colours not accurate on screen ISSUE 12 WINTER/SPRING 2017 PRI VATE £25 €30 $35 THE FEE FACTOR Why some terms are not as LP-friendly as you think

IMPACT FUNDS EQUITY Which LPs invest in them – and should they? RIPPLES OF CHANGE How PE investments disrupt entire business sectors FINDINGS KEEPING IT TO THEMSELVES Insights from the world’s private equity research Who profits from insider rounds in VC?

PLANTING THE RIGHT SEEDS Why some LPs outperform their peers

INCLUDING CONTRIBUTIONS FROM: CALIFORNIA INSTITUTE OF TECHNOLOGY COLUMBIA UNIVERSITY | ERASMUS UNIVERSITY HARVARD UNIVERSITY | MIT SLOAN SCHOOL OF MANAGEMENT SAÏD BUSINESS SCHOOL | STANFORD UNIVERSITY CONTENTS FOREWORD

rivate Equity Findings provides a We note the wide variations in the performance By the How do some LPs forum for debating the world’s best of investors’ private equity portfolios, and Jeremy Coller numbers outperform their peers? academic research into private equity, ask How do some LPs outperform their Chief Investment Officer, Coller Capital 4 16 Pfor challenging conventional wisdom peers? Using the findings of three recent on the asset class, and for sharing insights research papers, and perspectives from LPs split on impact investing; Higher fees and There is a wide variation in LP performance in private equity, from the general partners and limited partners two experienced private equity investors, carried interest not linked to top performers; but how much of this is due to LP type, governance or skill? who constitute the cutting edge of the industry. we examine whether these performance Expense allocations remain contentious for LPs; We speak to the authors of three academic papers on the subject For many years, the Coller Institute of variations are a consequence of LP skill, First-timers outperform established funds; and gather the views of two experienced LPs. Private Equity at London Business School or of governance differences, or even of LBO and VC performance – US president matters. played a critical role in the success of Private investor type. “The market today is just far more competitive for PE, Equity Findings, and we would like to record The article Be careful what you wish for so investors who are latecomers to the market won’t have our thanks for the outstanding work of casts a critical eye over the fees and incentives some of the advantages of LPs that were 15 or 20 years Professor Eli Talmor and Professor Francesca received by private equity managers, along PE’s transformative effect ahead of them into the asset class.” Cornelli in developing Private Equity Findings with the timing of their payouts, with results on industry sectors into the unique publication it is today. that many investors may find surprising. 6  Maria Kozloski, Global head and CIO, IFC This issue sees the formation of a new In our Head-to-Head feature, Assessing partnership between the Coller Research the impact, we analyse LPs’ growing interest Much has been written about the way private equity Institute at Coller Capital and Professor Josh in social impact investing, and provide a affects individual companies, but does its involvement Lerner of Harvard Business School. challenge to the trend from an experienced influence what happens across sectors? And if so, how? This edition of Private Equity Findings lifts private equity investor. Professor Josh Lerner Two recent academic papers study the issue. Assessing the veil on several less obvious aspects of Our final article, Life on the inside, focuses Head of Entrepreneurship Department, 22 the impact private equity policy and practice. on VC ‘insider rounds’ (funding rounds Harvard Business School In PE’s transformative effect on industry composed entirely of the company’s existing sectors, we discover that private equity’s investors). It highlights recent research by As impact investing increases in popularity, Be careful what disruptive effects extend far beyond individual academics at Caltech, Harvard and Stanford,  we examine a paper that looks at where demand portfolio companies, prompting significant which finds that insider rounds are associated 10 you wish for is strongest and ask a seasoned LP for her opinion change within the industry sectors in which with significant underperformance in the on this trend. those companies are operating. portfolio companies where they occur. The trend for more LP-friendly fee and carried interest This edition of Private Equity Findings has terms may result in some unintended consequences, already stimulated lively debate among its new research finds. We find out why. numerous contributors. We hope you find it equally stimulating and, as always, we welcome “I’ve often wondered why portfolio company fee Life on the inside your thoughts and feedback. You can contact negotiations centre on the fraction of offset rather than 25 us by email at [email protected]. the amount being charged. Until the SEC got involved, no one really talked about how these fees presented How do venture capital inside rounds perform compared to a conflict of interest.” those made alongside new investors? And why do VCs do them? We talk to the author of new academic research on the subject. Ludovic Phalippou, Saïd Business School “The paper’s findings are different than you might expect – we’re not seeing evidence of situations where the entrepreneur is being taken advantage of.”

Michael Ewens, California Institute of Technology

2 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 3 TRENDS AND STATISTICS BY THE NUMBERS First-timers outperform Expense allocations remain LPs split on social impact investing established funds contentious for LPs

Social impact investing is becoming an LP organisations’ policy on social investing over the next 24 months With nearly half (47%) of LPs telling Preqin The chart includes all private capital The way private equity firms account for, and increasing focus for LPs: half of the institutions that it has become harder to find attractive strategies (i.e., including real estate, report, their expenses has been the subject of surveyed for the Winter 2016/17 Global Private Begin 10% private equity fund opportunities over the infrastructure and private debt, as well intense scrutiny since the financial crisis, yet Equity Barometer either have social impact last 12 months, there is evidence to suggest as buyouts, venture capital, and growth). many LPs remain dissatisfied with the level investments in their portfolios or plan to add that they are increasingly turning to first- According to Preqin data, though, nine of of transparency among funds across a wide Increase 14% them within two years. 47% time funds. Over half of investors (51%) will the top 10 best-performing first-time funds range of items, according to an EY survey. This split tallies with some of the findings No plans to invest now invest, or consider investing, in first-time across all vintages are venture capital and Over two-fifths of investors say they are Maintain 26% reported in our feature on pages 22-24, funds, up from 39% in 2013, finds a Preqin buyout funds. More recent vintages (2006- unhappy with expense allocation reporting in which explores the demand for impact report, Making the Case for First-Time Funds. 2013) show a slightly different pattern, with relation to consultant, broken deal and annual investing among institutions. Decrease/stop 3% Those willing to back new players have five of the top 10 performers in buyout and meeting fees, the 2016 Global Private Equity However, despite institutions’ growing generated strong returns. Indeed, the venture capital, while infrastructure, real Fund and Investor Survey finds. engagement with social impact investing, Preqin figures suggest that the median net estate and distressed debt funds make up As we report on pages 6-9, LPs now have individuals working for these institutions LPs’ personal views on the appropriateness of social IRR for first time funds has outperformed the remainder. a greater focus on how fees (in this case overwhelmingly believe that social impact impact investing as a use of their organisations’ funds established funds in the post-crisis period portfolio company fees) are being levied investing is only an appropriate use of their by some margin. and reported. organisations’ funds if it does not reduce potential financial returns. It is not clear 20% 80% Private capital – median net IRRs by vintage year: % of investors dissatisfied with the level of that this personal caveat is acknowledged Yes, even if it fails Only if it does first-time funds vs. non-first-time funds transparency related to expense allocations to optimise our not reduce our in LP institutions’ current embrace of financial returns financial returns 25 impact investing. osutt First-time funds roe e Source: Global PE Barometer – 20 Coller Capital – Winter 2016/17 edition u meeti 15 ompie Higher fees and carried interest rates not linked to top performers estor port 10 Median net IRR (%) Non first-time funds isure Higher rates of management fees and carried Average management fee of private capital funds interest are not linked to better performance, by fund size and quartile ranking, all vintages 5 new analysis shows. Indeed, top-quartile 00 01 02 03 04 05 06 07 08 09 10 11 12 Source: EY: 2016 funds in all but the $1bn-plus fund size tend 2.5 Vintage year Source: Preqin Global Private Equity Fund and Investor Survey to charge among the lowest management fees, 3rd according to Preqin’s Private Capital Fund Quartile Terms report, while bottom- and third-quartile LBO and VC performance – US president matters 2.0 funds appear to levy among the highest management fees for many fund sizes. 2nd As the US settles into a new presidential those raised in Republican periods (1.21 PME Average private capital PME While this may lead some to assume that Quartile administration, research from State Street and versus 1.17 PME). e ors top-quartile players make up their lower 1.5 the Private Capital Research Institute analyses The analysis excludes funds raised in the last management fees through higher carried private equity returns according to the political two years of an administration before a change W ush e interest rates, further Preqin analysis suggests affiliation of the President at the time. It finds in political control, to account for the fact that this isn’t always the case. Over half of those Bottom that, relative to public markets, private equity these would be invested and harvested under W ito e Quartile charging a carried interest that is lower than management fee Average 1.0 Top outperformed most during the Bill Clinton the new administration. It also excludes the during investment period (%) Quartile W ush e the industry standard of 20% are top-quartile years (1.36 public market equivalent (PME)) immature 2014 and 2015 vintages. funds, while only 23% of those funds charging and least during the Ronald Reagan and m throuh more than 20% are in the top quartile. This Barack Obama periods (1.03 PME). Source: Leslie Jeng and Josh Lerner, 0.5 All Democrats 1.21 suggests that carried interest rates are not Less than $50 to $100 to $250 to $500 to More than Overall, the analysis suggests that private “Donkeys vs. Elephants: The Private Capital $50m $99m $249m $499m $999m $1bn a reliable indicator regarding the future equity vintages started under Democratic Edition,” State Street Private Equity Insights, All Republicans 1.17 performance of a fund. Fund size Source: Preqin administrations fare marginally better than 4th edition, Q2 2016.

4 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 5 FEATURE PE’s TRANSFORMATIVE EFFECT ON INDUSTRY SECTORS

Private equity clearly affects the companies it backs. But how far does its influence spread beyond individual businesses? Two recent papers suggest the industry’s impact could be greater than might be expected. By Nicholas Neveling

rivate equity’s impact on portfolio Settling differences of opinion Industry performance where PE investments are simply directed to Cross-fertilisation PE’s effect on behaviour companies has long been the subject “After the financial crisis and through the In the Bernstein et al paper, the authors seek the fastest growing and least volatile industries. In addition, PE investment may act as a Yet PE appears to affect more than industry of debate, but scrutiny of its broader 2012 US presidential election, private equity to establish whether PE investment within an These robustness checks suggested that signal to other businesses in the same sector performance. As the Harford et al paper Peffect on the industries in which it received a huge amount of attention,” explains industry had an impact on the sector’s growth reverse causality was not the sole driver of changes to come. PE’s ability to transfer demonstrates, investment seems to change invests has been less comprehensive, with Shai Bernstein, co-author of Private Equity and cyclicality. The academics examine the of results and that PE financing can have knowledge from one industry to another can board-level behaviour and decisions. This many studies concentrating on comparing and Industry Performance. “On one side, growth of industries with recent PE investment industry-level impacts. make competitors wake up. “One of the things paper studies the relationship between an the performance and characteristics of PE- people were saying that this industry was in comparison with those that have not It’s a finding that doesn’t surprise the private equity does well, investing as it does LBO and changes to the LBO target’s industry, backed companies against those without PE not regulated and having an adverse effect received PE financing. They find that PE- buyout practitioners, however. Jeremy Hand, across numerous sectors, is to cross-fertilise and finds that PE activity provokes reaction investment. Two recent research papers take a because of excessive leverage and cost- backed industries not only grew faster, but that managing partner at Lyceum Capital, says that knowledge and experience,” explains Charlie from competitors in a variety of ways. One of look at PE’s broader effect on the industries in cutting. On the other, people argued that there is no evidence to suggest PE involvement throughout his career in the buyout industry Johnstone, partner at ECI Partners. “We’ve the headline findings is that LBOs tend to lead which it invests, with some surprising results. private equity’s concentrated governance in a sector makes it any more volatile or he has regularly observed cases where private made a number of investments in the online M&A activity in a sector, prompting further model, discipline and provision of capital vulnerable to financial shock. “Before starting equity investment in a particular sector travel sector, for example, and we saw the deal-making by other financial sponsors and meant it made industries more robust. the research, I felt the results could have has sharpened the performance of other opportunity to apply what had worked there strategic buyers. The differences in perception were so sharp, gone either way,” says Bernstein. “What companies in the same sector. “If you look at to the insurance space, where digitisation Again, this is something well recognised it was an interesting area to research.” really surprised me was just how strongly all the mid-market brands on the high street is not as advanced. Applying experience by the buyout firms. “If you take the UK’s the findings on growth and low cyclicality you can see the impact of private equity,” he across sectors in this way is noticed by other veterinary sector as an example,” says came through.” says. “Private equity has turned areas like businesses in the sector and can lead to wider Johnstone, “private equity was the first to The authors perform a number of additional procurement efficiency and store roll-outs from productivity and efficiency improvements.” start making acquisitions with consolidation analyses to determine whether PE investments an art into a science. Managers are very good in mind, but then a significant amount of deal are causing these industry changes or whether at finding ways to improve margins and cash activity followed.” the results are detecting a “selection effect”, flow. That forces other companies to react.”

6 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 7 FEATURE

THE FINDINGS

In addition to increasing M&A activity within PE’s modus operandi consultancy. “Origination increasingly involves Bernstein also notes that his research looked Private Equity and Industry Performance, US, which have higher levels of PE activity, a sector, the study also finds that companies Jarrad Harford of the University of Washington, identifying targets where the manager sees at aggregate performance across an industry by Shai Bernstein (Stanford University), and also for continental Europe. However, respond to PE investment in an industry peer however, believes that one of the most the opportunity to make operational change.” with PE financing, whereas the Harford Josh Lerner (Harvard University), Morten the authors do suggest extending the study by investing in R&D and forming strategic interesting points to emerge from the study is ECI’s Johnstone adds that the value of paper was more focused on how individual Sørensen (Columbia University) and to capture the impact of the most recent alliances. Harford adds that there is strong what it reveals about the way in which PE is investing in industries undergoing change companies react to PE investments in their Per Strömberg (Stockholm School of economic cycles. evidence that companies seek to protect targeting companies and creating value. “In should not be underestimated. “We do actively industry. “The papers tie together Economics), seeks to establish whether themselves from acquisition by restricting order to assess what impact private equity seek to improve the companies we invest in, quite neatly,” says Bernstein. “We both find private equity investment in an industry In How Does an LBO Impact the Target’s board independence, buying back shares, was having on an industry, we had to establish but when you are a lower mid-market investor that selection bias is not the primary reason affects the aggregate growth and cyclicality Industry?, Jarrad Harford (University of and introducing anti-takeover provisions. that it wasn’t just investing in industries where like us, you are looking for growth stories so behind the observed industry impacts of of that industry. The authors use a sample of Washington), Jared Stanfield (UNSW For Rebecca Gibson, a partner at Oakley change would have happened regardless,” you will back companies in industries that are private equity. Our paper then finds an uptick about 14,300 PE investments between 1991 Australia) and Feng Zhang (University of Capital Partners, this finding in particular he says. “That produced some interesting already changing. You look at both aspects,” across overall industry performance, while and 2007, and they aggregate investments Utah) examine the broader impact of PE rings true. “If you go back to the early 2000s, insights into how private equity operates. The he says. the Harford paper finds evidence of shifts by country, industry and year to control for investments within an industry on industry when the number of buyout-backed take- analysis showed that firms are not just looking It’s clear that PE funds have different in company behaviour.” external effects of cyclicality and industry/ peers. The authors use a sample of 586 privates was on the up, you saw a number for arbitrage opportunities, but are proactively strategies to target and grow portfolio country macro events. The eventual LBOs between 1991 and 2002 to test three of companies pay much closer attention to seeking to move into industries where they companies, and that these affect both the Next steps dataset had approximately 3,900 country- hypotheses: first, whether LBO investors management compensation and retention. can lead change.” operations and performance of the companies While the findings from both papers reflect industry-year observations that received deploy capital in industries where change Private equity was coming in with the promise This starts at the individual company level. and the returns the GPs deliver to investors. positively on PE’s impact on industries, PE investment and 4,700 observations that is already under way; second, whether of some very attractive deals for management “In all our interactions with private equity The recent papers by Harford et al and adding to the overall debate on the benefits or did not receive PE investment. The authors the involvement of an LBO firm sends a teams, and compensation became a key firms, it is noticeable how important driving Bernstein et al show that the impact of PE also drawbacks of PE, there is still plenty of scope examine the relationship between the signal to other companies in that industry, defensive focus point for corporates,” operational change and elevating the skills of extends to competitor businesses in sectors for further research to build a fuller picture of presence of PE investment and the growth to which they react by making changes she says. management has become for value creation,” where PE has invested. its influence. For Bernstein, a more detailed rates of productivity, employment and capital themselves; and finally, whether LBOs says Andros Payne, managing partner at analysis of rates of layoffs, plant closings formation. The analysis measures the growth affect the competitive nature of the target’s Humatica, an organisational improvement Putting it all together and openings, and product and process rate in a particular industry relative to the industry, causing industry peers to undergo Harford et al find that PE impacts the innovations, are important avenues for future average growth rate across countries in the operational or strategic changes. These behaviour of companies in an industry whose enquiry. He adds that the buyout boom of same year. In addition, it uses country and three hypotheses are not mutually exclusive. competitors have received PE funding. These the mid-2000s was so massive, and the industry fixed effects to measure PE activity behaviours include M&A activity and corporate subsequent crash so precipitous, that it is still relative to the average performance in a The authors of the paper conclude that governance. Harford and his colleagues also too early to fully understand the consequences given country, industry and year. LBOs do prompt a reaction from industry examine performance using the return on of PE investment through recent cycles. We’ll peers, leading to increases in M&A activity, assets metric (ROA) but find no difference just have to wait a few more years before that The study finds that PE investment is R&D spending, the formation of alliances between firms with and without PE-financed particular debate can be tackled. associated with faster growth in production, and share repurchases. Firms are also more “FIRMS ARE NOT JUST LOOKING FOR industry peers. The Bernstein et al paper value added, labour costs and number of likely to change governance structures after measures performance in terms of growth in employees. Importantly, the authors find the LBO of an industry peer, by introducing ARBITRAGE OPPORTUNITIES, BUT industry production and employment – and no evidence that this growth comes at the anti-takeover provisions, for example. These finds stronger growth and lower volatility in expense of greater cyclicality and volatility findings are somewhat consistent with the ARE PROACTIVELY SEEKING TO MOVE PE-backed industries. for an industry. In fact, smaller employment second hypothesis that PE involvement fluctuations are associated with PE activity, conveys informational signals, which lead INTO INDUSTRIES WHERE THEY CAN contrary to a central concern that PE’s to future industry changes. However, LEAD CHANGE.” focus on financial returns leads to overall Harford et al believe their results provide reductions and volatility in the labour force. the most support for the third hypothesis: The authors find similar results for the PE induces real industry changes through subset of PE investments in the UK and competitive effects.

8 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 9 ANALYSIS BE CAREFUL WHAT YOU WISH FOR

Investors in private equity and venture capital funds are increasingly pushing for better fee and carried interest terms. Yet new research suggests that some arrangements widely considered to be LP-friendly could be quite the reverse. By Vicky Meek

he last few years, and in particular However, new research on venture capital Counter-intuitive? carry GPs, exits tend to cluster around the end This distinction between venture capital and those since the financial crisis, have funds by Niklas Hüther, David T Robinson, This seems counter-intuitive, yet one of the of the fund’s investment period – i.e., when buyout funds is important, given the difference seen limited partners in private equity Sönke Sievers and Thomas Hartmann- study’s authors, Robinson, believes that it the GPs are about to start raising a new fund. in risk profiles between the two types of Tand venture capital funds agitate Wendels suggests that the approach to carried reflects how incentives shape behaviour “It’s as if the firms with whole-fund contracts investment. In fact, Robinson is currently for better fee and carried interest structures interest structures should be more nuanced. among GPs. “People have a tendency to think needed to demonstrate a track record and working on a companion paper that looks at from their fund managers. The creation of Their paper, Paying for Performance in Private of funds with a whole-fund carry structure as therefore sacrificed some of the potential the same issue in buyout funds and his findings the Institutional Limited Partners Association Equity: Evidence from Management Contracts, being LP-friendly,” he explains. “Yet what I upside on certain investments to put points are – so far – different. “What we’re finding in (ILPA) over a decade ago is just one compares the performance of funds operating think some have been missing is that contracts on the board,” says Robinson. our VC paper is that deal-by-deal contracts expression of the desire for improved terms on so-called “GP-friendly” contracts that affect the choices that GPs make. If I hold “The second effect is that deal-by-deal are optimal when you want to provide maximal and increased transparency among investors. distribute carried interest on a deal-by-deal basis constant the GPs investment strategy, then contracts seem to be associated with taking incentives for swinging for the fences, as is One item that has almost become received with those that have whole-fund carry terms. sure, paying the LP first is definitely better for bigger risks – swinging for the fences, as commonly the case in VC,” says Robinson. wisdom among many LPs is that European- Their conclusions may surprise many the LP. But what if changing from deal-by-deal opposed to going for singles and doubles. “On the other hand, many LBO shops deliver style carried interest structures – where a pushing for European-style contracts: the to whole-fund changes the way GPs behave? With whole-fund contracts, you seem to see great returns by hitting lots of singles, doubles manager must return all the fund’s invested research finds that GPs with deal-by-deal This seems to be what we’re finding: that funds playing it safe early on, but then ramping and perhaps triples, but fewer home runs – and capital (plus a pre-determined hurdle carry perform better than those with whole- investment and exit strategies were different up the risk as the fund matures,” he adds. our companion paper so far seems to suggest rate, where one exists) before earning the fund carry, with public market equivalent based on the contract differences.” It’s worth noting that this study was based that for LBOs, a whole-fund carry is actually performance fee – is more LP-friendly than (PME) returns of 1.241 versus 0.833 gross The paper finds evidence that deal-by-deal on data from a single LP and therefore may not better for the LP than a deal-by-deal strategy.” deal-by-deal carried interest, which is more of fees and 0.967 against 0.638 net of fees, carried interest seems to provide sharper hold generally. It was also based on venture prevalent in the US. In its list of preferred respectively. While the authors suggest incentives for GPs to exit at optimal times capital fund terms and performance, as terms, for example, ILPA says that the whole- that some of the outperformance stems – the timing of exits in these GPs’ funds is opposed to those of buyout funds – which is fund model described above “should be from the ability of better performing GPs to more correlated with the portfolio company’s why the study’s findings on investment style recognised as best practice”. negotiate more GP-friendly contracts, they performance. Meanwhile, for the whole-fund are so pertinent. also find evidence that the terms change investment behaviour.

10 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 11 ANALYSIS

Finer distinctions Nevertheless, the exit and investment patterns Timing the market from proportional to the amount of work put Phalippou challenges the way many LPs have Fee offsets themselves change GP incentives, The findings suggest that LPs need to be found by Robinson and his fellow academics The effect on performance, Robinson’s into the company. It finds that fees were GP- historically approached the issue of portfolio and may reduce the impetus to further making finer distinctions between buyout chime with Ummenhofer’s experience during research finds, can be significant. “In our specific, and did not reflect different business company fees. He concedes that some of increase the fees, as Latham & Watkins’ and venture capital fund terms if they are to his 14-year span at the EIF. “Fundraising study, GPs in VC funds with deal-by-deal or economic cycles, or the work needed by the fees charged will have been subject to Benson points out. “The norm now is for generate the best returns possible. “In my cycles are much more pronounced in VC than structures are much better at timing exits individual portfolio companies. offsets. At the same time, he notes, many 100% fee offsets,” he says. “A decade ago, experience, there can be an assumption they are in buyouts, especially in Europe,” he for the peaks in the market,” says Robinson. “We found that there were some GPs of these offsets are subject to a wide range it was commonly an 80% offset, with 20% that the economics in VC will be structured says. “There is pressure on teams, especially “While they do better than whole-fund that didn’t charge fees, others that charged of exceptions, meaning that even with a going to the GP. What people didn’t take in a similar way to buyout funds,” says in younger firms, to exit investments in order contracts in pretty much every market moderate fees, and others that charged a lot,” 100% offset, not all will have been returned into account was that these fees were being Nick Benson, partner at Latham & Watkins. to increase fundraising potential. That isn’t scenario, they do a lot better than whole- explains Phalippou, co-author of the research. to LPs. His research claims that the fees extracted from portfolio companies, thus “And while established venture capitalists always optimal, especially if it can take six fund GPs in extremely strong markets.” “Yet the amount they charged bore no relation “mechanically reduced performance” since reducing the net profits on which carry was with predecessor funds based on deal-by- to seven years for a company to develop to StepStone partner and investment to what they actually did with the company – they extract value from the portfolio company. calculated at fund level. The move towards deal carry are unlikely to need to switch, for C-round stage.” committee chair Tom Keck agrees that they were fixed fees that were levied regardless Even where offsets occur, at 3.6% of EBITDA 100% offsets means GPs no longer have such newer groups, where the LP is in a stronger Ummenhofer even suggests that this exit timing is a big factor in performance. and the contracts were written in a very of the portfolio companies in the sample, an incentive to charge fees at portfolio level.” bargaining position, whole-fund carry is more difference in contract style may account for “Sometimes GPs sell too early because of blatant way – the language was pretty blunt to “the amounts are economically relevant and common practice.” at least some of the difference in investment the risk of carried interest evaporating,” he that effect.” significantly impact the finances of a large Matthias Ummenhofer, founder of VC firm strategy between VC funds headquartered in says. His firm, however, has a preference for The authors also quantified the amount number of corporations”. By negotiating mojo.capital and former head of the European the US and those in Europe. “From what I’ve whole-fund carried interest not only to avoid charged to portfolio companies, suggesting fee offsets rather than questioning the fees Investment Fund’s (EIF) technology investment seen, US VC funds, which usually have deal- clawbacks, but also to control the gross to net that GPs had extracted $20bn, or 6% of the themselves, LPs may be reducing the potential business, agrees. The mojo team is raising by-deal carry, are often more willing to take spread, as paying carried interest later in a equity contributed on behalf of investors, for returns. its maiden fund on a whole-fund carry basis, risks early on in the fund life,” he explains. fund’s life reduces its impact on the net IRR. from companies they backed in the sample but offering co-investments with deal-by-deal “In Europe, where whole-fund carry is more The impact of fund economics on returns timeframe (1995 to 2014). This doesn’t carried interest. “Our investor base is largely prevalent, there can be a tendency to play it is also explored by research that considers necessarily mean that the GPs in the sample European,” he explains. “Investors here expect safe in the early years, taking less risk on entry portfolio company fees levied by buyout funds pocketed this sum. Many industry experts to see whole-fund carry and so, especially as to ensure the fund can return capital plus the – a subject of focus for the US Securities and believe that GPs pass on most of the fees to “PEOPLE HAVE A TENDENCY TO THINK a first-time fund, any deviation would make it hurdle rate. At the same time, the suboptimal Exchange Commission (SEC) in recent years. their LPs via fee offsets. “Most funds now very difficult indeed to raise capital.” timing of exits by GPs with whole-fund carry Private Equity Portfolio Company Fees, offer 80% to 100% fee offsets,” says Antoine OF FUNDS WITH A WHOLE-FUND CARRY certainly has the potential to limit a fund’s by Ludovic Phalippou, Christian Rach and Dréan, founder of placement agent Triago, STRUCTURE AS BEING LP-FRIENDLY. overall return.” Marc Umber, finds that amounts charged “so the value passes through to LPs on to portfolio companies by GPs in the form portfolio company fees.” YET WHAT I THINK SOME HAVE BEEN of monitoring and transaction fees were far MISSING IS THAT CONTRACTS AFFECT THE CHOICES THAT GPs MAKE.”

12 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 13 ANALYSIS

Inherent conflict? Dréan agrees that LPs look closely at fees What’s it all for? Benson suggests that fee-free arrangements The Phalippou research raises issues around nowadays. “If you go back 20 years or so, All of which begs the question of what these will remain the exception rather than the THE RESEARCH conflict of interest. “There tends to be a lot LPs didn’t look very closely at the fees being fees were (and are) charged for. “While we norm, and LPs accept that these fees are still of negotiation between GPs and LPs around charged,” he says. “But thanks to ILPA and don’t like these fees, it is possible to argue, customary in buyouts. The main focus, he In Paying for Performance in Private Equity: of risk-taking. The paper concludes that whether portfolio company fees are partially the SEC investigations, among other initiatives, especially recently, that GPs provide services adds, is on ensuring that GPs are transparent Evidence from Management Contracts, different carried interest structures affect or fully offset against management fees,” he LPs are now very strict on fees that aren’t and advice to portfolio companies that they with their investors, so the latter understand David T Robinson, of Duke University, returns and GPs’ behaviour in exit timing says. “I’ve often wondered why negotiations management fees – they either don’t want would have to pay for anyway,” says Keck. the nature of the fees being charged. Niklas Hüther, of Indiana University, and and risk-taking. centred on the fraction of offset rather than fees or they want offsets, and they want clear “GPs certainly spend a lot more time making With transparency comes a greater ability Sönke Sievers and Thomas Hartmann- the amount being charged. Until the SEC reporting so that there is full transparency.” operational improvements to companies, and for an investor to determine whether its Wendels, both of University of Cologne, Private Equity Portfolio Company Fees, by got involved, no one really talked about how This increased focus on portfolio company there is clearly value in that.” interests are aligned with those of other LPs, explore the timing of carried interest Ludovic Phalippou, of Saïd Business School, these fees presented a conflict of interest – fees in recent times is precisely what the Nevertheless, there are still many well- GPs and portfolio company management. payments to GPs to determine differences and Christian Rauch and Marc Umber, of GPs take money out of the company through Phalippou paper finds. By examining the known firms that don’t charge such fees – “Alignment is the most important feature of in performance between VC funds with High-Tech Gründerfonds, looks at a different these fees, yet the GPs have control of the fundraising performance of GPs against the Warburg Pincus is one firm that does not levy the industry,” says Keck. “It outweighs the deal-by-deal carry and those with whole- set of fees – those charged by LBO funds to company boards.” level of fees charged, the academics find that, portfolio company charges. EQT is another. macro picture when it comes to performance, fund carry. portfolio companies. It’s a point picked up by Keck. “We post-crisis (2009-15), GPs charging least While the latter declined to be interviewed and we spend a lot of time on this.” absolutely prefer GPs that don’t charge raised more money in a shorter amount of time. on the subject, it did release this statement Overall, these two papers, tackling Using 85 US VC funds raised between Based on 1,044 GP investments, between management fees to portfolio companies,” So were LPs unaware of these fees to Private Equity Findings: “To promote different aspects of this alignment, provide 1992 and 2005, the study measures 1995 and 2014, in 592 leveraged buyouts he says. “There is potential for conflict of beforehand? Phalippou thinks not. “LPs transparency and to avoid conflicts of interest some interesting insights into how terms are the timing and size of gross cash flows (drawn SEC filings), the research finds that interest because the portfolio company knew about them because they were in the in relation to investors or portfolio companies structured and how that structure can affect exchanged between the funds and their total fees charged (including transaction and doesn’t have the ability to negotiate at arm’s documentation – they just didn’t react,” he EQT does not charge its funds or their portfolio performance. “Our papers are yin and yang 3,552 portfolio companies to produce monitoring fees) reached $20bn, on a total length with the GP on these fees. Company says. “Around 2011, these fees began hitting companies any transaction fees, monitoring in certain respects,” says Robinson. “However, public market equivalent (PME) returns enterprise value of the sample of $1.1trn, or management also doesn’t like these fees the headlines, as the SEC started to investigate fees, or any other similar fees relating to a if you take them together, you get a much data. The study finds that, where whole- 3.6% of the companies’ EBITDA. because the team sees them as a dividend the them. Once the news was out, trustees and decision to participate in a transaction.” richer picture of the industry than if you take fund carry is provided for, gross of fee GP is taking out of the company, which they, CIOs started asking questions, so the PE either in isolation.” PMEs are 0.833, versus 1.241 for deal- It finds that fee levels do not vary by GP as equity holders, cannot share in.” teams at LPs had to start acting. I think that’s by-deal terms; while net-of-fee PMEs are performance, by business or LBO cycles, or why we see the results we do in our study.” 0.638, versus 0.967, respectively. by company characteristics – but rather that they remain consistent by GP – i.e., the level The authors find that exit timing in funds of fees charged is GP-specific. The study with whole-fund carry terms spikes around also looks at how fees charged to portfolio the end of each fund’s investment period, companies affect a GP’s ability to raise a often when a new fund is being raised. In successor fund, and finds that in the post- “I’VE OFTEN WONDERED WHY NEGOTIATIONS those with deal-by-deal arrangements, exit crisis period, past fee structures have had a timings more closely match the evolution significant impact: firms charging portfolio CENTRED ON THE FRACTION OF OFFSET of net asset values in the underlying companies the least raised more capital RATHER THAN THE AMOUNT BEING CHARGED. companies. In addition, the authors find in the 2009-14 period. The paper raises that GPs with whole-fund carry tend to take questions about conflict of interest, given UNTIL THE SEC GOT INVOLVED, NO ONE REALLY less risk up-front, with greater risk-taking as that these fees are charged to companies the fund ages, while GPs with deal-by-deal whose boards are controlled by the GP. TALKED ABOUT HOW THESE FEES PRESENTED carry have a more uniform concentration A CONFLICT OF INTEREST.”

14 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 15 ROUNDTABLE

There are many studies looking into how GPs perform and why, but what about LPs? Why does their performance in private equity vary so much? We speak to the authors of three academic studies in this area, HOW DO plus two LPs, to gather their views. Chaired by Britt Erica Tunick. SOME LPs OUTPERFORM Much has been said about the divergence of returns between private equity fund managers themselves, yet it’s also true that there is a wide variation in the performance of individual limited partner portfolios. Now that the industry has matured significantly, academics have sufficient data THEIR to analyse the reasons for the different returns LPs generate from private equity. We consider three papers: the first (by Lerner, Wonsungwai and Schoar) looks into how performance varies according to investor type; the second (by Sensoy, Weisbach, Cavagnaro and Wang) analyses the importance of skill in generating LP outperformance; and the third (by Andonov, Hochberg and Rauh) examines PEERS? how the governance structures of US pension plans affect returns in their private equity portfolios.

Let’s start with the academics’ perspectives. we find is that differences in performance are Yael Hochberg: “We also looked at how All three papers examined the variations in related to skill levels. the incentives of politicians sitting on these performance of LPs’ portfolios. What were “I should also mention, however, that I have boards might differ from those of pension the biggest factors you found to account for better answers about what doesn’t explain plan participants. We found evidence that these differences? these differences. We do see variations in skills politicians are possibly motivated by a desire between endowments and public pensions, but to achieve other goals, such as economic Antoinette Schoar: “We found that foundations we also see a good deal of commonality, and development and that sort of thing, or by and endowments had the best performance in we consequently find less difference between political donations and contributions favourable venture capital (although not as strong on the different LP types than Antoinette’s study did. to their political careers.” PE side), while banks and funds of funds were It looks like it’s kind of a maturing industry and worst. The good performance of foundations some investors are better than others, but it’s and endowments is correlated with their ability hard to put that into neat buckets in terms of to predict when partnership performance is what is going to be good. It’s kind of like, likely to deteriorate. Also, they do not invest if ‘What makes a good basketball player?’” a partnership grows very quickly from one fund to the next. Anecdotally, we also heard that LPs Joshua Rauh: “Our focus was specifically who do not treat PE as an asset class do better on US public sector pension funds and their – meaning they only invest in it if they can place governance, particularly the extent to which money with good GPs and otherwise sit out.” a board is comprised of politicians. We find there is some underperformance by boards Berk Sensoy: “We took the starting point that that are heavily populated by participants different LPs perform differently and we tried or members of pension plans, particularly to dig into that, to figure out the extent to which when they are lacking in relevant experience. these differences are due to skill or luck. What So we also find that skills are a factor.”

16 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 17 ROUNDTABLE

Joshua and Yael, are you saying that political Yael: “Our research shows that two of these What do others make of this finding? Going back to LPs’ local investments, the What are the views of the professional investors Brad Thawley: “We at Texas Teachers also involvement directly affects pension plan three seem to play out. We find evidence Berk: “Endowments and public pension plans findings in two of the papers are not positive, among us? Do you see a direct correlation believe process structure is critically important. performance? of political favouritism for local investments have different governance structures, and are they? between the way an LP is structured and And I think that can come down to incentives. Joshua: “To the extent that governance is (e.g., in real estate) and where that happens in the past people have found differences in Antoinette: “No. We find that a high the PE returns it is able to produce? Incentivising the PE team to strive for linked to political considerations, we find the investments underperform; we also performance across these LP types. But I’m prevalence of local investments has a negative Maria Kozloski: “An LP’s structure is hugely performance and basing incentive structures that for every 10% of the board made up of find some evidence of quid pro quo, where not sure that plays out so much anymore: as effect on performance. In particular, our important for performance, as it will generally on performance are critical. I agree with state officials, PE performance is reduced returns are suboptimal as a result of political the industry has matured, more expertise has research shows that state pension plans tie into how rigorous your investment process Maria, here, that putting structures in place to by 0.5% to 0.9% net IRR points. There are contributions from the finance industry – the become available and LPs have adopted best (and the pension plans of state universities) is and whether your governance is aligned with ensure team stability is also a critical element three potential explanations: one is the control more we see financial contributions to the practices. I think, however, there is a recognition are more heavily invested in local (within- your objectives. Things to consider include: in maintaining the LP skills referred to by Berk, hypothesis, where politicians are trying to direct campaigns of politicians on the board, the that political pressures should be avoided the-state) VC and PE funds, and these how does your process work? Is it efficient? as an LP with a higher turnover rate will be funds to local investments that will promote worse performance we see. What we don’t see when it comes to investment decisions.” investments do particularly poorly.” Does your structure provide the necessary disadvantaged compared with its peers. And their political careers; the second is straight- is any problem finding political board members resources for the team to understand the turnover on a board can lead to unnecessary out corruption, where politicians direct capital with asset management experience – many Joshua: “Our study shows that the opportunity set? How well are portfolio or unwarranted shifting of commitments or according to ‘pay to play’ considerations; and are pretty knowledgeable about finance.” underperformance of boards with a strong construction needs being considered in strategies within a portfolio. This affects access the third is confusion: that politicians may just representation of politicians who are investment decisions, and are those needs to the best managers, too. High-performing be better at politics than they are at investing.” government officials is related to this local reflected in the size of the team? If there is GPs prefer LP stability, because that means investment finding, particularly in real estate. a board in place, what are its objectives? they don’t have to pitch as frequently or to new Local real estate investments motivated by Sometimes a myriad of factors come into play, LPs who are not acquainted with the fund and political motives tend to underperform.” and you need to be cognisant of them.” thus require more time for due diligence and term negotiations.”

Brad Thawley Maria Kozloski Antoinette Schoar Joshua Rauh Yael Hochberg Berk Sensoy Brad Thawley is a senior investment manager Maria Kozloski is the global head and CIO Antoinette Schoar is a professor of Joshua Rauh is the Ormond Family professor Yael Hochberg is an associate professor of Berk Sensoy is a professor of finance at for the Teacher Retirement System of Texas, of PE funds for the International Finance entrepreneurial finance at the MIT Sloan of finance at the Stanford Graduate School entrepreneurship at Rice University, where the Ohio State University Fisher College of where he focuses on all PE growth strategies Corporation (IFC). Prior to joining IFC, she School of Management and chair of the MIT of Business, a senior fellow at the Hoover she serves as the head of the university’s Business. His research areas of interest across multiple geographies as well as middle was a managing director for Lockheed Martin Sloan finance department. She is also an Institution, a research associate at the Entrepreneurship Initiative; the academic include entrepreneurial finance, VC and PE, market buyouts. Among his responsibilities, Investment Management Company, where associate editor of The Journal of Finance, National Bureau of Economic Research, and director for the Rice Alliance for Technology and empirical corporate finance. He previously he sources new PE GP relationships, she headed up PE and real estate, and before co‑chair of the NBER Entrepreneurship an associate editor of The Journal of Finance. and Entrepreneurship; a research affiliate at worked as a visiting professor of finance at the monitors those relationships, and performs that she was with The World Bank Group, Working Group and the co-founder of ideas42, He specialises in empirical studies of corporate the MIT Sloan School of Management; and a Fuqua School of Business at Duke University due diligence for the underwriting of PE where she managed PE for The World Bank’s a non-profit organisation that solves social investment and financial structure. research associate for the National Bureau of and as an assistant professor at the Marshall investments by the fund. He is a member pension system and invested in emerging problems using insights from behavioural Economic Research. She is an associate editor School of Business at the University of of more than 20 advisory boards for buyout, markets for IFC. economics and psychology. of the Journal of Banking and Finance and the Southern California. growth and venture GPs. Journal of Empirical Finance.

18 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 19 ROUNDTABLE

THE RESEARCH

The LPs clearly believe financial incentives Brad: “Yes, one thing LPs can do is to hire And do some LP types really outperform into the best GPs. The big trick in PE investing Smart Institutions, Foolish Choices?: The that an increase of one standard deviation in are vital to performance. What does the individuals who are particularly interested in others, in your experience? is to determine which GPs are good and to Limited Partner Performance Puzzle by skill levels leads to a 3% increase in IRR. research say on this? the greater cause – whether that means they Brad: “I’m not convinced by the lumping persuade them to take your money, as the best Josh Lerner and Wan Wongsunwai, both of Berk: “Incentivisation is very important: if you are driven to improve retirement for teachers, together of LP types. Some of the research ones won’t usually accept money from just Harvard University, and Antoinette Schoar In Political Representation and Governance: don’t have strong incentives, it’s not likely that or that they have a passion for an endowment’s refers to buckets of LPs, and at times there anyone. Our paper shows that some LPs are of MIT Sloan School of Management, Evidence from the Investment Decisions of you’ll see significant differences in outcome mission. Another approach is to bind the is overemphasis on the similarities of LPs better at that than others; the consistency of examines how LP performance varies Public Pension Funds, Aleksander Andonov attributable to skill, as opposed to noise. incentives of the investment professionals with within those buckets. There is actually a lot their outperformance cannot be attributed to according to investor type. Based on data (Erasmus University), Yael Hochberg (Rice Unfortunately, we’re not able to measure the the cause of the beneficiaries, to make sure of deviation in the strategies of LPs within just noise or luck. So what we’re finding in PE from 352 LPs and 838 private equity funds, University) and Joshua Rauh (Stanford strength of incentives within individual LPs, they are striving for a clear goal closely aligned each bucket.” is that you need to pick your PE limited partner it finds that, on average, endowments University) explore the relationship between and the skill sets within those LPs, because with the endowment’s own goal.” personnel well.” generated returns that were nearly 21% pension fund governance and private equity we just don’t have the data.” Maria: “I agree. I don’t think it’s the LP type higher than those of the average LP, while investment performance. Using data on Assuming you have the right incentives and that matters per se. The research suggests Brad: “One of the things that jumped out banks performed the worst. The academics US public pension plans and biographical Antoinette: “Yes, there is little or no data that governance in place, is LP performance then that endowments do better, followed by as being particularly interesting is the ‘seat find that endowments (and to a lesser data on board members, plus data on allows us to measure the incentives that the down to skill? corporate pension plans and then public at the table’ suggestion – the notion that extent public pension funds) are better private equity funds and performance investment managers in different types of LP Brad: “Only to a point. An LP’s access to top pension plans. But endowments, followed endowments benefit from historical access to than other investors at predicting whether drawn from Preqin, the academics find receive. However, we have heard anecdotes performers may not necessarily be based on by corporate pension plans, have been in top-tier GPs, which they gained in yesteryear. a follow-on fund will have high returns. that pension fund boards with a higher to suggest that endowments take a more skill but rather on the size of the LP. Many the investment class longer. When they got They have a seat at the GP table, whereas new Their research also suggests that this type proportion of government officials are long-term approach. They do not incentivise pensions or sovereigns are just too large to started, it was a more nascent market. The entrants don’t have the benefit of access to of LP proactively uses the information associated with poorer performance in managers simply to ‘put money into the justify investments into smaller GPs, and the market today is just far more competitive for the same managers. When I think about Texas gained from being an existing investor in a private equity investments. Boards with asset class’, which might lead managers funds they do access may have different risk/ PE, so investors who are latecomers to the Teachers and our strategy versus other new predecessor fund when selecting funds for high percentages of members elected by to focus on the volume of capital invested reward ratios. market won’t have some of the advantages of entrants within the past decade, we focus our investment, while other LP classes do not. pension plan participants/beneficiaries also in PE, rather than their chosen funds’ quality “Another issue is the risk appetite of the LPs that were 15 or 20 years ahead of them strategy for capital deployment on what we Overall, the academics find that LPs vary in perform poorly. or expected performance.” LPs, as this is a super-large contributor to into the asset class.” can control – things such as large size, ability sophistication levels and objectives. returns in various market conditions. The and willingness to make a large commitment, For each 10 percentage points of the So is it possible for LPs to attract experienced research does acknowledge that there are So what should LPs take away from the long-term partnerships, and our unique view Measuring Institutional Investors’ Skill from board made up by government officials, PE investors without sacrificing efforts to unobservable conditions at play here and that research? of the competitive landscape. We play to their Investments in Private Equity examines performance is reduced by between 0.9% maintain manageable compensation schemes these could have an impact on the findings. Yael: “For most of the public pension funds we our strengths… The other big takeaway for to what extent returns vary between LPs. net IRR and 0.5% net IRR. These boards or violating governance requirements? Additional factors that could be included in examined, their board composition was set by me is that it gives historical context about Berk A Sensoy and Michael S Weisbach tend to invest more in real estate and funds Maria: “I think so, but you do need to pick the risk, but are difficult for the academics to statutes many years ago and is fairly stagnant. how much the PE industry has evolved and (both of Ohio State University) and Daniel of funds, and show a bias towards small, in- your decision-makers well; you need a measure, could be the underlying investments That opens up a lot of questions regarding the continues to evolve. The industry’s strategies Cavagnaro and Yingdi Wang (both of state, and less experienced fund managers. certain level of skill and experience within themselves, the spread of returns, the use of sort of predilections we might be seeing from and sub-strategies have changed in both California State University, Fullerton) use According to the research, this factor an investment team. LPs should provide leverage in companies, team chemistry risk, a certain type of board member and how that complexity and breadth since the early a sample of 12,043 investments made accounts for between 50% and 60% of the incentives to those who manage investments culture risk, valuation environment – all of affects the ability of a public pension fund to 1990s, and understanding this is essential by 630 LPs to determine the importance underperformance. When looking at reasons well and should build teams that will stay. which are extraordinarily difficult to adjust for maximise its returns.” for future planning.” of LP skill in private equity performance. for this underperformance, lack of financial Institutions do well if they hire talented in the findings. I think the reality is far more By comparing the theoretical distribution experience (confusion) is a contributing individuals for their in-house team who nuanced than some of the findings suggest.” Berk: “I think it’s a talent evaluation approach. Maria: “These papers are a good reminder of returns if LPs had made random factor for boards with high member-elected believe in the mission of the institution they There’s a large body of information suggesting to institutional investors of how important commitments to the study’s fund universe representation, but not for those with a are representing, and who are also vested that in the huge universe of mutual funds there it is to set up your structure well: how the with the distribution of returns from LPs’ high proportion of state officials, many of in the outcome.” is not much difference between constituent investment process will function, and how actual fund commitments, they find whom have good financial knowledge. For members, and you might as well just pick an decision-making will be done. This will have a persistence of performance over time the latter, the academics find that political index. However, the PE literature generally notable impact on performance. You shouldn’t among individual LPs. Higher-skilled and contributions (corruption) and political teaches us that there are differences in the short-change that, because it will make a big lower-skilled LPs consistently outperform favouritism (control) are negatively related skills of GPs, and as an LP you need to get difference to the organisation itself.” and underperform respectively. They find to performance.

20 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 21 HEAD TO HEAD ASSESSING THE IMPACT

Impact investing has risen in popularity, but which investors are looking closest at this type of fund? We look at a new paper on the subject and asks one experienced LP for her opinion.

nitiatives such as the Principles “We wanted to find out which investors by over 13%.” This links to academic The reasons for the variations, according This leads to a separate – but related – for Responsible Investing (UNPRI), were committing to impact funds and what research into other areas of sustainable, to the research, boil down to high demand question: does this finding provide an incentive Ayako Yasuda established by the UN in 2006, was driving them to do so,” says Yasuda. responsible, impact investing (SRI), she says. among those investing on behalf of households for funds to badge themselves as impact Ayako Yasuda is a visiting associate professor Idemonstrate the high interest in “After all, traditional models of finance assume “There are related findings in other studies (as per above), mission-focused investors and funds? Not according to Yasuda. “All funds of finance at Haas School of Business, socially responsible investing. Nearly that investors target only financial returns.” suggesting that non-pecuniary considerations those facing political or regulatory pressure these days have boilerplate about ESG,” she University of California Berkeley. She has 1,500 organisations – representing almost What they found surprised the authors. are important to many households. There to invest in impact (such as the Community says. “But impact funds are different in that received numerous professional awards and $60trn of assets under management – are “We had expected there to be some variation is evidence that some households value Reinvestment Act legislation for US banks); they explicitly state that their objective is to has published in leading academic journals signatories, but relatively little capital has in appetite for impact between investors, but social or environmental outcomes – such as those less inclined to invest in impact funds generate social or environmental externalities such as The Journal of Finance, Journal been actually deployed with the expressed we didn’t think we’d find such a great disparity ensuring a less degraded environment for are generally those facing legal restrictions – these are non-financial objectives. If you are of Financial Economics and the Review intent of generating social impact. Observing or such a rich variation,” says Yasuda. By future generations – and are prepared to make against non-financial investment, such as raising capital in a competitive marketplace, of Financial Studies. She co-authored an that private capital, unlike philanthropy and comparing the investment rates into impact investment choices accordingly.” (See page 16 those subject to the Employee Retirement that is a disadvantage as not all investors MBA course textbook Venture Capital and government programmes, has the scale to funds with those of more traditional VC for an article about the oversight of a key Income Security Act (ERISA) and the Uniform find this an attractive attribute and some, the Finance of Innovation, which has been address global social and environmental funds, not only did they find above-market institution that invests for households, public Prudent Management of Institutional Funds such as ERISA investors – which account for adopted at many of the world’s top universities. challenges, a new paper by academics demand for impact funds overall, but also pension funds, which suggests the possibility Act in the US. Interestingly, however, the a large amount of capital – face restrictions Brad Barber, Adair Morse and Ayako Yasuda that certain types of investor were more of substantial governance issues in many authors found that organisational charters in investing for impact objectives above analyses the demand for a specific type interested in impact funds than others. Public cases and offers perhaps another explanation requiring a focus on financial returns didn’t financial ones.” of fund designed to meet such demand pension funds, banks, insurance companies, of these results.) hinder demand for impact funds. – the impact fund. foundations and – naturally – development The study also found that certain categories Yet impact investing comes at a cost, as organisations all had high demand for of LPs displayed significantly higher above- further research by the authors is starting impact funds. By contrast, endowments market demand (i.e., higher investment rates to uncover. “We’re currently working on a appeared to actively avoid impact, with similar, compared with traditional VC funds) for impact follow-on study that, so far, suggests that although weaker results for corporate and funds than others. Perhaps predictably, LP investors in impact funds should expect “WE HAD EXPECTED THERE TO government investors. signatories to the UNPRIs had stronger above- some trade-off in returns – the initial “We were particularly surprised by the market demand for impact funds (25.8%) than findings are that returns are lower for BE SOME VARIATION IN APPETITE strength of the result for households (i.e., did non-signatories (7.1%). Yet geographic impact funds than for traditional venture FOR IMPACT BETWEEN INVESTORS, investors, such as pension funds, which are location also played a part: European investors capital and growth funds. However, we investing on behalf of households),” adds were found to have three times the amount also find that investors are willing to BUT WE DIDN’T THINK WE’D FIND Yasuda. “There, we found that LPs with a of above-market demand for impact funds accept this.” household constituency increased demand of US investors. SUCH A GREAT DISPARITY OR SUCH A RICH VARIATION.”

22 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 23 HEAD TO HEAD THE LAST WORD LIFE ON THE INSIDE

How do inside rounds of venture capital, where only existing investors provide fresh capital, perform? And what motivates VC managers to do inside rounds? A new piece of research sheds light on these issues. By Peter Kneller

Salovaara also argues that it is possible to tart-ups with big ambitions often “The paper’s findings are different than you Katja Salovaara have an impact socially or environmentally THE RESEARCH rely on venture capital to help drive might expect – we’re not seeing evidence of Michael Ewens Katja has been a senior private equity portfolio without sacrificing returns by investing in private growth, and many of the most situations where the entrepreneur is being Michael Ewens is the associate professor manager at Ilmarinen since January 2000. equity more generally rather than specifically Impact Investing, by Brad M Barber Ssuccessful companies will welcome taken advantage of.” of finance and entrepreneurship at the Ilmarinen is a mutual pension insurance in impact funds. “Many buyout funds make and Ayako Yasuda of University of on board a growing number of venture capital California Institute of Technology (Caltech), company based in Helsinki, Finland, managing investments that arguably have a significant California, Davis and Adair Morse of the backers as they get closer to a successful To what extent did you expect to find that which he joined in 2014. Ewens is also a €36bn, with 6% currently invested in PE. impact socially or environmentally,” explains Haas School of Business, University exit. However, this is not always the case. inside rounds led to poorer outcomes? quantitative advisor for Correlation Ventures, Before joining Ilmarinen, she worked at the Salovaara. “They can do so because they of California, Berkeley, examines the Around 30% of investment rounds (excluding “When I first started looking at this area, a quantitative-focused venture capital firm Shell UK Pension Fund in London analysing PE operate at a much larger scale than the VC and demand for impact venture capital and initial investment rounds) in entrepreneurial years ago, I found it surprising, and I only based in San Diego. funds and monitoring a global private equity growth funds examined in the study.” She points growth funds among limited partners. companies between 1992 and 2014 are found it more surprising as time went on. portfolio with over $1bn of commitments. to the example of an investment in an irrigation Using a dataset comprising over 25,000 classified as “insider” financing rounds, Venture capital is extremely expensive for Before that, she worked at Pantheon Ventures. company. “The investment to help this company capital commitments to more than 5,000 where no new investors were involved. everyone involved, apart from the venture grow to scale provides the potential for good funds and a hand-collected sample of Academics Michael Ewens, Matthew capitalists themselves. LPs pay a fee, while returns,” she says. “But because of the scale, 161 impact funds, it finds that there is a Rhodes-Kropf and Ilya Strebulaev undertook entrepreneurs give up control, and large equity or long-standing private equity investor its effect on saving water and improving crop 14.1% higher investment rate in impact an exhaustive study, reviewing the stakes, to preferential shareholders. In that Ilmarinen Mutual Pension Insurance yields is significant. If you want to make an impact funds (defined as having dual impact performance of over 10,000 VC-backed setting, you would think that VC managers Company, the issue is clear. “The law globally, while also focusing on returns, buyout- and financial objectives), compared with companies, to analyse the difference in would extract an enormous amount of value Fmandates that we invest in a secure backed businesses can provide the solutions. more traditional VC and growth funds and outcome between insider and outsider funding from entrepreneurs by doing inside rounds and profitable manner – we have to pursue If you focus on a subset of VC funds, the impact that this excess demand has increased rounds. They found that the former are more at very low prices, in order to increase their returns as our objective,” says the investor’s will be much lower and the returns are affected substantially in recent years, with above- likely to leave investors worse off, with inside returns at exit.” senior private equity portfolio manager because VC funds are expensive vehicles market demand rising from 7.1% in the rounds associated with a higher likelihood Katja Salovaara. – the bar is higher to generating returns.” period before 2007 to 21.8% from 2007 of failure, lower probability of IPO and lower Is the implication therefore that new investors However, the issue is larger than a And then there’s the question of investor and onwards. The authors also document cash-on-cash multiples than rounds with new cast a more critical eye over the numbers? straightforward legal obligation, she adds. type. “It’s very interesting that endowments that above-market demand is present investors. Private Equity Findings caught up “That is certainly consistent with the story, “If you are investing on behalf of pensioners, are least likely to have demand for impact among development organisations with Ewens to discuss the findings. although maybe a better way to say it is that they are relying on the returns that you funds,” says Salovaara. “Studies have shown (17.7%), foundations (11.1%), banks an outside investor evaluates the company generate for their retirement income,” she (see Roundtable, page 12) that endowments (22.2%), insurance companies (24.0%) Why did you decide to explore this area going forward rather than its value now and says. “If you don’t generate adequate returns, are some of the best-performing LPs.” and public pension plans (17.3%), while of research? looking back. It’s almost as if outsiders bring the contributions necessarily have to rise. Finally, given the appetite demonstrated by other investor types eschew such funds, “The setting of inside rounds is an a discipline that means you don’t overpay, Most investors are structured to benefit the the research, Salovaara suggests that there is including endowments (-31.1%) and environment where predictions from which is the opposite of what a standard ultimate constituents and so in most cases, a “meaningful” incentive for firms to market corporate or government investors. They economic theory are quite clear, but when model would predict.” it’s hard to argue that impact objectives should themselves as impact funds. “LPs do need to find evidence that above-market demand I first investigated the simple relationships, be followed if there is a trade-off with returns. be sceptical of some of the claims,” she says. for impact is driven by households (as the patterns went in the opposite direction. If the constituents wish to follow an impact “The measurement of social and environmental opposed to organisations), mission- objective, there needs to be an opt-in or opt- impact is very difficult to achieve with any focused investors and those facing out mechanism.” degree of accuracy. As ever, there is no political or regulatory pressure to invest substitute for thorough due diligence.” in impact.

24 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 25 THE LAST WORD PRIVATE EQUITY FINDINGS

So are venture capitalists using insider “Maybe these inside rounds are occurring at So should the VC fund model be changed? Published by the Coller Research Institute with the financings as a “backstop” when portfolio a point in the fund’s lifecycle where the cost of “It’s unrealistic to think we can find a contract THE RESEARCH support of Bladonmore and Bella Research Group. companies are struggling to raise capital? capital – the underlying risk-adjusted return to to resolve every single thing. My view is that “When we asked venture capitalists why rationalise investments – is lower. The evidence despite the underperformance of inside Inside Rounds and Venture Capital they thought other venture capital managers suggests that the propensity for inside-round rounds, the benefits that come from the Returns by Michael Ewens of Caltech, conduct inside rounds, one of the more behaviour tends to be much higher when limited fund life, the investment period rule, Matthew Rhodes-Kropf of Harvard Contributions from: popular answers was that they might be venture capitalists are in the second half and all the other terms that LPs and GPs have University and Ilya Strebulaev of Stanford trying to help a company recover from a of a fund – a time when most investors are negotiated over the years, outweigh the costs University analysed the outcome of California Institute of Technology recent shock. Yet as an insider I’m not just restricted from making new investments.” of inside-round behaviour. investment in 10,104 venture capital- California State University considering this individual series C, I’m “One of the more interesting facts that has backed entrepreneurial firms from 1992 considering the whole position I have in the Why do you think inside rounds tend to be emerged from the data I work with is that, to 2014, assessing the findings from Columbia University start-up. By not investing in this company and negative net present value? across venture funds as a whole, there is 22,382 investment rounds (excluding Duke University letting it fail, I lose, let’s say, a $10m stake, “What’s important here is that the cost of very little difference in the fraction of a fund’s the initial investment rounds), of which Erasmus University but if I put $500,000 in, I can increase the capital is changing over the fund lifecycle. investments that fails. What really separates 6,645 financings were inside rounds chances of the company not going under.” An NPV analysis that ignores the fund lifecycle the best-performing funds is a couple of (approximately 30%). More than Haas School of Business and settles on a fixed 15-20% cost of capital big winners.” 40% of the firms in the sample are Harvard University How might the way funds are managed looks like sending good money after bad. from California, while the information and raised account for poorer outcomes But taking into account the fund lifecycle, What should venture capitalists and LPs take technology sector comprises more than High-Tech Gründerfonds for inside rounds? the NPV analysis could turn positive.” away from the findings of your research? half of the dataset. Indiana University “An important assumption that people make “Looking at it as a potential syndicate member, when they say that this is a bad investment You looked into whether venture capitalists were I think it’s important to consider the fund stage The research uncovered that inside MIT Sloan School of Management is that there is some kind of benchmark for window dressing their fund performance through of the existing investors. In a sense this input rounds are 20% more likely to lead to Ohio State University the right return. When venture capitalists inside rounds, didn’t you? What did you find? can be predictive for both LPs and outsiders, failure, are 27% less likely to lead to IPOs, make a new investment in a start-up, they “The best time to window dress would be in a way that maybe could help bring capital have 30% lower exit valuations, and Rice University must believe that its returns will at least when managers are raising a new fund. to some of these rounds. Some of these generate 15-18% lower cash-on-cash Saïd Business School exceed the opportunity cost of investing However, while I think window dressing plays rounds are overvalued, and it’s possible that if multiples than outside rounds. Inside in an average start-up. a role in a significant fraction of these deals, outsiders were able to incorporate this additional rounds also appear to have a negative Stanford University there is very little evidence in the data to information – that they’re in the second half of NPV, suggesting that investors make Stockholm School of Economics suggest fundraising is linked to big, overpriced the fund, etc – that could give them an edge in inefficient follow-on decisions. These University of California Berkeley inside rounds happening more often.” understanding what the right deal and price is. suboptimal investment decisions can “LPs don’t like inside rounds. Their view is be attributed in part to the dynamics University of Cologne often that this isn’t a priced round because of the VC fund lifecycle, in which, post- University of Utah they didn’t have the market come in and say investment period, venture capitalists what the right post-money valuation is. Maybe must allocate remaining capital solely University of Washington “IT’S ALMOST AS IF OUTSIDERS BRING one lesson from this is, again, to incorporate to existing investments. This lowers UNSW Australia the fund lifecycle into this and treat inside the opportunity cost of making a A DISCIPLINE THAT MEANS YOU rounds as a little more complex.” follow-on investment. DON’T OVERPAY, WHICH IS THE www.bladonmore.com OPPOSITE OF WHAT A STANDARD www.bellaresearch.com MODEL WOULD PREDICT” www.collercapital.com © 2009-2017 Coller Capital

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