. This is in allocations has fallen to 13% 12 months. stark contrast to just a year (vs 20% last year). previously, when only 29% said their returns were 10% or less.

$100bn $205bn $41.3bn

 The amount of capital raised in final fund closings in  The quarterly amount of capital Q2 2010, according to Preqin, which had anticipated an Preqin predicts will be raised at final increase on Q1 2010’s $60bn. This is the lowest amount closings in 2011, provided that deal recorded since 2003, reflecting the harsh fundraising and exit activity continues to improve.  The amount of capital raised in environment: 39% of final closes in Q1 2010 took final fund closings in Q2 2007, between 19 and 24 months to reach and 24% took according to Preqin figures. This was between 25 and 37 months to raise. Three per cent of the highest ever recorded in a quarter. funds have been on the road for more than three years.

Source: Preqin Quarterly, Q2 2010 (figures include private equity real estate funds)

4 Private Equity Findings < 1%< 1% 17% 17% 52%52% 31%31% 396396 2010*2010* 4% 4% 30%30% 28%28% 38%38%

IPOs pulled; secondary buyouts boom l Despite a flurry of activity at the start of 2010, European exits via IPO failed to take off in any big way. European exits 0 17 52 31 Several were pulled, with sponsors citing uncertain 2009 2010* 0 17 52 31 and volatile public markets. This reflects a broader trend seen in global markets: IPOs with a value of 4 4 30 30 2828 3838 $69.7bn were postponed or aborted across the globe Less than 1% 4% in the nine months to the end of September, according to Thomson Reuters Deal Insight. This was a 6% increase on last year and translates into 150 pulled % IPOs during the period. 17 31% l Instead, buyout houses turned to their peers as 38% 30% secondary buyouts saw an increase in numbers for the first nine months of 2010 over the whole of 2009 and a near doubling in terms of proportion of exits. This is the result of pent-up demand for deals among firms that have dry powder and a slight improvement % in the credit market. 52 28% l Trade sales also picked up, as corporate buyers’ confidence levels increased over the first three quarters n IPO n Secondary buyout n Insolvency n Trade sale of 2010. Meanwhile, receiverships fell sharply as a proportion of European exits, although they were still *First nine months only running far higher than during the boom times: in 2006, just 13% of European exits were via receivership. Source: cmbor.com/Barclays Private Equity/Ernst & Young Venturing into emerging markets Expected growth in next five years – number of VC firms l Emerging markets look set for a rapid expansion of the number of firms, % of respondents while developed nations will see a decline, Brazil according to research conducted by Deloitte and Canada the US National Venture Capital Association. It polled 516 venture capital firms globally. China

l In line with this, LPs’ interests are expected to France shift towards emerging markets venture capital funds, with Brazilian, Chinese and Indian Germany respondents expecting LPs to be more inclined to invest in their home markets than has historically India been the case and US, French and UK Israel respondents expecting to see a decline in LP interest. UK

l Respondents expect to be investing more in USA cleantech (80% said they would increase their investment in this area) and healthcare services 0 10 20 30 40 50 60 70 80 90 100 (63%), while semiconductors and Increase significantly (more than 30%) Decrease slightly/moderately (1%-30%) telecommunications will see the biggest slowdown in investment – 38% said they would decrease Increase slightly/moderately (1%-30%) Decrease significantly (more than 30%) investment in the former and 25% in the latter. Remain the same

Source: Deloitte/National Venture Capital Association

5 Analysis Where next for private equity? For decades, private equity has attracted blue-chip institutions on the basis of a reputation for superior risk-adjusted returns. But as the industry swelled in size, has it burst at the seams? Kimberly Romaine asked three key figures for their views.

rivate equity has been because even as certain investors built on the premise of leave – and they will – others will enter. rewarding patience with Therefore, we will see elements of the handsome returns. Yet other three scenarios that pan out.” many believe the real Halusa: “It won’t come as much of a Ppicture is less rosy, as a handful of surprise that I believe the most likely studies have shown disappointing scenario is a recovery. The industry performance from the industry. In had its own moment of irrational 2005, Kaplan and Schoar found exuberance during the boom; however that average buyout returns net of if you talk about relative performance, fees were lower than the S&P 500; I continue to believe that private equity a claim backed four years later by will generate better returns for its Phalippou and Zollo (as explored by investors during this period. Private Equity Findings in Issue 2, “When investors look at the pp12-15), who estimated that private ongoing performance of the potential equity returns lagged the index by investment universe, I strongly believe 3% annually. that they will continue to view private One of the most respected equity as one of the few sources where academics in the field, Harvard This is an industry ripe for they can generate Alpha. The long- Business School’s Josh Lerner, added “ term trend for sophisticated investors to the debate in his keynote speech a rethink – the terms and will continue to be an increase in at the Coller Institute of Private allocation to private equity.” Equity’s 2010 Private Equity Findings conditions were created at a time Lerner: “The problem with the Symposium. In it, he said that these argument about PE being an asset unfavourable findings could be when there were $20m funds. class that offers superior risk-adjusted underestimating the true bleakness of Now there are $20bn funds” returns is that it hasn’t been shown the situation because of the survivor empirically. A series of recent bias of most returns studies – the JOSH LERNER, JACOB H. SCHIFF PROFESSOR OF studies that analysed PE/VC returns worst performers are often left , HARVARD BUSINESS SCHOOL suggests the asset underperforms on out altogether. a risk-adjusted basis; a couple even In addition, all studies to date have suggest that it underperforms the S&P been based on data that predates Which scenario is most likely, 500. This is particularly the case for the current financial crisis. In his and why? buyouts. The situation may be even presentation, Lerner put forward Lerner: “I feel the truth will probably worse, since the worst-performing several scenarios for what might lie between the first and second funds are often omitted from samples.” happen to the industry over the next scenario. This is because a cyclical few years. They are based roughly on recovery will take place, but many What will be the different fates two variables: loyalty of investors and players will leave altogether. These of VC vs buyouts? robustness of returns (see box-out on will largely be the groups that had no Pajarola: “Venture globally is going p7 for details). business entering in the first place through a real shake-up, but we are Private Equity Findings spoke to or whose strategies are no longer speaking mostly of the US, since Lerner, together with Martin Halusa, successful. Their departure will leave European venture never really became worldwide CEO of , and more opportunity for those left – but the size that was hoped for. Despite Cath Riley Sandra Pajarola, partner at Partners this adjustment will take time.” the fact that US venture has just Group, to debate some of the issues Pajarola: “What is least likely is scratched the surface of positive

Illustrations: raised in the presentation. scenario three: LP desertion. This is returns over the last decade, it will 6 Private Equity Analysis Findings

be redefined and survive. This is because people like to rattle off “Firms with very large pools of 10 home runs that inspire them. capital per head benefit because However, such successes are extremely rare, so as an LP you have it allows them to pay dramatically to invest in a diversified portfolio to find the winners, although that, higher compensation to attract and of course, dilutes your returns. So venture will survive, but it retain the best talent” will undergo a major shift. We’re MARTIN HALUSA, WORLDWIDE CEO, APAX PARTNERS already seeing significant fund-size reductions. small number of winner deals and would look very different if we could “Buyouts will not see as much in turn a small number of winner see similar charts based on the latter, change, because returns volatility groups. Other influencing factors which is a far more important way is much lower than venture. This include the ability to attract resources; of measuring performance. Large down cycle has once again separated ability to have ties/contacts; and the funds that are seventh or eighth the wheat from the chaff. What was ability to recruit the right executives.” generation are popular with investors different in the past cycle was that Pajarola: “People don’t remember because the manager is able to point unprecedented fund sizes were the last cycle, which is largely why to long-term persistence. First-time being raised. We now know the they speak so much about skewness funds are a far more risky proposition timing was not ideal, but the market now – but over the last 10 years about and account for the large number of opportunities for such large buyouts 30% of investment managers left the vehicles that deliver negative returns. will come back.” market. This in turn presents great “European PE performance Halusa: “We have been out of the opportunities; for example, 2009 was is more negatively skewed, and venture market for some time, but I do a fantastic year for secondaries.” I suggest that this is a result of a know that it has been difficult. Even in Halusa: “The charts [that less mature and far more fractured the US, VCs have struggled to generate demonstrate this] are weighted by market than the US. Intense decent returns for some time. number of funds rather than weight competition at all levels of the market “Over time, there will be of capital, but I am sure the picture has helped to keep US firms honest.” consolidation at both ends of the market. But it is important to see it as a Josh Lerner’s four scenarios continuum – both are equally critical in providing the engine for growth.” 1) Recovery. In this scenario, the buyout and venture 3) LP desertion. Poor returns see many investors Lerner: “There is a continuum industries are cyclical, with too much money piling leave the asset class altogether – not only are between VC and buyout. You see it in during booms, raising prices and dampening returns down, but fees whittle them down even in many ways, such as the increased returns. After the boom comes the bust, with creative further in this scenario. Those that remain call importance of growth equity in many destruction leading to a correction. Funds then return for term tweaking – including decreased fees and traditionally buyout-focused funds as performance improves, and so begins the next cycle. increased investor rights to intervene in troubled and the greater emphasis on later- funds. If LPs despair of seeing changes and better stage investing by major VC groups. 2) Back to the future. Returns are inherently returns, this scenario sees the pool of investors and I disagree with the argument that skewed in this scenario, with a select few funds capital decrease. buyouts will not see much change, doing consistently well, but most generating subpar or that it is low volatility – there are returns: the top funds generate the lion’s share 4) Broken industry. Despite the apparent imbalance likely to be major disruptions in the of returns, particularly in venture capital – and of risk-return profiles and inefficient remuneration established order.” keep outperforming. The flip side in this scenario: structures, private equity continues to raise funds, many funds do poorly over extended periods. the result of slow reactions by LPs (largely owing to Why is the trend for skewness Many LPs that experience bad returns abandon excessive optimism and the slow process by which of returns intensifying (see their allocations, leaving the playing field to more information on performance is channelled back charts on p8)? sophisticated investors. to investors). Lerner: “Skewness of returns is an inherent part of the asset class. Small CONSTANT INVESTOR BASE TURNOVER IN INVESTOR BASE differences in ability can correspond ‘FAIR’ RETURNS RECOVERY BACK TO THE FUTURE to huge and disparate variances in returns. Reputation makes the DISAPPOINTING RETURNS BROKEN INDUSTRY LP DESERTION biggest difference – this means a 7 Analysis

Lerner: “The charts of returns do is a lot of conservatism in the business. count individual funds equally. But “There will be consolidation, “Any change will occur in slow a well-documented pattern in PE motion. In 1983 the technology market literature is that larger funds actually with around 10 big brands crashed. It took six to eight years before underperform rather than outperform, you saw a significant decrease in the especially in the buyout space. So acting as multi-asset number of groups. This is because capital weighting would actually investment a typical private equity group is one accentuate the skew.” with a 10- to 12-year fund and with a managers because stream of management fees.” To what extent are we likely to Halusa: “As the market matures, it see a change in the way that funds returns are will continue to concentrate. Eventually, are managed and fees charged only a couple of handfuls of firms will following the crisis? so cyclical” emerge as truly global bulge bracket Lerner: “This is an industry ripe for a SANDRA PAJAROLA, PARTNER, champions, in a process that will rethink – the terms and conditions were PARTNERS GROUP ultimately see 80% of the capital created at a time when there were $20m and gravitate to 20% of funds. Now there are $20bn funds. I’d the firms, in parallel with investment like to see a shift towards a decrease in We’ve seen how one cycle can kill banking. This is a process we have fee income and at the same time carry an otherwise robust brand with an already witnessed in more mature ramped up. It’s normal to see 25-30% excellent track record. Diversification professional services businesses such carry in venture funds, so this could be a and critical mass are crucial, making it as accountancy and consultancy. step in the right direction in conjunction harder for smaller players to survive. The prize for those few that are able with sharp fee cuts.” “Fundraising will be different too. to crack this challenge is a big one; Pajarola: “When investors complain A sound investment manager raising capital will continue to migrate from about fees, they are mostly talking a new fund can expect about 60% of traditional asset classes to alternative about huge funds. But there are only previous investors to return, committing assets that are best able to boast long- around 10 of these globally. In Europe about 75% of the sums they did in term outperformance. and the US we’re seeing decreasing the previous investment programme. “It is clear that firms with very fees as funds launch new investment This is because we will see some LPs large pools of capital per head programmes. One of the larger ones in leave the market and/or decrease their benefit because it allows them to pay the market has just announced a 100% allocations, just as new money comes dramatically higher compensation offset of transaction fees – this may in. This new money will largely come to attract and retain the best talent. catalyse followers.” from the sovereign wealth funds.” This scale also comes to bear in the Lerner: “The exit of less informed functional infrastructure of firms. A How will the industry look in five investors will mean an increase in 20-man professional investor relations to 10 years’ time? returns going forward. But what would team cannot be amortised over a $1bn Pajarola: “There will be consolidation, make the model truly much stronger – fund, but it can be justified if your with around 10 big brands acting fundamental change in remuneration – fund size is $10bn. These teams are as multi-asset investment managers will probably not happen unless there is upping the ante for everyone else in because returns are so cyclical. a more severe disruption because there the industry.” SKEWNESS – A DIVERGENCE IN RETURNS

%IRR %IRR US buyout returns %IRR European private equity returns %IRR 400 150 400 150 350 120 350 120 300 90 300 90 250 250 60 60 200 200 30 30 150 150 0 0 100 100 -30 50 50 -30 0 -60 0 -60 -50 -90 -50 -90 -100 -120 -100 SOURCE: ThomsonReuters/Lerner -120 100 90 80 70 60 50 40 30 20 10 0 100 90 80 70 60 50 40 30 20 10 0 Percentile Percentile Measures returns of 1,927 funds from inception to 31/03/2008 Measures returns of 1,225 funds from inception to 31/12/2007

European private equity returns chart includes venture capital. The data used for these charts runs up to the 2003 so that only mature funds are included. 8 Accurate information is the key to success 14,000 private equity funds 16,000 buyout deals

4,000 LP investor profiles

performance metrics for 5,200 funds

5,000 fund manager profiles

London: +44 (0)20 7645 8888 New York: +1 212 808 3008 Singapore: +65 6408 0122 www.preqin.com

preqinad.indd 1 10/11/2010 11:07:42 Head to head

Today’s fund, tomorrow’s reward? Much is made of carried interest as a means of incentivising managers, but how much of a factor is future fundraising? It may be larger than many think, according to a new study. By Fay Sanders.

implicit component or the fees and carry success in the eyes of the market,” they expect to receive from successive he explains. funds. The authors argue that the These results may have an impact on performance of the current fund will investors’ willingness to invest in buyout have an effect on the ability of funds as they increase in size, according partnerships to raise larger funds in the to Sensoy. “Over time, the implicit part future and consequently lead to higher will get smaller, but the explicit part fees on those funds. typically doesn’t change so the total pay Berk Sensoy The paper compares the extent to for performance is going to go down,” which private equity houses are he says. (Total pay for performance is motivated by the prospect of raising calculated by adding the explicit Berk Sensoy is assistant professor of finance at Ohio State University. future funds versus the more imminent interest in a GP’s current fund to the He received his PhD in finance from the University of Chicago in 2006. gains of receiving income via carry and implicit pay for performance.) His publications and working papers span a broad range of topics in management fees in the current fund. finance, including entrepreneurship, venture capital, private equity, “There has been much talk about the Buyout vs venture corporate investment, mutual funds and securities lending. 20% carry giving a strong incentive to Another key discovery is that buyout GPs, but the possibility of raising future funds are more affected by implicit funds also gives a strong incentive,” incentives than venture funds. “This anager motivation is points out Sensoy. matched our expectations since you one of the key areas have more scalability on buyout for LPs to explore Future funds investment abilities, as you can invest when investing in a A key conclusion is that the implicit larger sums of money. In venture fund. LPs generally incentive of raising successor funds is investments the scale of money is more Maccept that there is a price to pay for important and, in the case of most limited,” says Sensoy. outstanding returns and they tend to buyout funds, of equal importance to In their research, the academics focus on the way in which the 2 and managers in their motivations as the had to allow enough time for GPs to 20 model applies to particular funds. explicit incentive of receiving carried raise follow-on funds, so few of the Yet are there other factors that interest. This is especially true in the vehicles studied were raised during the come into play? At the Coller Institute case of new partnerships and those current recession. “Although a few of Private Equity’s 2010 Private with a higher fee structure. were, they were not studied Equity Findings Symposium, Berk Over time, the balance shifts. “The specifically,” admits Sensoy, who Sensoy presented his recent research implicit incentives from future agrees that external factors such as the (with Ji-Woong Chung, Lea Stern and fundraising get smaller as partnerships impact of the recession on LP or GP Michael Weisbach, all of Ohio State get older,” Sensoy notes. This is investment capability could be the University), Pay for Performance perhaps not surprising but the finding focus of new research. from Future Fund Flows: The Case should help LPs get to grips with the The results of the findings should of Private Equity. This set out to qualitative judgement necessary for help LPs to make more informed discover the true motivation behind understanding GP motivations. “As investment decisions, says Sensoy. GP investment decisions. partnerships get older, the market has “LPs are concerned about incentive The authors define two components a better idea of how good they are, and alignment and this research shows the of a GP’s incentive: the explicit current performance has less impact importance of implicit pay for Fred Van Deelen Fred Van component of their compensation on future fundraising. If Blackstone, performance to GP incentives; and that contract, which includes the fees and say, has a fund that does poorly, that its importance is relative to fund type

Illustrations: carry on the current fund; and the will not erase its long track record of and partnership age,” he adds. 10 Private Equity Findings

he pre-crisis years make in successful groups and rewarding fundraising seem effortless managers whatever the outcome of their in retrospect. Riding high investments. How can they decide when on the financial bubble, the pay structure is out of kilter? many GPs invested their For Andersen, it’s simple: past currentT fund quickly to take advantage success is the key determinant for of favourable economic conditions and investing and if fees are high at an Søren Brøndrum then raise much larger follow-on funds. absolute level, this is the price that LPs Andersen The problem for LPs is that it can take have to pay to be investors in top quartile some time to determine how successful funds. “Proven investment ability is one previous funds will be, says Søren of our top criteria when selecting funds. Søren Brøndrum Andersen is a partner in the investment team at ATP Brøndum Andersen, partner at Danish So we have to accept that fee income Private Equity Partners. He joined in 2004, having previously worked ATP PEP. “It takes a may be substantial, but it’s a trade-off. If with direct private equity investments at Procuritas, the Nordic mid- number of years before you have we avoid investing in funds with ‘unfair’ market buyout fund. visibility on the performance of a private fee incomes, we could risk not getting equity fund given the blind pool into some of the best-performing funds.” It can be tough for first-time funds to structure,” he says. This uncertainty get into the market, owing to their lack of allows GPs to raise substantially larger Will there be tiers? track record. Yet this in itself can also be funds before their true ability is known. However, there is scope for change. He an advantage for the GP as there is no However, Andersen thinks LPs need questions whether all GPs should be evidence of any negative previous to look at why some GPs were raising granted the same performance fee examples, Andersen points out. “We’ve larger funds in 2006 and 2007. “Those structure. “It’s puzzling why the carried backed first-time funds when we’ve felt who did it just because of the fee income interest percentage is 20 for all funds,” a strong motivation that counter did it for the wrong reason.” Chung, says Andersen. “GPs should be more balances the lack of experience.” Sensoy, Stern and Weisbach’s research open to several tiers of carry depending The research demonstrates the helps remind LPs they should be looking on IRR or money multiple performance. importance of LPs having a view on not just at how GPs are incentivised for The carry range could go from as little as GPs’ future fund prospects. “As an LP their current funds, but also at how 10% to as much as 30%.” we need to have a good idea of how current fund performance might impact Despite some of these issues, GP much money GPs want to raise in their future fundraising, he adds. fund contributions can offset some of next funds and what is incentivising As firms scale up and implicit the imbalance. “We are not so much them,” says Andersen. “We should be incentives become less of a factor but looking for a specific percentage of GP concerned by GPs too incentivised by fixed fees become a more important part commitments, rather to go a step further the fixed fees and that are investing of the overall pay structure, LPs need to and determine whether the amount in quickly to raise a considerably strike the right balance between investing question is sufficient,” he notes. larger fund.”

The research

The paper Pay for Performance but this ability is unknown. Given manager of a buyout fund, implicit ability of managers to translate their from Future Fund Flows: The Case observations of returns, the investors incentives are as large as explicit abilities into larger funds depends on of Private Equity examines the can learn about the GP’s ability and, incentives from carried interest in the production process. The authors sensitivity of GPs’ incentives to in turn, decide how much capital to the current fund. In some cases, the argue that buyout funds are more performance of the current fund. allocate to the partner’s next fund. implicit incentives can be 1.1 to three scalable than venture funds. The GPs earn income from both the The model predicts that the more times as large as explicit incentives. model supports this hypothesis and explicit contractual basis of fees and informative the current fund returns By the time the GP has raised a predicts that future fundraising for carry on the current fund (explicit are of the GP’s ability, the more third fund, the ratio of implicit to buyout funds is more sensitive to incentives) and the market basis: the sensitive future fundraising will be to explicit incentives declines to a range current performance. For every extra better their performance, the more current performance. of 0.25 to 0.46. This is supportive dollar returned to LPs, the GP earns likely they are to raise larger funds The academics studied a sample of the informativeness of returns $0.25 in carry and $0.32 to $0.66 (implicit incentives). of 843 private equity partnerships hypothesis as the returns of the first in expected fees and carry from The authors present a model in that manage 1,745 buyout, venture fund are more informative of a new future funds. For a venture capital which GPs have an ability to earn capital and real estate funds. They GP’s ability compared to the returns fund, the implicit incentive from abnormal returns for their investors find that for a typical first-time on their third fund. Furthermore, the future funds is $0.11 to $0.13. 11 Roundtable

Why management counts Why is management so important? And how much difference can individual managers really make? We spoke to the authors of a handful of studies in this area, a GP, a private equity management specialist and a former PE-backed CFO. Chaired by Richard Young.

anagement, management, to a company’s performance and that results vary management” is private according to ownership structure and country. The equity’s mantra. And, with second demonstrates that individual managers an increased focus on with their own styles have a profound effect on the “operationalM improvement in private equity portfolios decisions made within companies and on financial resulting from lower levels of available debt, performance, showing the importance of getting the management has become still more key to success. right team on board. And the third examines how But how much do the people in charge and the private equity ownership affects management style. practices they deploy really matter? It finds that PE backing results in consistently better- Three pieces of research (for details, see p15) managed companies, particularly in comparison examine precisely these points. The first finds that with government, family-owned and privately-owned management practices make a significant difference companies with no PE backing.

Roundtable participants

Antoinette Schoar Nicholas Bloom MIT SLOAN SCHOOL OF Conor Boden STANFORD UNIVERSITY MANAGEMENT ADVENT INTERNATIONAL

Bloom is an associate Schoar is professor of Boden is responsible for professor of economics entrepreneurial finance managing a network of at Stanford University. at MIT Sloan School of leading chairmen, CEOs and His main interests are Management. She received non-executive directors with measuring and explaining the Fellowship of the the aim of enhancing PE firm management practices, but George Stigler Center, 1997- Advent International’s he also works on innovation 99, and the ERP Doctoral ability to originate and and IT, as well as the Scholarship of the German execute deals, as well as causes and consequences Ministry of Trade, 1995-97. maximising the value of of uncertainty over the portfolio companies. His business cycle. main focus is developing Advent’s programme. 12 Private Equity Findings

Why do management practices matter so much? “Most companies get complacent somewhere Why management counts Bloom: “Management practices along the line – they stop worrying about are strongly linked to firm performance. We find firms with the the detail, lose sight of objectives and don’t best management practices grow much faster, are far more profitable aggressively manage problems. PE firms tend and are much more likely to survive not to make those mistakes in the long run. ” “It’s impossible to infer direct NICHOLAS BLOOM, STANFORD UNIVERSITY causation between practices and performance from the research we do, of course. But we’ve done work How do you account for And professional management in India to test the link by dividing a differences in management is important in terms of adopting set of similar companies into a test practices? modern practices, rather than family- group and a control group. Bloom: “Key factors include or government-managed firms which “The control companies simply competition, regulation and tend to be more old-fashioned.” carried on as they were, while the professional management. We Schoar: “Age counts. Interestingly, test companies received, effectively, find strongly competitive markets after the dot-com crash, many a full Accenture consultancy. have much better-managed firms technology firms hired older CEOs They rolled out a number of new because badly run firms need to – in some cases, bringing them out management practices and improve or exit. Light regulation is of retirement. At that point, they the results were stunning. important in allowing firms to get on realised they needed managers who’d Performance on a number of with managing effectively without been through different business criteria was greatly improved.” constraints from governments. environments and their young CEOs in many cases had only seen boom years. “We’ve conducted more recent research to look at how CEOs and their approach to management are shaped by the prevailing economic conditions at the start of their careers. You find CEOs who begin their working life during a recession really do become different kinds of managers later in life. They tend to be more conservative – they Jim Weight Peter Hodson prefer lower financial leverage, WEIGHT PARTNERS CAPITAL NVM PRIVATE EQUITY lower SG&A ratios and do fewer deals, preferring to invest in their Weight started his career with Hodson joined mid-market own business’s capabilities. And on Boston Consulting Group, PE firm NVM in 2004 from average, they deliver higher ROIs. then became one of the top 70 , having previously spent CEOs who start their careers in boom group of strategic managers five years at BMW Group years are more market-orientated, around Sir Geoffrey Mulcahy where he implemented applying more leverage and engaging at Kingfisher. He became CFO BMW’s manufacturing in more acquisition activities.” at PE-backed Westminster process into the Land Rover Weight: “Managers can make a Healthcare and HIT production facility. He has difference, but it’s not just about Entertainment, before setting a special interest in the one person. For example, some up his own firm, Weight exhibitions, logistics and people are good at making a lot of Partners Capital, which has healthcare markets. decisions intuitively – others are good just made its first investment. at thinking to death a small number of decisions. The best PE guys fall 13 Roundtable

into the second category. But a lot of Hodson: “In private equity, the deals, where there hasn’t been managers aren’t very good at doing investment process weeds out an time to change much in the way of that – they get on with day-to-day awful lot of the dead wood. To do a management, probably skew the PE decisions to keep the show on buyout, a management team has aggregate score downwards. the road. to have a well-worked-out business “There’s no secret sauce “I know of one CEO in a plan, they’ll have to go through here – our research shows this is multinational who decided to write a rigorous due diligence process simply about being methodical and down every decision he made, and work closely with experienced rigorous with management practices. every day, to see if he could find private equity operators before the Most companies get complacent out whether he was any good at deal is even done. So they’re going somewhere along the line – they decision-making. At the end of two to learn a lot about the disciplines stop worrying about the detail, lose years, there were 2,000 decisions on of planning and KPIs during the sight of objectives the list – and he reckoned that on deal. You can certainly build on that and don’t aggressively manage 1,998 of them, it didn’t matter what post-deal – but it needs to be there problems. PE firms tend not to he’d decided. All that mattered was to some degree beforehand.” make those mistakes.” that a decision was made and life Boden: “The first 100 days are Schoar: “When you look at the moved on – bad choices would end critical. We expect managers to typical private equity reward up rectifying themselves.” hit the ground running and stay structures for management, running. And it’s not just the they’re a lot better at engineering How important are guys at the top. There should be performance. Those companies management incentives in strong alignment of management are simply better governed. And getting results? throughout the organisation, it’s the ability – and willingness – to Schoar: “Talent should be motivating people at every level to change management that is PE’s key rewarded. And to get the best, you help execute the programme.” governance advantage.” have to offer good compensation packages. If you look at the There is a view that PE-backed So PE firms are just more governance reviews of companies, businesses are better run. To brutal about it? the problems always appear when what extent is this true? Bloom: “If you look at papers on the pay structures look wrong. In Bloom: “Our data clearly shows this subject, you can get closer to well-managed firms, a much higher that PE-owned firms tend to be some reasons for PE’s success. proportion of total compensation is very well managed – they attain the Davis, Haltiwanger et al (see performance based – and it’s usually best scores in our survey, which Findings, Issue 2, pp17-20) looked based on long-term performance. In measures the management practices at US companies bought by PE, poorly governed firms, you have high that are in place and how effectively and there was a clear improvement levels of salary and the options are they’re being deployed. If you look in performance post-transaction. just piled on top.” at firms that have been owned by Around half of that was through PE for a reasonable length of time, closing down underperforming And how quickly can the scores are even higher. We think assets – so they’re taking some individual managers make this is because PE firms often buy tough decisions that perhaps a difference? underperforming businesses and incumbent management didn’t feel Schoar: “In our data, we see that improve them – so the more recent able to, but which were the best a change in the type of manager ones for the health of the business.” shows up in the performance of the Schoar: “A private equity event company very quickly. Typically, in a business is usually a good specific manager effects are visible “Looking across the most opportunity to make changes – within the first year. The CEO fixed successful MDs in our portfolio, it’s a ‘reset event’ in the life of effects were actually less important the company. It means a lot of in the financial variables, where you see so many different traits entrenched practices – which the the CFO fixed effect was critical. CEO under the previous ownership For CEOs, it was much more and characteristics. So it’s hard might have wanted to change, about influencing strategy. But it’s to say one or another is an but couldn’t – are suddenly up for important you get both right and review. A good manager exploits this many PE firms see the CFO as a absolute given” to push through changes that manager that can be changed for might have looked painful in a PETER HODSON, NVM PRIVATE EQUITY good effect.” steady-state business.” 14 Private Equity Findings

“You never get the complete package The research in one person. Having enough In Measuring and Explaining Management Across Firms and Countries, Nicholas Bloom and John van Reenen use interviews self-awareness to know how to round of plant managers to evaluate and explain differences across out the team or bring in advice is management practices. The authors find that an increase in the management score by one (the scale of scores are from one very important. A lot of strong, to five) coincides with an increase in sales of about 3% to 4%. Higher management scores also coincide with higher ROCE, determined CEOs don’t bring in Tobin’s Q and sales growth. The authors find a large heterogeneity complementary CFOs, for example. across firms in the same country. They show that this can be partly explained by product market competition and the They want a lapdog” succession structure in family firms. JIM WEIGHT, WEIGHT PARTNERS CAPITAL Antoinette Schoar and Marianne Bertrand wrote Managing With Style: The Effect of Managers on Firm Policies to investigate just Weight: “Big plcs also have good a business, externally and internally. how much correlation there is between managers’ styles and their management practices. It’s the lazy, The other big thing is drive.” companies’ performance. They looked at 30 years of data, covering lower-middle-market ones that tend Schoar: “Steve Kaplan, Morten 500 CEOs, and other top executives including CFOs and COOs, to to struggle. They don’t have investors Sorensen and Mark Klebanov wrote analyse how different styles of management affected companies. with large enough shareholdings to some interesting research* on the They concluded that most aspects of corporate policy are justify spending any real time with type of CEOs that private equity is significantly affected by managers, especially M&A policy, them, so the governance isn’t as more likely to hire. They worked with good. The two take-privates I worked an executive search firm to obtain cost-cutting and interest coverage. Managers with a more in were both situations where the data on the attributes their PE clients positive impact on ROA are employed by companies with a large shareholders weren’t interested. looked for in managers going into shareholder, which may be the better-governed companies. This Private equity ownership was just a buyout situations. A lot of it was the may suggest that these companies are hiring managers with better model.” kind of things you might expect in “better” styles. any manager – high cognitive ability, Management style was shown to be significantly affected by the What kinds of managers thrive for example. But they also sought age and education of the CEOs. Younger managers, for example, with PE backing? managers who were more tolerant of use more aggressive leverage strategies – for every 10-year Boden: “We look for a strong track risk and more aggressive.” decrease in age, financial leverage increases by 2.5% and those record, particularly their ability to Hodson: “Since management is with MBAs generate a 1% higher rate of return on assets than deliver on a strategy. Anyone who the absolute key for us, you might those without MBAs. knows how to transform a business think we would have drilled down and raise profits is an exciting into the factors for success. But Do Private Equity-Owned Firms Have Better Management manager in our eyes. But we’re also when you analyse it, it’s simply not Practices? by Nicholas Bloom, Rafaella Sadun and John van Reenen looking for a broad range of skills scientific. Looking across the most sought to discover the extent to which PE ownership improves that go to create value. For example, successful MDs in our portfolio, management practices. Their findings are based on a sample of are they strategically minded? Will you see so many different traits and 4,000 PE-owned and other businesses in Asia, the US and Europe. they be able to come through on characteristics. So it’s hard to say They find that, on average, the PE-backed companies are the the exit plan? And do they have the one or another is an absolute given.” best-managed group in the sample, although widely held public operational expertise? Often when Weight: “The other thing I’d throw companies are not significantly different. The average score for deals go bad, it’s because a in is that you never get the complete PE-backed companies is 3.25, against 3.24 for publicly owned perfectly good strategy hasn’t package in one person. Having companies and around 2.75 for family-run and founder-managed been well implemented.” enough self-awareness to know firms. Even when country, industry and firm-level characteristics Weight: “Being positive and how to round out the team or bring optimistic is almost a given. But you in advice is very important. A lot are taken into account, PE-owned companies continue to show need to be clear on decision-making of strong, determined CEOs don’t better management scores. This is because there are very few badly – and acting decisively is far more bring in complementary CFOs, for managed PE-backed companies. important than intellectually analysing example. They want a lapdog.” Private equity owners are especially good at driving operations everything down to the last detail. improvements (using lean manufacturing, comprehensive Leadership is also important – in the * “Which CEO Characteristics and Abilities performance documentation, etc) and monitoring practices using sense that you have to be able to deal Matter?” July 2008 – Kaplan, Sorensen merit-based hiring, firing, pay and promotions practices. with the human aspects of running and Klebanov. 15 “How do you turn around a business? Private Equity takeover or managerial buyout?”

Professor Eli Talmor Chairman, Coller Institute of Private Equity, London Business School

The Masterclass in Private Equity Featuring selected case studies from our impressive catalogue, together with respected industry speakers, this three day Masterclass will transform your approach to private equity.

Leading Financial Thinking

Next programme: 23 March 2011

Visit www.london.edu/pe/ Call +44 (0)20 7000 7051 Email [email protected] Private Equity Findings “How do you turn around a business? Private Equity takeover or managerial buyout?” The end of Professor Eli Talmor the captive? Chairman, Coller Institute of Private Equity, London Business School Regulatory reforms across the world are prompting a wave of spin-outs from banks’ private equity operations. Is this a healthy

development for the industry and for the posed by various of the large banks’ economy as a whole? A recent piece of activities, including private equity. This is what led Lily Fang of INSEAD The Masterclass research sheds light on the risks posed by and Victoria Ivashina and Josh Lerner, banks’ principal investment activities, with both of Harvard University and NBER, in Private Equity to look into this area. some interesting results. By Vicky Meek. The result, Unstable Equity? Combining Banking with Private Equity Investing, concludes that not only have Featuring selected case studies pin-outs have been a bank-affiliated groups accounted for a feature of private equity significant share (26%) of private from our impressive catalogue, since the dawn of the equity transactions on average between together with respected industry industry. Indeed, many 1983 and 2009, but they are more ofS its best-known independent prone to invest cyclically than speakers, this three day Masterclass firms started life as part of banks. independent firms. This tends to Bridgepoint, Charterhouse Capital exacerbate cycles in private equity and, will transform your approach to Partners, Montagu Private Equity, although private equity currently Apollo Management and CVC Capital represents only a small fraction of private equity. Partners are just a few examples. banks’ assets, it could potentially Yet over recent times, the pace of increase banks’ risk exposure (for more banks shedding their private equity detail see box-out on p20). teams has accelerated (see table, “Research on private equity has p19), driven largely by anticipation generally focused on stand-alone of reforms such as the new Basel III firms,” says Ivashina. “Yet, as we found regulatory capital requirements and in our research, a quarter of all deals the Volcker rule in the US. The trend are done by bank-affiliated groups. is also the result of mergers in the We wanted to see whether banks do Leading Financial Thinking banking sectors and government something different and how they make intervention in the financial sector use of potential synergies so we could following the crisis: some banks must determine what had allowed this shed assets to meet state aid rules. segment to become so prominent. We While not all these rules are also wanted to explore the extent to specifically aimed at private equity which private equity created the same Next programme: 23 March 2011 investing (Volcker excepted) – and concerns that exist for other banking there may be some in the sector activities, such as securitisations.” who are tempted to mutter about The authors found more than they Visit www.london.edu/pe/ Corbis/Katie Edwards unintended consequences – the recent were expecting. “We had thought that Call +44 (0)20 7000 7051 financial crisis prompts a number of bank-affiliated groups would follow Email [email protected] Illustration: questions about the systemic risks the trend of cyclicality in investing but 17 Beyond the abstract

that the cycles would be downplayed took up the invitation to comment. in these groups because the parent, in There are certainly plenty who theory, should provide their private believe that the model is flawed, at equity units with potentially better least in the way that most banks tend deals,” explains Ivashina. “Yet we to manage their private equity arms. were surprised to find that banks’ “The motivations for setting up private investment cycles were even equity arms in Europe, at least, have more pronounced than those for been primarily to do with cross-selling independent groups. This appears rather than access to the best deal to be the result of affiliates’ direct flow,” says a limited partner. “They access to credit that independent do get deals through the banking PE firms don’t have, suggesting that network, but the rationale for investing their synergies lie more in the credit is often not the same as a private markets than access to deal flow equity motivation – it’s more to do with through informational advantage. The completing the product range and result is private equity on steroids.” creating business volume than Interestingly, it’s a sector-wide “It seems that some investment selection. It’s my view that phenomenon too. “We analysed banking and private equity are not whether this cyclicality was more of the concerns are correct compatible under one roof.” present in banks that had gone on to Conflicts of interest can be hard have significant problems,” says Fang. – the contagious element for bank-affiliated groups to deal “But actually, we found that these with. “One of the issues before we patterns are not limited to a few among different pieces spun out was that we found we were aggressive banks.” of banks’ business is competing against clients of other The authors are quick to point out parts of the bank for deals,” says that the results do not suggest that replicated in private equity” Ted Virtue, CEO of MidOcean private equity in isolation would cause Partners, which spun out of Deutsche a financial shock. Instead, they say, VICTORIA IVASHINA, HARVARD UNIVERSITY Bank in 2003. it shows the way in which private “This was a factor in our building equity fits in with the overall picture. deep management expertise to “We are not singling out private equity a link to the broader concerns about source proprietary deals and avoid as a driver for banks’ systemic risk,” banking business models. It seems competitive auctions. We were not the explains Fang. “Rather, it is a powerful that some of the concerns about only ones and it’s a fine line for banks illustration of the fact that profit-driven the systemic implications of banks’ to tread. It’s one of the reasons why banks engage in cyclical activities. private equity investment are correct many banks have now opted for the It is this general behaviour that – the contagious element among co-investment model.” increases systemic risk and amplifies different pieces of banks’ business He points to (which, the cycles. The broader-picture is replicated in private equity.” incidentally, makes up a large part of questions, such as ‘If they don’t And it’s a risk that is not necessarily the bank-affiliated sector, accounting engage in private equity investing recognised by many interested parties, for 30% of this group’s activity by deal what else would they do and how else Ivashina adds. “The nature of the volume, according to the research). would such behaviour show up?’, are risk of expanding in cycles is not “They now do a lot fewer control areas that should be the subject of acknowledged by GPs, LPs, regulators ownership deals to avoid competing future research.” or banks,” she says. “The model of with clients,” he says. “They have Banks investing in private equity banks’ engagement in private equity developed a model through which they create risks, according to Ivashina, mirrors that of securitisations and can help clients by providing different who adds: “Given that we found syndication and that has important types of capital for deals.” the counter-intuitive result of high implications for how people should The other point is that bank- cyclicality in banks’ private equity view this risk – it’s not diversifiable.” affiliated groups often suffer from Lyndon Hayes Lyndon investment and that access to leverage This is clearly a controversial point. brain drain. “There is a tendency for was the determining factor in this, the None of the regulators, banks or bank- talent to jump ship,” says Thomas

Illustrations: research demonstrates that there is affiliated groups contacted for this piece Bernhardt, senior private equity 18 Private Equity Findings

Examples of recent spin-outs and sales by banks

PARENT BANK-AFFILIATED GROUP NEW GROUP DATE JPMorgan Chase Merchant Banking November 2008 Lehman Brothers Merchant Banking Trilantic Capital Partners April 2009 Capital Partners March 2010 Lehman Brothers Lehman Brothers European Mezzanine Partners Neovara May 2010 Fund-of-funds business, mezzanine and feeder funds, co-investments Lexington Partners/Stepstone Group acquired interests July 2010 Lloyds Banking Group BOSIF Cavendish Square Partners July 2010 Bank of America Capital Ridgemont Equity Partners August 2010

Barclays Capital Barclays Private Equity Under discussion Under discussion HSBC All private equity activities Under discussion Under discussion

SOURCE: Private Equity Findings research

research principal at PCG Asset Aren’t we seeing the end of the captive Management. As the Ivashina, Fang in any case? and Lerner paper points out, banks “Five years ago almost every bank typically receive between 25% and had a private equity arm,” says Virtue. 50% of the carried interest earned by “But the regulatory capital issues, their private equity arms. “It’s true to concerns about volatility and the fact say that these groups get a lot for that: that banks do not want to invest in the marketing, financial muscle and illiquid assets means that there are back office support,” says Bernhardt. now very few captives left – private “However, once managers have built equity arms are either minority-owned, up a track record, these advantages have spun out or have sought mainly become less attractive and they see third-party money.” that they can get better remuneration Yet there is plenty of evidence to and more freedom of action outside suggest that the findings will remain bank ownership.” relevant for some time to come. While Perhaps these are some of the one of the big selling points for bank- reasons why the research found that, affiliated groups of having large balance despite bank-affiliated companies sheets to invest from will disappear “We were competing against receiving better banking terms than under the 3% Volcker rule, the effects their independently-backed peers, of the new regulations in the US and clients of other parts of the performance from these investments Basel III remain unclear, particularly as tends to be slightly worse than those in they will be phased in over time. bank for deals – it was a non-bank-affiliated portfolios (see “Nothing has to happen right box-out, p20). away,” says Bernhardt. “It will take factor in our building deep Given the regulatory environment at least 18 months for the new rules (in particular the Volcker rule, which in the US to be formulated and then management expertise to stipulates that banks will not be able to there will be time for banks to adjust, hold more than 3% of their Tier 1 so any major change won’t need to source proprietary deals and capital in private equity or, indeed, happen for at least five years.” more than 3% in any one fund) and In any case, many believe that, avoid competitive auctions” the fact that many banks are now while banks may be forced to act at TED VIRTUE, MIDOCEAN PARTNERS shedding their private equity some point, they will continue to be businesses, does this really matter? lured by the private equity model and 19 Beyond the abstract

The research

Based on a sample of 7,902 US private equity deals (buyouts and ) completed between 1978 and 2009, Unstable Equity? Combining Banking with Private Equity by Fang, Ivashina and Lerner looks at the role of bank-affiliated groups in the private equity market. The key findings are: l The share of banks in the private equity market is substantial. More than a quarter of all deals (26%) in the sample between 1983 and 2009 involved bank-affiliated groups. l Banks’ involvement in the asset class is highly cyclical – more so than seen in deals financed solely by independent groups. In the buyout wave of the late 1980s, banks’ share of “Our research is a powerful number of deals peaked at 25% before falling to 10% in the recession of the early 1990s. illustration of the fact that profit-driven Banks’ private equity activity reached an all- time high of about 35% of total number of deals banks engage in cyclical activities. This in the recent credit boom before falling sharply behaviour increases systemic risk and with the onset of the credit crunch in 2008. l In the 2005-06 boom period, banks’ private amplifies the cycles” equity exposure represented on average 23% of their total equity (or 26% of their revenues). LILY FANG, INSEAD In the preceding four years, however, private equity accounted for just 4% of their equity will remain involved to some degree. banks are profit-driven and they want to (5% of revenues). “It’s a classic case of fear and greed,” find ways of using synergies to drive new l Transactions that involved bank-affiliated says Virtue. “The pendulum always revenues. So principal investing will not private equity groups, where the bank is the swings back. In good markets, private go to zero and will probably return, key lender, enjoyed better terms than other equity looks like an extraordinarily easy although perhaps not to the extent that transactions. Having the parent bank in the business and banks will be tempted we’ve recently witnessed for some time.” lending syndicate increases the loan amount when underwriting debt, running an The independent groups may be by $801 million, the maturity by more than four IPO process or conducting M&A work watching the developments closely years and reduces the loan spread by 47 basis to invest directly.” – after all, fewer or weakened bank points. Financing terms are particularly generous “Banks like to be in private equity,” groups may mean greater deal flow during the peaks of the private equity boom. agrees Bernhardt. “They make good for them. Yet it seems unlikely that l Better financing terms for bank-affiliated profits from other areas of the business, bank-affiliated groups will disappear groups are not explained by access to better such as M&A and IPOs, and this is altogether. Indeed, Lloyds Banking targets. Although targets of bank-affiliated facilitated by private equity investing.” Group, Royal Bank of Scotland, HSBC, groups have better operating performance (higher After shedding most of its private equity Barclays, Santander UK and Standard EBITDA/assets, EBITDA/sales, net income/sales business in the early 2000s, for example, Chartered have recently agreed to and cash/assets), exit outcomes are marginally is now back in the asset invest up to £1bn in a venture capital poorer. More specifically, targets acquired by class following its acquisition of fund-of- fund in a government-backed initiative bank-affiliated private equity are more likely funds business Sal. Oppenheim Private that some are comparing to the origins to experience bankruptcy, by about 6.2%. Overall, Equity Partners earlier this year. of 3i. And while history has a habit of the cyclicality of bank-affiliated investments, the Yet the scale of banks’ involvement is repeating itself, the regulatory time-varying pattern of the financing benefits likely to be smaller. “We will always see environment may even be one that and slightly worse outcomes (in terms of IRR) cyclical patterns,” says Fang. “We will encourages an improved model for than those involving independent private see a period of curtailing activities in the financial institutions – giving teams equity firms suggest that banks may not have face of regulatory headwinds and greater independence and operating a significant informational advantage. reduced capital markets activity, but the units at arm’s length.

20 Coller-091110-outline.indd 1 24/11/2010 10:05:50 Coller Institute of Private Equity News Private Equity. The Masterclass Now in its fourth year, this course, like the asset class, has a lot to live up to.

s part of the London group work, resulting in a rewarding Business School’s and intellectually stimulating Finance Executive classroom experience. Programmes, The The syllabus is constantly updated Masterclass in Private to reflect industry trends and recent EquityA is an intensive three-day private equity transactions. The course run biannually, led by content is augmented with lectures Professor Eli Talmor, chairman of the from Professor Oliver Gottschalg, Coller Institute of Private Equity. The HEC, and a changing roster of Masterclass is one of the highest- industry-leading guest speakers rated courses of the Executive gives lectures. Programmes, consistently receiving The latest class of 46 comprised high scores from participants. 29 nationalities. With the exception Ann Iveson, senior adviser, Coller of Antarctica, all the continents Institute, caught up with some of the were represented, and 17% of latest class to hear why they took part the participants were women. and whether the course delivered. Investors, GPs, business owners and Since 2007 more than 300 professional services attended. professionals, comprising 67 The class had a taste or a nationalities, have attended reminder of life in a business school. the Masterclasses at London Arranged in groups, they prepared Business School. Nearly half of the eight case studies, each providing participants are at board level, or a different angle, skill or aspect of are managing directors or heads operating within the private equity of business. Such international industry. The course was challenging diversity, combined with professional as the groups switched from one seniority, brings broad and new moment looking at a transaction perspectives to class discussions and in South Africa, to acting as a GP

Review of The Masterclass in Private Equity 2007-10

Clifford D. Jolly, president, ELS Technology, institutions operate. The course has given Alberto Osorio, head of investments, Inc., United States (2009 participant) “A me an excellent overview of where to focus Millennium Banque Privée, Switzerland friend asked me before going: Why fly from as we expand our exposure and professional (2008 participant) “Participating on the Colorado over the top of some 100 great capabilities regarding this asset class.” private equity programme gave me a universities to go all the way to London? Dapo Okubadejo, partner and head of complete view on the industry, upstream I left London mentally energised, with a transaction services, KPMG, Nigeria (2009 and downstream.” clear vision of how I could dramatically participant) “Excellent programme with a very Eric D. Tierie, director, Xegasus, The improve my company’s performance.” See good balance of theoretical principles and Netherlands (2010 participant) “I enjoyed it full testimonial at http://www.london.edu/ practical case studies of real transactions immensely. The speakers were excellent.” masterclassprofile/ delivered by the real actors in the deal.” Vishal Jajodia, chairman, Euresian Group, Nicolai Boserup, legal adviser, IFU, Denmark Daniel Duku, CEO, Venture Capital Trust Fund, India (2007 participant) “I would advise (2010 participant) “Private equity is Ghana (2010 participant) “London is still colleagues looking for investments from expanding rapidly in developing countries, the centre. The PE industry is here and this private equity houses that this is a where IFU and other development finance brings a wealth of research and contacts.” ‘must-do’ programme.”

22 Private Equity Findings

running a fund in Latin America the next, then being a UK business owner selling to a GP and taking a company public, to establishing a fund as a foreigner in Vietnam. In addition to the shared experience, the class gained a comprehensive overview of some of the more interesting, real issues facing practitioners.

All Masterclass alumni can now stay connected by joining their dedicated page on LinkedIn. This page allows alumni not only to interact with each other, but also to further their exposure to the private equity community through the Coller Institute.

EVENTS PAST EVENTS O’Gara, Matteo Luoni, Matteo Masi and Chris categories for case studies and management Steinbaugh (all MBA 2012) proceeded to reports for London Business School students. ● COLLER INSTITUTE MEDIA BREAKFAST the final in Rotterdam where they won the In respect of the PhD category, many global 17 SEPTEMBER 2010 inaugural competition on 23-24 October. institutions were represented, including the Francesca Cornelli presented on the Institute This provides prime evidence of the strength University of Washington, Stockholm School and her role as academic director while of London Business School’s student body. of Economics, University of Hong Kong, Said Florin Vasvari, London Business School, Business School and Technical University of discussed his research (with Eli Talmor and ● ANNUAL MVISION ROUND TABLE – Munich. Please see www.collerinstitute.com Oliver Gottschalg, HEC Paris) with the BVCA 2 NOVEMBER 2010 and the next edition of this publication for on return attribution in PE. Private equity has attracted considerable details of the winning submissions. differences in opinion since the asset class ● CITY WEEK – THE UK INTERNATIONAL was thrust into the limelight. Supporters of UPCOMING EVENTS FORUM  the industry herald private equity due to a   THE RETURNS DEBATE: DEMYSTIFYING perceived superior governance model which is ● PRIVATE EQUITY SYMPOSIUM – WHETHER PRIVATE OUTPERFORMS OR able to generate higher returns for its investors. 2-3 JUNE 2011 UNDERPERFORMS 21 SEPTEMBER 2010 Others denigrate the industry for destroying Our 2011 Symposium will explore the theme Chris Higson, London Business School, jobs, using high levels of debt and escaping “Private Equity: The New Normal”. The event introduced the Roundtable article in Issue 2 the veil of regulation. Many of these topics were will convene the world’s leading academics of Private Equity Findings, which delved into raised in a recent CSFI report by Peter Morris and a number of senior practitioners to debate the academic studies on the topic of returns. entitled Private equity, public loss? A panel of what will constitute the new normal as private experts assembled to debate the report. equity emerges from the financial crisis. The ● PRIVATE EQUITY CASE STUDY new normal has been formed by a variety of COMPETITION 29 SEPTEMBER 2010 ● COLLER PRIZE EVENING – forces, including how value is created without As a preliminary round of the European 30 NOVEMBER 2010 the benefit of high leverage, exploration of MBA Private Equity Case Competition, the This year’s Coller Prize evening included new frontiers as opportunities in developed Coller Institute, with the student club, held the presentation of our inaugural award markets have dried up and the uncertainty a competition on a hypothetical buyout of a for the PhD category (which is open to PhD of regulatory changes. Stay tuned for further US toy company. The winning team of James students from across the world) as well as the details including speaker announcements.

23 Coller Institute of Private Equity Coller Institute of Private Equity London Business School | Regent’s Park London NW1 4SA | United Kingdom

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