ISSUE 17 2021 £25 30 $35

PRI VATE A WINNING STRATEGY Does private equity genuinely outperform public equity?

THE VANISHING PUBLIC COMPANY EQUITY Is the public company an out-of-date model in the 21st century? IS THE RACE TO THE SWIFT? Why some LPs seem to consistently outperform their peers

FINDINGS SHOOTING THEMSELVES IN THE FOOT Insights from private equity research worldwide Are male investors neglecting female entrepreneurs at their own cost?

BUILDING VALUE Is value creation in buy-and-builds principally from multiple arbitrage?

INCLUDING CONTRIBUTIONS FROM: CALIFORNIA INSTITUTE OF TECHNOLOGY | BOSTON COLLEGE CARROLL SCHOOL OF MANAGEMENT ERASMUS UNIVERSITY ROTTERDAM | HARVARD BUSINESS SCHOOL | MIT SLOAN SCHOOL OF MANAGEMENT | THE OHIO STATE UNIVERSITY SAÏD BUSINESS SCHOOL UNIVERSITY OF OXFORD | THE UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS THE UNIVERSITY OF ILLINOIS AT CHICAGO | UNIVERSITY OF NORTH CAROLINA CONTENTS

By the numbers The vanishing 4 16 public company Global private equity soars through the pandemic; Covid-19 impact on PE potentially worse than the Global Financial Crisis; The number of public companies in the West is waning, Growth in PRI signatories is accelerating; Over half of limited yet private equity AUM is growing rapidly. Why is this? We partners plan to access PE’s secondary market; Biotech and discuss the trend with a panel of three academics who have pharma venture capital deals smash records. studied the reasons for the decline, plus three seasoned private markets investors, to understand what’s behind the shift from public to private.

Building value “Having a healthy public market matters because, ultimately, 6 private equity has to exit. We are transitional owners”

Do buy-and-build strategies genuinely deliver on their promise of value creation? Or are they simply a multiple arbitrage play? Roberto Quarta, Clayton, Dubilier & Rice We explore recent academic research that seeks to throw light on these questions. 24 A winning strategy Is the race to the swift? Private equity firms make much of their ability to outperform 10 public markets. But is the asset class really achieving this? Two In an industry with such a high dispersion of returns, backing leading academics, Ludovic Phalippou and Steven Kaplan, take the right private equity funds and co-investment opportunities opposing sides in the debate. can make a significant difference to limited partner returns.

So what does it take to be a successful investor in the asset class? Two new research papers lift the lid on the relative Shooting themselves importance of skill versus access. 28 in the foot

“Any investor that can generate an extra 2% in private equity Early-stage investing has often been accused of gender bias. returns is making a significant contribution – that usually Yet to what extent does discrimination exist in investment translates into many millions of dollars” selection? We highlight the findings of a new paper that uncovers some interesting behaviours that could be detrimental to some Michael S. Weisbach, The Ohio State University investors’ overall returns.

“Many women have had success raising capital through crowdfunding, but you are not going to get complex businesses funded this way”

Sarah Turner, Angel Academe

2 PRIVATE EQUITY FINDINGS 2021 FOREWORD

Professor Josh Lerner Jeremy Coller Entrepreneurial Management Unit, Chief Investment Officer, Harvard Business School Coller Capital

t a time when many companies exposure to the asset class. While PE papers that uncover the variation are feeling the pain of repeated has grown over the past two decades, of performance among LPs’ investments lockdowns and economic the number of companies listed on in funds and in alternative vehicles A malaise, there is a greater need public markets has declined markedly. such as co-investments, culminating than ever for investors capable of building In this issue’s roundtable discussion, in a discussion of what makes a stronger, more efficient businesses. The vanishing public company, leading successful LP. academics and practitioners discuss Private equity firms, which have the reasons behind the decrease and Finally, in an era when diversity and increasingly adopted buy-and-build whether PE’s rise is part of the answer. inclusion have become key action items strategies, might argue that they fit for the industry, we profile the findings the bill perfectly by creating resilience Comparisons of public and private of a recent paper on whether there is a through scale and operational synergies. markets also feature in another of gender bias among early-stage investors. But some detractors counter that, our pieces: A winning strategy. To the extent that a gender bias does by pursuing serial add-on acquisitions, Here, prominent academics Ludovic exist, Shooting themselves in the foot the industry is simply engaging in Phalippou and Steven Kaplan offer also asks whether this harms returns. multiple arbitrage. Our cover feature, opposing views of whether PE really Building value, uses the results of outperforms public markets. We hope you find our latest issue an recent academic research to examine engaging and thought-provoking read. which version of the story is closer to Of course, in an asset class with a As ever, we welcome any feedback the truth and which buy-and-build high dispersion of returns among you may have; please get in touch approach might offer the greatest fund managers, there will be clear with questions or comments at: potential for operational and outperformers. Much research has been [email protected]. performance improvements. done to determine the extent to which outperformance can be explained by the Despite tougher economic conditions, expertise of fund managers, but rather limited partners continue to allocate less on the skill of LPs. Is the race to the capital to PE, with many increasing their swift? explores the findings of two new

COLLER RESEARCH INSTITUTE 3 PE TRENDS AND STATISTICS

BY THE NUMBERS

Global private equity activity soars through the pandemic Covid-19 impact on private equity potentially worse than • Despite disruption from the onset of After a pause in Q2 as investors the Global Financial Crisis the pandemic in the first half of the digested the effects of the pandemic How will the Covid-19 crisis affect the industry year, 2020 proved to be exceptionally on the economy, PE houses resumed compared with the GFC? busy for private equity firms globally. dealmaking from Q3 onwards in a bid More severely Over US$580bn of buyout deals were to deploy dry powder. Slightly more recorded – the highest annual figure 24% severely since the run-up to the Global Financial • PE activity levels in H2 2020 reflect 44% On a similar level Crisis, when a record US$662bn of PE broader M&A trends. According to deals were struck, Refinitiv figures show. Mergermarket, US$2.2trn of M&A 32% deals were announced in H2 2020, Source: Dechert, Global • The second half of 2020 accounts the highest half-year figure on record. Private Equity Outlook 2021 for much of the increase in activity for However, at US$3.2trn, the whole year’s • The GFC certainly disrupted the the year. In H2 2020, US$378bn of total was down slightly on the US$3.4trn private equity industry, but many PE deals were struck, up significantly of M&A value for 2019. executives believe the eventual impact from the H1 value of US$210bn. of Covid-19 will be worse, according to Dechert’s Global Private Equity Outlook Global PE investment by value 2021. Three-quarters of the survey’s respondents believe the pandemic will affect the PE industry more severely – either to a greater (44% of respondents) or a lesser extent (32%).

• It is well known that certain sectors – hospitality, bricks-and-mortar retail, and travel, for example – have suffered significant damage from lockdowns, but the extent of the scarring on the wider

US$bn economy remains to be seen. With 90% of Dechert’s respondents expecting an increase in distressed deals in the wake of the pandemic, PE professionals may be anticipating more widespread pain.

• Other effects of the pandemic expected by industry players are: delays to deals

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 (82%); more fund restructurings (64%); Source: Refinitiv and suspended fundraisings (55%).

4 PRIVATE EQUITY FINDINGS 2021 Growth in PRI signatories is accelerating Biotech and pharma venture capital deals smash records PRI signatories by number and AUM • With annual venture capital deals

Signatories in the US breaking the US$150bn mark for the first time in 2020, one of the brightest spots was the biotech US$trn and pharma sector, according to the Pitchbook-NVCA Venture Monitor

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 for Q4 2020. This was perhaps Source: PRI Association AUM (US$trn) Number of signatories unsurprising given the huge health impact of Covid-19. • With responsible investing and • Indeed, the acceleration of PRI’s environmental, social and governance growth was particularly noticeable US VC biotech and pharma deal activity issues entering mainstream investing, in the year just gone. the Principles for Responsible Investment (PRI) Association passed two major • The number of new PRI signatories

milestones in 2020 – the number of PRI increased by 28% in 2020 (to 3,038) Deals signatories topped the 3,000 mark for the compared with 2019 and signatory US$bn first time and the total AUM of signatories AUM rose by 20% (to US$103.4trn). exceeded US$100trn.

Over half of limited partners plan to access PE’s secondary market 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Value (US$bn) Deal count

• Just over half of limited partner Planned LP activity in the secondary market in the Source: PitchBook-NVCA Venture Monitor, Q4 2020 institutions (52%) expect to buy or sell next two years (excluding GP-led secondaries) assets as secondaries in the next two • US VC investment in the sector years, according to Coller Capital’s latest in 2020 reached a record high of Global Private Equity Barometer. Some US$27.4bn across 998 deals – 20% plan to be both buyers and sellers; easily surpassing the previous record another 19% to be buyers only; and of US$19.8bn set in 2018. The report 13% to be sellers only. adds that in 2020, investment was equally split between late, early, and • This finding demonstrates LPs’ reliance seed investment stages. on the secondaries market as a portfolio management tool, particularly at a • Amid an increased need for disease time of great economic change. Nearly treatments and prevention during the Source: Coller Capital, Global Private Equity Barometer, nine in 10 LPs planning to access the Winter 2020-21 pandemic, valuations have increased secondary market (88%) say they will markedly. The Monitor finds that use it to refocus resources on their • The Barometer notes that “these valuations for VC deals in the sector hit best-performing general partners; priorities are broadly similar to those an all-time high in 2020, reaching an 84% to increase liquidity; and 77% reported by investors at the time average of US$134.2m and a median to rebalance their portfolios between of the Global Financial Crisis” of US$35m – up from just US$97.3m different types of private equity. (Winter 2008-09). and US$22.8m, respectively, in 2019.

COLLER RESEARCH INSTITUTE 5 ANALYSIS

BUILDING VALUE

Buy-and-build strategies have become a standard component of the private equity toolbox. But do they deliver value creation via operational synergies or simply via multiple arbitrage? A group of academics decided to find out. By Nicholas Neveling.

6 PRIVATE EQUITY FINDINGS 2021 uy-and-build capabilities have and non-exited investments) increases “From 2000 to 2010, we experienced become a key part of private by an average of 27% over the first what I would describe as a period of equity’s value creation pitch five years of PE ownership, compared ‘rampant’ buy-and-build strategies,” says B to investors and management with a pre-deal average of 5.6%. Duncan Johnson, head of Caledonia teams. As the asset class has become Private Capital. “We saw a number of more competitive and entry multiples “Our research confirmed that aggressive, acquisition-driven, growth have climbed, buy-and-build activity has buy-and-build strategies provide an strategies in the decade running up ballooned. In 2020, add-on acquisitions additional source of value creation to the GFC. By the end of the decade, accounted for over 72% of all US buyout for PE managers, compared with though, it was apparent that in rampant activity, according to PitchBook figures – traditional leveraged buyouts,” Smit buy-and-builds it is harder to deliver an all-time high. says. “Leveraged buyouts create fundamental value.” value through the use of debt and But do buy-and-builds deliver genuine restructuring. Buy-and-builds give operational synergies, or are they managers the same tools as strategic “PRIVATE EQUITY IS COMBINING simply an exercise in accumulating buyers to implement operational COMPLEMENTARY RESOURCES assets so financial sponsors can synergies. PE is combining TO BUILD A UNIQUE HYBRID capitalise on the higher multiples and complementary resources to build APPROACH TO M&A” refinancing opportunities available a unique hybrid approach to M&A.” to larger entities? Han Smit Co-author Volosovych adds that Erasmus University Rotterdam Academics Dyaran S. Bansraj, although the study did reveal cases Han Smit and Vadym Volosovych of underperformance – suggesting explored this question in a new research that some general partners are not Johnson cites the asset class’s paper, Can Private Equity Funds Act focused on post-deal integration – consolidation of the insurance broking as Strategic Buyers? Evidence from on average, buy-and-builds did sector pre- and post-GFC as an Buy-and-Build Strategies. create operational value. example of how PE’s approach to buy-and-build has evolved. In the The research looked into whether “Limited partners will be aware 2000s, firms saw the opportunity serial buy-and-build acquisition of the possibility that some GPs to consolidate myriad small brokers strategies delivered the kind of use buy-and-builds to justify and find synergies, but also to lock operating synergies, such as fundraising or spending unused in revenue upside (because brokers economies of scale, that would be capital,” Volosovych says. handling a larger volume of business expected from strategic acquisitions, “We do see some underperforming can obtain better pricing from or whether these strategies were little strategies in our sample but, on insurance providers). In the race to more than window-dressing – a charge average, buy-and-builds do seem vacuum up businesses, however, that has been levelled at the industry to deliver improvements in operating integration was neglected and cost by some critics. performance consistent with a synergies were never realised. synergy interpretation.” Hybrid M&A approach “Firms piled businesses on top of each In fact, the paper evinces strong View from the ground other without integrating. That was evidence that buy-and-build For GPs, these findings ring true. fine until the music stopped in 2008,” transactions deliver profitability It is only in the decade following Johnson says. “EBITDA in many cases superior to comparable strategies. the 2008 Global Financial Crisis, was substantially less than forecast It finds, specifically, that return on however, that PE has genuinely because synergies were not delivered sales (for the whole sample of exited focused on operational integration. and due diligence had not been done

COLLER RESEARCH INSTITUTE 7 ANALYSIS

well enough when buying bolt-ons. Horizontal or vertical? and replace the products of competitor To keep the EBITDA story going, firms In addition to its core conclusion suppliers of safety-at-height-equipment had to keep doing the next bolt-on.” that buy-and-builds deliver operational with products procured from our own, synergies, the study also uncovered lower-cost, supply chain in China. PE’s return to insurance broking in the interesting findings about the types This saw big improvements to the gross decade following the GFC, however, of bolt-on deals pursued by margins of the acquired businesses.” was more thoughtful. “PE has since buyout managers. made a better fist of it. Banks have got better at assessing the risks, and At the start of the project, Smit “IF YOU JUST DO A SERIES OF sponsors have built more coherent says, the expectation was that most ACQUISITIONS WITHOUT businesses, rather than simply buy-and-builds would be horizontal PROPER INTEGRATION, YOU accumulating EBITDA,” Johnson says. acquisitions, where sponsors combined END UP WITH A PLATFORM businesses in fragmented markets. THAT IS UNSTABLE” Nordic Capital partner Thomas As the research progressed, however, Vetander says operational integration “we also saw a high number of vertical Thomas Vetander is now essential and increases value on acquisitions, where sponsors used Nordic Capital exit. “Buy-and-build only works when buy-and-build strategies to integrate it delivers improvement in margins and supply chains”, he adds. increases growth,” he explains. “An The paper concludes that, as operational strategy is essential for that Buy-and-build strategies have buy-and-build plays evolve and take to manifest. If you just do a series of become more sophisticated over on a deeper operational approach, acquisitions without proper integration, recent years, with PE firms PE firms “need to target longer-term you end up with a platform that is pursuing different objectives. investment opportunities and carefully unstable and at risk of disintegrating.” “Some buy-and-builds will be about select the types of company in their driving revenue synergies through portfolios, taking into account the He cites Nordic Capital’s buy-and-build additional products, wider geographies, entire production value chain”. investment in veterinary clinic group or cross-sell opportunities,” says AniCura as an example. AniCura Dunedin partner Nicol Fraser. This raises interesting questions about completed 150 bolt-on acquisitions “Other strategies are more focused whether PE firms are becoming more before it was sold to Mars Petcare in on cost rationalisation or on driving and more like acquisitive corporates, 2018. The exit value was undisclosed, value through the supply chains of which in turn could see managers but media reports suggest the deal bolt-on acquisitions. In our investment re-think fund structures. “Longer-term secured a €2 billion valuation to deliver in Kee Safety, for example, a value investment strategies such as a 7x money multiple for investors. creation driver was to acquire buy-and-build may require longer companies in our installer base investment periods, since completing “AniCura was a successful buy-and-build deals takes time,” says co-author in the veterinary industry,” says Vetander. Bansraj. “Therefore, the limited lifetime “At the core of that strategy was of a PE fund may complicate the the creation of a business that successful execution of a buy-and-build offered clinicians opportunities for strategy, essentially motivating a peer-to-peer collaboration and care change in the fund structure that quality that could not be delivered allows for longer holding periods.” outside the group. That sat at the heart of the value proposition.”

8 PRIVATE EQUITY FINDINGS 2021 Nordic Capital’s Vetander notes the expansion of operational teams and resources as “PE has become far more KEY FINDINGS sophisticated in the approach to, and execution of, operational change”. In their paper Can Private Equity Funds Act as Strategic Buyers? Evidence from Buy-and-Build Strategies, Dyaran S. Bansraj (Cass Business School), Han Smit He says: “At Nordic Capital, a strategic (Erasmus University Rotterdam and Erasmus Research Institute of Management) agenda has always sat at the core of the and Vadym Volosovych (Erasmus University Rotterdam and Tinbergen Institute) ask investment thesis, but our operational whether buy-and-build acquisition strategies deliver the operating synergies expected team has expanded and we have put from strategic buyers. in place institutional processes that enable us to build on past learnings and The study looks at 818 platform companies and 1,346 follow-on acquisitions achieve repeatable success.” completed between 1997 and 2016 in seven European PE markets. The authors also construct a “synthetic portfolio” of control group companies with similar attributes Yet while there is an argument that (industry, size, profits, and growth histories) to act as comparators. Using their largest PE is moving closer to strategics in sample (both exited and non-exited investments), the research identifies a 27% some respects, exit timelines and the increase in return on sales (ROS) for buy-and-build acquisitions. requirement to recycle capital draws a significant distinction between the The paper then considers only the exited investments to pinpoint the effect of two. “PE is paid when a liquidity event operational synergies resulting from buy-and-build strategies. The authors find happens and a business is sold. That evidence of synergies among these exited buy-and-builds, in both short-term exit has a fundamental impact on strategy,” strategies (exits four or fewer years after the platform acquisition) and long-term exit Johnson says. strategies (exits after five or more years) – with, for the former, improvements of 41% against pre-acquisition ROS; and, for the latter, improvements of 55% against Smit adds that PE firms are also pre-acquisition ROS. “less driven by empire-building motives” and “less exposed to the risk The research also shows that PE is not just pursuing horizontal acquisition strategies of overvaluation on entry, which is a (consolidation of fragmented industries), but is also seeking to integrate supply chains feature of corporate deals, where with vertical investments. It finds that these vertical strategies result in increased buyers can use their own shares to sales-to-assets and labour productivity – key measures of operating synergies. make acquisitions”.

Next steps For Volosovych, a thought-provoking bolt-on acquisitions are valued, given The paper’s findings suggest new follow-up “would be to look at what that sponsors pursuing buy-and-build avenues for additional research. is similar and different between the are incentivised to make acquisitions. Bansraj is interested in exploring what acquisition strategies of corporates buy-and-builds mean for consumers. and buy-and-build platforms, given the “What premium does the sponsor “The consolidation may not be differences in their management and have to pay? It would be interesting to immediately visible on the streets, governance structures”. explore this using discounted cash-flow but, behind the scenes, more and and game theory models,” Smit says. more companies will be owned by the Meanwhile, Smit is intrigued by same investor, and this changes market whether operational synergies from competition. The effect of this strategy on buy-and-builds impact net returns for the consumer is unclear,” Bansraj says. investors. He is also curious about how

COLLER RESEARCH INSTITUTE 9 FEATURE

IS THE RACE TO THE SWIFT?

Picking the best private equity funds is clearly vital for investors. But how important is limited partner skill when it comes to generating strong performance? Or does it all just come down to access? Two recent academic papers explore this issue. By Vicky Meek.

s many limited partners so much research around mutual funds, be explained by chance. They also found continue to increase their and if ever there was an investment type that some LPs perform consistently well, allocations to PE, their that doesn’t have skill, that would be while others perform consistently poorly. A investment performance it,” says Weisbach. “Yet PE executives in the asset class is becoming an really have to know what they are doing They then sought to quantify the impact ever more important element of the and to know the businesses they back of skill on performance. Weisbach overall returns they need to meet their to add value. The questions we wanted explains the process: “We ran statistical obligations and liabilities. Yet what to address are how investors decide tests to uncover the extent of skill needed determines how well individual LPs which funds to back, especially given to pick the best-performing PE funds,” perform across their PE portfolios? the limited access to some funds, and to he says. “Having established that skill what extent is selecting PE funds similar is needed, we wanted to work out how When it comes to making PE fund to selecting mutual funds (or to PE much this matters. We had to assume investments, a group of academics investing itself) in terms of skill?” a distribution of ability, because you believe they have the answer. In can’t say, for example, that three points their paper, Measuring Institutional The researchers’ initial analysis showed of extra ability leads to two percentage Investors’ Skill at Making Private Equity that skill exists among LPs. When points of increase in returns – what, after Investments, Daniel R. Cavagnaro, Berk compared with a simulation in which LPs all, constitutes a point of ability? So the A. Sensoy, Yingdi Wang and Michael were identically skilled, they found that standard deviation is a way of expressing S. Weisbach look at how LPs’ skill levels the differential in actual performance that distribution of ability and the effect impact their returns from PE. “There is between individual LPs was too great to this has on returns.”

10 PRIVATE EQUITY FINDINGS 2021 “SOME LPs ARE DEFINITELY SEEN AS THOUGHT LEADERS IN PE. GPs ARE KEEN TO HAVE THESE ON BOARD”

Warren Hibbert Asante Capital

COLLER RESEARCH INSTITUTE 11 FEATURE

The academics found that a one checking, going well beyond the list feeder funds. In Investing Outside standard deviation in skill results in a given by general partners, and then the Box: Evidence from Alternative one to two percentage-point increase in trying to join the dots.” Vehicles in Private Equity, Josh Lerner, annual IRR, suggesting it has a pretty Jason Mao, Antoinette Schoar and large effect. “Any investor that can Investment skill is as much about the Nan R. Zhang find that LPs with the generate an extra 2% in PE returns is funds LPs don’t choose as the ones strongest returns from their overall PE making a significant contribution – that they do, adds Ryan. “Knowing when portfolios also do well in AVs, while those usually translates into many millions of to say no is a critical skill,” she says. with lower overall PE performance fare dollars,” says Weisbach. He adds that “Some funds were great in the late poorly in AVs. The authors suggest that the research team also tested other 1990s; they’re not so great now. You this, at least in part, is because top LPs explanations for outperformance, such can’t just look at historical track records are offered preferential access to top as access to funds and risk preference, because the best may be behind some AVs and that high-performing LPs have but they found that the results for skill groups and there may be much better strong bargaining power. were far stronger. options available today.” The research builds on previous work It’s a view shared by Mark Florman, by Lerner together with Victoria Ivashina “ ANY INVESTOR THAT CAN chairman and CEO at Time Partners. and Lily Fang (The Disintermediation GENERATE AN EXTRA 2% IN “Skill is important in LP returns, of Financial Markets: Direct Investing PE RETURNS IS MAKING A and I think there is an interplay here in Private Equity) that analysed direct SIGNIFICANT CONTRIBUTION with relationships – these really help investments by seven LPs. In this later – THAT USUALLY TRANSLATES with judgment calls. There is only paper, however, the dataset is far richer INTO MANY MILLIONS so much that desktop research can – it is drawn from custodial information OF DOLLARS” tell you, and so you really need to from State Street covering more than get under the skin of the team to 100 of the largest LPs. “We can see Michael S. Weisbach understand who makes the decisions every dollar flowing in and out of funds, The Ohio State University and what drives them. GP decks are co-investments and special purpose so similar, you have to get to what vehicles,” says Lerner. “It allows us to differentiates a firm or team.” capture between 5% and 10% of PE Digging deeper activity over four decades.” The importance of skill in LP fund Yet, in contrast to the paper’s findings, investment decisions naturally comes they both also stress the importance as little surprise to those at the coalface of access to funds when it comes to “YOU REALLY NEED TO GET – PE practitioners themselves. But returns. As Ryan points out, “in an UNDER THE SKIN OF THE TEAM it does lead to the question of what industry with such a high dispersion in TO UNDERSTAND WHO MAKES constitutes LP skill in today’s market. returns between GPs, it doesn’t matter THE DECISIONS AND WHAT “Everyone should be able to analyse a how skilled you are if you don’t have DRIVES THEM. GP DECKS ARE SO track record these days, so you can’t access to the best-performing funds”. SIMILAR, YOU HAVE TO GET TO differentiate yourself as an LP that way,” WHAT DIFFERENTIATES A FIRM says Rhonda Ryan, partner and head Skill or access? OR TEAM” of European PE at Mercer. “So it really This relationship between access and comes down to qualitative analysis: How skill is the subject of another academic Mark Florman good is the investment team? Are they paper that looks at LP performance in Time Partners going to stay together, even if things PE, venture capital, and private debt get tough? What’s the culture like? You alternative vehicles (AVs), such as also need to be diligent in reference co-investments, parallel funds, and

12 PRIVATE EQUITY FINDINGS 2021 AVs are an important area to study, Indeed, the size and quality of the team shows most. The paper suggests this is given the rise of co-investments and matter far more than investment ticket down to preferential access for top LPs, other investments being made outside sizes, say some. “The size of annual who have the most bargaining power. Yet main funds. Indeed, the paper shows PE allocation has very little correlation it could also equally demonstrate Ryan’s that by 2017, almost 40% of PE capital to the budget for paying the investment earlier point that skill is about knowing was raised through AVs. Yet, despite the team,” says Warren Hibbert, managing when to say no to an opportunity. lower or non-existent fees and carried partner at Asante Capital. “There may interest often associated with these even be an inverse correlation, as some vehicles, the research shows that even LPs with the most capital to deploy have “ IN PE YOU REALLY NEED average AVs underperform the main the lowest team budget and end up TO LOOK AT WHAT funds of the GPs sponsoring them. aggregating their capital across fewer OPPORTUNITIES ARE “LPs can’t view AVs as a cure-all,” mega-managers, rather than selecting AVAILABLE AND DETERMINE says Lerner. “Co-investments won’t the best from thousands of GPs.” YOUR EXPOSURE FROM necessarily boost returns or make up for THAT – YOU CAN’T poorer performance elsewhere. Fund Instead, it appears that a combination FORCE ALLOCATIONS” investing is a tough enough game; of access – LPs need to see the best co-investments are even harder.” opportunities to do well – and skill leads Antoinette Schoar to outperformance. Investing Outside MIT Sloan School of Management the Box looked at results according to “YOU ARE MORE LIKELY TO whether LPs had discretion over AV BE SHOWN GOOD DEALS investments. “We found the biggest Opening doors AND OFFERED A DECENT differential in performance between the For Geoffrey Geiger, head of PE ALLOCATION IF YOU ARE SEEN top and worse-performing LPs for the AVs funds and co-investments at USS, AS A RELIABLE, PROFESSIONAL where LPs had discretion,” says Schoar. co-investments have, on average, AND PREDICTABLE PARTNER “There is definitely something about outperformed the underlying funds they WITH THE CAPACITY TO sophistication and skill that accounts for invest in. He says achieving this requires ACT QUICKLY” some LPs’ better performance.” an appropriately staffed and skilled investment team, which in turn opens Geoffrey Geiger Even more interestingly, the paper also access to good opportunities. “Securing USS looked at the AV performance of top the best co-investments is down to and lower-tier LPs when investing in access and the relationships you build the same fund. The authors found that with GPs,” he says. “You are more likely Is bigger better? top LPs still outperformed the rest. to be shown good deals and offered a So what does the paper tell us about LP “It has long been a mantra of the PE decent allocation if you are seen as a skill and how it relates to other factors industry that as long as you get into the reliable, professional and predictable such as LP ticket size, reputation and top-quartile funds, then you’re all set,” partner with the capacity to act quickly.” access? It is often said, for example, says Schoar. “Yet our paper shows that larger investors can have significant that, even when looking at a given GP, Indeed, having a reputation for skill – advantages over others in terms of GP there is still a difference in performance being a savvy investor – is a sought-after access and invitations to high-quality among top and lower-tier LPs in AVs. characteristic for GPs where access may co-investments. Yet Schoar says the This matters because AVs are attracting be an issue. “Some LPs are definitely research suggests this is not always increasing amounts of capital.” seen as thought leaders in PE,” says the case. “We find that the sheer size Hibbert. “GPs are keen to have these on of a limited partner is not predictive of And it’s perhaps here that the board.” He adds that this is a function of performance,” she says. interconnection of access and skill team size, experience and talent.

COLLER RESEARCH INSTITUTE 13 FEATURE

“The Ivy League endowments are the familiar in the short to medium term Indeed, Lerner says the overall lesson typically at the top of the list – they are as LPs have been unable to meet new from the two papers is that “LPs are not able to pay market rate compensation GPs,” says Florman. “We’ll see a lot of created equal and skill is an important to retain the brightest academics and re-ups and larger ticket sizes in situations differentiator – I’d argue that skill and investors their systems produce. They where LPs already know GPs, because bargaining power are two sides of the tend to focus on GPs that can generate they will have a higher conviction on same coin. In private capital, unlike in the highest absolute risk-adjusted those opportunities than on new ones.” mutual funds, where you get your money return globally.” from makes a big difference. It’s clear that some LPs are just more savvy and Building that reputation takes time as well L “ IMITED PARTNERS CAN’T this plays out not just at fund level, but as resources, as Lerner points out. “It’s VIEW CO-INVESTMENTS AS also at the AV level.” clear that some LPs are more attractive A CURE-ALL – THEY WON’T to GPs than others,” he says. “Some of NECESSARILY BOOST RETURNS this can be down to financial firepower, OR MAKE UP FOR POORER but it’s also a combination of: staying PERFORMANCE ELSEWHERE. power – that the LP is in private markets FUND INVESTING IS A for the long haul; continuity of the team, TOUGH ENOUGH GAME; which can really matter when you’re CO-INVESTMENTS ARE raising your next fund, because you EVEN HARDER” really want existing LPs to re-up; the LP’s sophistication and level of understanding Josh Lerner of PE; and whether the LP is seen as Harvard Business School ‘smart money’, because that can really help attract other investors to your fund.” Quite how this will affect LP performance will only be known several years down “KNOWING WHEN TO SAY the track. Yet the findings from the two NO IS A CRITICAL SKILL. papers serve as good reminders that PE YOU CAN’T JUST LOOK AT investing is very different from other types HISTORICAL TRACK RECORDS of investment: pressure to deploy capital BECAUSE THE BEST MAY BE can result in negative outcomes because BEHIND SOME GROUPS AND LPs really have to discriminate between THERE MAY BE MUCH BETTER GPs with the potential to perform well OPTIONS AVAILABLE TODAY” and the rest if they are to generate strong returns. “The most successful Rhonda Ryan LP strategies tend not to treat PE like an Mercer asset class,” says Schoar, drawing on this and her previous research. “Unlike fixed income or public equities, where This all really matters to LP performance you have a target allocation and then at a time when access to the best- find investment opportunities to reach performing GPs and, by extension, their that allocation, in PE you really need to co-investment opportunities, may be look at what opportunities are available more constrained than usual because of and determine your exposure from that – the pandemic. “There will be a flight to you can’t force allocations.”

14 PRIVATE EQUITY FINDINGS 2021 THE RESEARCH

In Measuring Institutional Investors’ Skill at Making Private Equity Investments, Daniel R. Cavagnaro, Yingdi Wang (both of California State University, Fullerton), Berk A. Sensoy (Owen Graduate School of Management, Vanderbilt University) and Michael S. Weisbach (The Ohio State University) set out to examine the extent to which LPs’ skill affects their returns from PE.

Using a sample of 27,283 investments made by 1,209 LPs between 1991 and 2011, the authors first examine whether differential skill exists. They simulate the distribution of LP performance on the assumption that all LPs are identically skilled and then compare the results against actual performance data. The comparison reveals that more LPs do consistently well or consistently poorly (above or below median performance, respectively) in selecting PE funds than would be the case if there were no differential skill. “Some LPs appear to be better than other LPs at selecting GPs who subsequently earn the highest returns,” the paper says.

The paper finds that a one standard deviation increase in LP skill leads to a one to two percentage-point increase in annual IRR for the LP’s PE investments. After testing a number of other explanations for outperformance, such as risk preference, political pressure to invest in certain types of funds and access constraints, the authors conclude that skill is an important factor in LP performance and that the difference in performance is “economically meaningful”.

In Investing Outside the Box: Evidence from Alternative Vehicles in Private Equity, Josh Lerner (Harvard Business School), Jason Mao and Nan R. Zhang (both of State Street Global Exchange) and Antoinette Schoar (MIT Sloan School of Management) examine the performance of LP investments in alternative vehicles (such as co-investments, parallel funds, and feeder funds) with a view to understanding why some investors outperform others.

The researchers use custodial data from State Street on 108 LPs, capturing US$500bn of commitments and 20,000 investments, to analyse cash flows between the LPs and GPs. They find that AVs accounted for almost 40% of capital raised by PE firms by 2017 and that better-performing managers – based on past fund performance using public market equivalent (PME) measures – offered higher-performing AVs than those offered by poorer-performing GPs, but that AVs overall perform worse than the main funds of a GP.

They also find that LPs with better past performance across their entire PE portfolio had above-average performance in the AV investments and that they often outperformed the main fund of the GP sponsoring them, while LPs with worse past performance invested in AVs with lower PMEs. The authors suggest this reflects a combination of access and skill. Top-tier LPs are almost three times more likely than lower-tier LPs to be offered AV investments by top-tier GPs. But they also note that the outperformance of the top LPs is strongest in discretionary vehicles, where the LPs’ skill matters. “The sophistication of an LP within the PE space becomes more important as partnerships offer a gamut of different vehicles,” the research says.

COLLER RESEARCH INSTITUTE 15 ROUNDTABLE

THE VANISHING PUBLIC COMPANY

The past decade has seen the number of public companies shrink, while the ranks of businesses owned by private market investors have swelled. What’s driving this trend – and does it matter?

16 PRIVATE EQUITY FINDINGS 2021 After steady growth in the 1980s and 1990s, the number of public companies in the West has plummeted over the last two decades, with peak-to-trough declines of around 30% across many large economies, according to World Bank data. At the same time, assets under management in private markets have soared to US$6.5trn, an increase of 170% in the decade to 2020, according to McKinsey & Company.

But what are the reasons for the sharp decline in the number of public companies? To what extent do cost of capital, the contrasting governance models of private and public ownership, and relative investment performance play a part? And how have changes in the regulation governing public and private markets altered the picture?

Here, three academics who have studied why public markets have lost their shine join forces with three private markets investors to debate why the number of publicly listed companies has declined so dramatically. They also discuss the consequences of there being fewer public companies, why this matters to retail investors unable to access private markets, and how this trend will affect businesses that have historically raised capital through public markets. Chaired by Amy Carroll.

Why are fewer companies listing on ownership in terms of liquidity, there short-term nature of public markets, public markets? are a lot of obligations to fulfil as well.” has diluted a board’s decision-making capabilities, stifling the entrepreneurial Roberto Quarta: “I have a foot in both David Layton: “I agree that it is about the spirit of many companies. We call these public markets and private equity, cost of regulation and compliance. Both things governance correctness. That has and my view is that there is a time for investors and entrepreneurs have grown become so entrenched, it is a real inhibitor. entrepreneurship, a time for companies weary of the corporate governance to be held privately, and a time for changes required in order to go public. “The other major factor, of course, companies to go public. There is no In an attempt to address the implicit is the maturation of private markets. doubt, however, that regulations and tension between managers and owners, I don’t think it’s a coincidence that from governance requirements in public there have been successive waves of 2000 to 2019, the number of public markets have become a lot more laws. But the combination of regulations, companies fell significantly, while private demanding in the past two decades, so proxy advisers and so-called best markets’ assets under management grew while there may be attractions to public practice codes, combined with the to almost US$7trn.”

COLLER RESEARCH INSTITUTE 17 ROUNDTABLE

Gregory Brown Thomas Chemmanur Joan Farre-Mensa Gregory is professor of finance and Thomas is professor of finance and Joan is an associate professor in director of the Frank Hawkins Kenan Hillenbrand Distinguished Fellow at the department of finance at The Institute of Private Enterprise, University the Boston College Carroll School University of Illinois at Chicago, having of North Carolina. He is also the founder of Management. He was previously previously worked at Northeastern and research director of the Institute for associate professor of finance at the University and Harvard Business Private Capital. He previously served as Graduate School of Business, Columbia School. He is particularly interested director of research for Amundi Smith University, and has also taught at in understanding how a firm’s Breeden and worked at the Board of Massachusetts Institute of Technology, listing status affects its financing Governors of the Federal Reserve System. New York University, and Duke University. environment and policies.

Gregory, your research posits that David Layton: “I think PE’s advantage is there is a cost/benefit framework in “WHEN COMPANIES HAVE the ability to focus on those things that will which investors and management teams IMPORTANT STRATEGIC have real impact. You could argue that in balance the benefits of a lower cost CHOICES TO MAKE, IT IS FAR the past this focus has been applied one of capital in public markets with the EASIER TO DO THAT IN A dimensionally to returns. But I think the governance advantages of PE. What are PRIVATE SETTING” industry is maturing and firms are now those governance advantages? taking broader stakeholder needs into Gregory Brown account. That is far more easily achieved Gregory Brown: “Public company University of North Carolina when the board, management team, and ownership structures are diffused. entire company are aligned with a single Even the biggest institutional investors, set of objectives, rather than being pulled such as Vanguard and BlackRock, may “The notion that public boards and in 10 different directions. hold just 5% [of a company]. And those public owners are going to be well investors will own stakes in thousands of positioned to undertake difficult “I would also say: do not underestimate companies, so their ability to undertake decisions is therefore quite a stretch. private capital’s ability to look into good governance and monitoring of When companies have important the future. Private market solutions management is extremely limited. strategic choices to make, it is far easier are increasingly long term. Quarterly The other disadvantage of public to do that in a private setting, where you reporting is restrictive. Public markets ownership is the ‘free rider’ problem. have just one or, at most, a handful of get tired of long-term stories in a way Even if you spend a lot of time and effort controlling shareholders.” that private capital doesn’t.” trying to influence a company, you get just a small fraction of the benefit.

18 PRIVATE EQUITY FINDINGS 2021 David Layton Anne Glover Roberto Quarta David is co-chief executive officer of Anne co-founded Amadeus Capital Roberto is chairman of Clayton, listed private markets investor Partners Partners alongside Hermann Hauser Dubilier & Rice Europe, having Group. He is also head of the PE in 1997. She started out in the US at played a particularly important role business department and a member of Cummins Engine Company and was then in the firm’s investments in SPIE and the global investment committee. Layton at Bain & Company, before returning to Rexel. Quarta is also chairman of was previously head of Partners Group’s the UK to join Apax Partners. She was listed companies WPP and Smith & PE business in the Americas. also chief operating officer of investee Nephew, and served as chief executive company Virtuality Group, after it listed officer of BBA Group from 1993 to on the London Stock Exchange. 2001, before taking over as chairman.

rapport. Then there is a real regulatory David Layton: “I would say that “DO NOT UNDERESTIMATE burden with public ownership and more companies are staying private PRIVATE CAPITAL’S ABILITY TO potential compensation issues in some altogether. This isn’t a delay; it’s LOOK TO THE FUTURE. PUBLIC markets, too. That is particularly true in about a structural shift in behaviour MARKETS GET TIRED OF LONG- the UK, and can cause real problems and I think it’s fuelled by a private TERM STORIES IN A WAY THAT with attracting and retaining talent.” markets industry that is broader, more PRIVATE CAPITAL DOESN’T” substantial and able to solve more Do you think we are seeing a delay to problems than ever before.” David Layton the point at which companies are listing, Partners Group or are more companies just avoiding When can it start to make sense public markets altogether? for companies to list? In what circumstances does the lower cost of Roberto Quarta: “With the PE model, the Gregory Brown: “We are definitely seeing capital in public markets win out? management team and investors are on both. We see cases where companies the same side of the table. That allows are staying private longer. The average Gregory Brown: “From an investor for a direct conversation in real time. time from the first round of venture standpoint, the biggest advantage of In a public company, there might be funding to initial public offering has public ownership is liquidity. If they thousands of investors, as Gregory says. increased significantly. But we are also want to trade out, they can do so in Anyone looking to make a significant seeing an increase in companies that a nanosecond. And when a business move usually sounds out their top 20 never go public. They either remain reaches a certain size, it can definitely investors to get a sense of support, but private companies or go straight into make sense. There are no trillion-dollar it’s very different to having that close strategic acquisitions.” private companies. Access to cheaper

COLLER RESEARCH INSTITUTE 19 ROUNDTABLE

capital is a real draw. And when the trial has failed or a particular currency didn’t have other means with which company’s strategy is relatively easy has gone haywire. It doesn’t matter. to access capital. Yet today, private to understand, information asymmetry Public markets don’t like volatility.” markets players are willing to pay is low. By far the most corporate value prices on a par with public markets is held on public markets after all, so David, your firm – Partners Group – is because they have confidence in their clearly there are some benefits.” a public company, but your role is to ability to drive value.” extol the virtues of private ownership Anne Glover: “I think the lower cost of to management teams. How do you So how much of the increase in private capital argument is a bit spurious. In balance the two? capital AUM is about deregulation – addition to the governance benefits, in and how does that square with the private capital it is possible to create a David Layton: “Despite having superior governance and resulting leverage structure that optimises what listed our management company, outperformance we’ve just discussed? is needed for a company’s specific we have continued to apply a corporate situation. This is in contrast to public governance philosophy that prioritises Joan Farre-Mensa: “Deregulation markets, where you can clearly raise entrepreneurial growth. In any case, plays a significant role. Our argument debt, but it is all intermediated by I absolutely believe that public is that a US federal law passed in ratings agencies and bond issuances. markets can provide opportunities for 1996 – the year when IPOs peaked businesses – to increase their profile, in the US – made it easier for private “The whole capital structure in for example, or to provide an important firms to raise capital across multiple public markets only makes sense channel for succession planning. We states by unifying the states’ regulatory for very large companies. Listed took one of our portfolio companies, environments. We think that was so markets are incredibly important for VAT, public in 2016 and we continued significant because we observed a those multinationals – being able to to govern it with an entrepreneurial sharp increase in the ability of issue corporate bonds during the spirit even as it transitioned onto the late-stage start-ups – traditional IPO coronavirus crisis has been essential public markets. That was the right candidates – to raise large amounts of to their survival. But that is only move for that company at that time, private capital from investors at that relevant to a certain market and we would do it again. time. Slow-changing factors, such capitalisation and above.” as private firms’ potential superior governance, would not have resulted So is it just about size? “ACCESS TO LATE-STAGE in such immediate changes.” VENTURE CAPITAL IS SO Roberto Quarta: “I think size is critical. MUCH GREATER NOW, SO Thomas Chemmanur: “We also found In my experience, when you get to THESE UNICORNS DON’T support for the more abundant PE a certain size it becomes far more NEED TO GO PUBLIC AND financing hypothesis, which we also difficult to sell in a private setting and INCUR ALL THE COSTS believe was driven by deregulation and an IPO almost becomes inevitable.” ASSOCIATED WITH THAT” the end of the US blue sky laws [state-by-state laws against securities Anne Glover: “I don’t think it’s just Thomas Chemmanur fraud]. Access to late-stage venture about size. It’s about predictability. The Boston College Carroll School capital is so much greater now, so these public markets don’t like unpredictable of Management unicorns don’t need to go public and performance. Three strikes and you are incur all the costs associated with that.” out. If you disappoint three times, you are a stock that no one will touch, even “In the past, companies would have Gregory Brown: “There is no doubt if there are valid reasons for why you wanted to go public to achieve an that regulatory changes in the US have disappointed – perhaps a drug attractive valuation, or because they and elsewhere did make it easier to

20 PRIVATE EQUITY FINDINGS 2021 raise private capital. But just because Anne Glover: “Quality is an interesting Gregory Brown: “Has the threshold for you can do something doesn’t mean term, though. Start-ups can be high going public increased, or are these it makes sense. There has to be an quality but might have losses. And companies better positioned to remain economic rationale behind it as well. if you are looking at quality in terms private? It is hard to say for certain, but And the evidence is that capital is going of simple measures of productivity, I do think there is evidence to refute the into venture and buyout funds because such as revenue per employee, that quality threshold claims. What about the returns have been superior.” is misleading. Google and Microsoft special purpose acquisition companies have incredibly high revenue per [SPACs]? People are just throwing money Anne Glover: “Actually, I would invert employee and therefore incredibly high into the market for what is essentially a the argument altogether. Deregulation profitability. But a start-up or growth blind investment. That’s not low quality; is not material here. In the US, the company may not. The whole point is it’s completely unknown quality. And if you Sarbanes-Oxley Act has added that you are investing in the creation of look at some of the Chinese companies $1m to $2m annually to the cost of wealth, and that is not the same thing as that have been able to raise substantial going public. No small company can productivity. Productivity is a function of sums of money in the US, despite inferior withstand that. And in Europe, scale and misses innovation completely.” transparency, that doesn’t support this MiFID II has reduced sell-side hypothesis either.” research dramatically, while the Combined Code [in the UK] has made WE “ HAVE REGULATED OUR WAY How does the rise in SPACs inform being the non-executive director of a AGAINST ATTRACTING TALENT this debate? small public company an extremely TO THE BOARDS OF PUBLIC unenticing prospect. We have regulated COMPANIES... IT IS INCREASED Anne Glover: “Originally, public markets our way against attracting talent to REGULATION THAT HAS KEPT were used to form capital – to do IPOs. the boards of public companies. COMPANIES PRIVATE, RATHER Today, 99% of trading is in the secondary So, I would say that it is increased THAN DEREGULATION” market. That’s what has led us to this regulation that has kept companies fascinating phenomenon of the SPAC. private, rather than deregulation.” Anne Glover Capital raising is now so difficult, even in Amadeus Capital Partners the US, that backable teams are raising Thomas’s paper suggests that the capital and then going on the hunt for quality threshold for public companies acquisitions. It is just a way of short-cutting has increased since 2000. Do you Joan Farre-Mensa: “Some commentators the whole IPO process, which has become think that is the case, and how relevant are claiming the opposite: they argue extremely painful.” might that be to this debate? that by trying to incentivise more companies to go public – by reducing Can you foresee anything that would slow Thomas Chemmanur: “We found a disclosure requirements for smaller listed or change the direction of this trend from greater sensitivity to product market companies, for example – we could be public to private ownership? competition in firms going public degrading the protections that public since 2000 – only stronger firms with offerings provide. Indeed, commissioner Anne Glover: “More appropriate regulation better business models have chosen Allison Herren Lee of the Securities and of public markets. I am spending a lot of to list since then. The evidence we Exchange Commission recently argued my time on exactly this point because, have to support this is firms that have that, if we stay on this path, we may see even if only 10% of our companies go gone public since 2000 have had a continued decline in both the quantity public, it is of massive benefit to underlying greater total factor productivity on and quality of public offerings, to the investors when high-potential businesses average, compared with those that detriment of all investors.” list and to the domestic economy where went public previously.” they list, because it keeps that company and that leadership at home.”

COLLER RESEARCH INSTITUTE 21 ROUNDTABLE

Thomas Chemmanur: “Regulation is investments. At the moment, PE is certainly one answer. The JOBS Act IF “ DISCLOSURE REQUIREMENTS available only to institutional investors – or Jumpstart Our Business Startups AND OTHER REGULATIONS and the very wealthy, and it seems Act – in the US, was designed to do THAT APPLY TO PUBLIC unfair to tell ordinary citizens that just that, by relieving the regulatory and COMPANIES WERE EXTENDED they cannot have access to the transparency burden of going public TO PRIVATE COMPANIES, highest-returning investments.” for smaller companies. The evidence THAT COULD MAKE ALL of success, however, is mixed. The THE DIFFERENCE” David Layton: “I agree. If a larger alternative is to reduce the cost of and larger share of the economy – going public, possibly in the form of the Joan Farre-Mensa and increasingly the most compelling, direct listings we have seen from the The University of Illinois at Chicago best-governed, and best-returning likes of Spotify and Slack.” situations – is owned in the private markets, then I think society has to Joan Farre-Mensa: “If disclosure David Layton: “But I think the wrestle with the lack of access that requirements and other regulations phenomenon of governance correctness ordinary people currently have to that apply to public companies has become so entrenched it is likely those investment opportunities.” were extended to private companies, to persist for the foreseeable future. that could make all the difference. If private markets fail to meet broadening Anne Glover: “But PE is not a For example, if the Sarbanes-Oxley needs for environmental, social and long-term holder of businesses. It is Act were to be applied to private governance considerations and very good at transitions – restructurings companies, that could reduce the stakeholder impact, that could possibly or high growth spurts. It is not good at appeal of remaining private. So, slow the trend. But in fact we are long-term sustained planning. anything that makes private companies seeing real progress on that front, look more like public companies could and as long as that continues, I think “For example, companies like BP and eventually slow the trend.” the shift towards private ownership Shell that operate in climate-sensitive will persist.” sectors are having to plan far into the future. Yes, they need to deliver Finally, does it matter that there short-term performance, but scenario are fewer public companies if PE planning needs to be long term. has the capital and skills to build strong businesses? “I think for some of the big problems we are facing in the world today, public Gregory Brown: “Personally, I think ownership is the right answer.” it’s fine. The economy is evolving, and it is not clear to me that small Joan Farre-Mensa: “Society is putting companies, where almost all of the a lot of effort into making sure public decline in public ownership has taken companies behave in a certain way. place, are better served by public Take, for instance, the recent board markets. So, economically, we could be diversity requirements passed in better off with more private companies. California. If more and more of the Certainly, there is productivity research economy remains in private markets, to suggest that this is the case. those regulations will apply to a smaller and smaller set of companies – not “One challenge we do face, however, necessarily a good or a bad outcome, is who has access to those private just a matter of fact.

22 PRIVATE EQUITY FINDINGS 2021 I also agree about this issue of investor access. Not only are more companies THE RESEARCH now unlisted, making it hard for retail investors to invest directly, but Three separate academic research papers attempt to explain the dramatic shift more pension plans are now defined away from public company ownership structures in favour of private markets. contribution, which, unlike defined benefit plans, rarely allocate assets to PE.” In Public or Private? Determining the Optimal Ownership Structure, Gregory Brown and Sarah Kenyon (University of North Carolina, Frank Hawkins Kenan Institute of Roberto Quarta: “I think having a Private Enterprise) and Andrea Carnelli (Pantheon) argue that there is a cost-benefit healthy public market matters because, framework in which companies trade off the governance benefits of private equity ultimately, PE has to exit. We are ownership with the potential for a lower cost of capital in public markets when transitional owners, as Anne says. We deciding on an ownership structure. buy businesses, make them better and then exit in some form. That will typically The authors note that public markets offer a large pool of capital and extensive risk involve the public markets at some stage. sharing but can be expensive to access, inherently short-term in outlook, and can suffer from misalignment between management and shareholders. PE may not have “Of course, that listed company may the same depth and risk-sharing capabilities, say the authors, but it offers strong then be taken private once again, for all alignment that can overcome the governance issues of diffuse public markets. sorts of reasons. Then we see the story come full circle and we begin again.” The paper finds that companies pursuing complex strategies or requiring a long-term investment horizon benefit most from private ownership and argues that governance engineering by PE sponsors can explain the rise of private markets to HAVING “ A HEALTHY PUBLIC the detriment of public ones. MARKET MATTERS BECAUSE, ULTIMATELY, PE HAS TO Deregulation of Private Equity Markets and Decline in IPOs, by Joan Farre-Mensa EXIT. WE ARE TRANSITIONAL (The University of Illinois at Chicago) and Michael Ewens (California Institute of OWNERS” Technology), takes a different approach. The paper explores how the deregulation of securities laws in the US, and in particular the National Securities Markets Roberto Quarta Improvement Act of 1996, increased the supply of private capital to late-stage Clayton, Dubilier & Rice start-ups, giving entrepreneurs more bargaining power and enabling companies to remain private for longer.

Meanwhile, The Disappearing IPO Puzzle, by Thomas Chemmanur (Boston College Carroll School of Management), Jie He and Xiao Ren (both of the Terry College of Business, University of Georgia), and Tao Shu (Chinese University of Hong Kong), investigates the decline in US IPOs since 2000. They find that abundant PE funding is keeping companies private, while also suggesting that the quality threshold has been raised for public companies since the year 2000.

COLLER RESEARCH INSTITUTE 23 HEAD TO HEAD

A WINNING STRATEGY

Has private equity really outperformed public markets? Two academics present their contrasting views on this important issue.

24 PRIVATE EQUITY FINDINGS 2021 In his recent paper, An Inconvenient Fact: Private Equity Returns & The Billionaire Factory, Ludovic Phalippou finds that performance between PE funds and public markets has been remarkably similar since at least 2006. Steven Kaplan, however, takes a different view, arguing based on his research that PE has outperformed public markets.

n the 20th century, the financial For PE investors to break even, they must Ludovic Phalippou economics literature studied also recoup their cost of capital, which Ludovic Phalippou is professor of financial companies’ cost of capital, and can be approximated using public market economics at Saïd Business School, I a puzzle emerged: why is capital returns. The annual US public market University of Oxford. With a focus on so expensive? Raising public equity in return has averaged approximately 10% private equity and asset management, his the US was found to cost up to 7% of over the long run. This is equivalent to research focuses on areas of the industry the amount raised, and raising public a 1.46x return over a four-year holding that are of interest to investors. He is the debt was found to be only slightly less period, indicating a high cost of capital author of Private Equity Laid Bare. expensive. Further exacerbating the high for PE investors. cost of capital, funding vehicles that intermediated between savers and public There are, however, exceptions to markets added significant additional high equity returns. First, the largest expenses through fees, some of which size decile of stocks returned 7.2% were opaque and indirect. annually between 1996 and 2009, whereas the other nine deciles returned The 21st century only exacerbated the a more common 11.2%. Thus, any puzzle. During this time, capital was large-cap index, such as the S&P 500, diverted from public markets to private underperforms smaller-stock indices over markets through vehicles such as PE that time period. Second, indexing follows funds. These funds, however, involve ex-ante rules which may or may not be expensive fees: the consensus lower good trading strategies. This means that bound estimates for the total expense different indices can perform differently ratio is approximately 6% per year. from one another. The Russell 2000, for example, underperforms the S&P 600 In addition, transaction costs associated by a wide margin, even though both are with PE funds are large and frequent, mid-cap indices. Third, emerging market as portfolio companies change hands stock returns in US dollars have been every four years. To illustrate the high poor, especially over the past 10 years, cost of fees, I estimated the total cost as a result of foreign exchange effects. of financial intermediation for $200bn of equity and $400bn of debt invested This diversity in public market indices (which is about the yearly volume for thus allows GPs and consultants US PE) to be $100bn. This must be to cherry-pick vintage years and recouped over the typical four-year benchmarks strategically to make relative holding period of a portfolio company. performance appear stronger. In addition, as PE has been divided into many asset classes, it is possible to cherry-pick what is defined as PE.

COLLER RESEARCH INSTITUTE 25 HEAD TO HEAD

For example, funds investing in the on the exact benchmark and time-period natural resources industry have – quite a low relative performance. performed poorly. They can be labelled real assets and thus taken out of We might expect this low relative the PE universe. PE returns are thus performance of PE funds to worsen, stronger against the public markets if we given low interest rates, which increase exclude real asset funds. Similarly, an asset prices and decrease returns. The international portfolio of PE will compare deterioration in performance is further favourably to global public equity exacerbated by the industry’s high fixed Steven Kaplan benchmarks. Even if both the PE portfolio transaction costs and fees. Yet, an odd Steven Kaplan is professor of and the public equity benchmark put the but popular line of reasoning concludes entrepreneurship and finance at The same geographic weight on the US, the the opposite: one obtains higher returns University of Chicago Booth School PE portfolio still has an advantage over with more risk and illiquidity; PE has of Business, a research associate the public equity benchmark. This is both, so it must outperform, especially at the National Bureau of Economic because emerging markets, which have in a low interest rate environment. Research, and associate editor of the historically performed poorly, make up a Journal of Financial Economics. He is relatively smaller share of global PE but co-creator of the Kaplan-Schoar public a relatively larger share of a global public “DIVERSITY IN PUBLIC MARKET market equivalent (PME) private equity equity benchmark. INDICES ALLOWS GPs TO benchmarking approach. CHERRY-PICK VINTAGE YEARS Similarly, PE funds with vintage years AND BENCHMARKS TO MAKE In his recent and widely publicised paper, from 2006 onwards will look as if they RELATIVE PERFORMANCE Ludovic Phalippou claims that private performed poorly when measured against APPEAR STRONGER. equity fund managers have made a great a large-cap stock index but will look as IN ADDITION, AS PE HAS deal of money without outperforming if they performed well when measured BEEN DIVIDED INTO MANY public markets net of fees. He also argues against Russell or MSCI world indices. ASSET CLASSES, IT IS POSSIBLE that PE return expectations going forward Performance for pre-2005 vintage funds, TO CHERRY-PICK WHAT IS rely on unrealistically high increases in however, will look great against large-cap DEFINED AS PE” portfolio company earnings. However, stock indices, Russell and MSCI world by any reasonable measure, PE funds indices, but will look poor against have outperformed public markets. mid-cap indices such as the S&P 600. Another curious argument maintains While there is no guarantee that PE will that fund managers must be paid continue to outperform, his second claim Taken together, these points emphasise performance-based fees to incentivise relies on a significant conceptual error the need to choose a reasonable hard work and strong returns. Although which, when corrected, results in more benchmark to properly measure PE data is kept secret, it is easy to estimate reasonable PE return expectations. returns over time. If we compare all US these fees with reasonable precision. buyout funds against the S&P 600, the We find that investors had to reward Phalippou claims that PE “has returned public market equivalent (PME) is 1.10 for US fund managers with a payoff of about the same as public equity indices 1996-2005 vintages and 1.05 for 2006- US$370bn – despite an unimpressive since at least 2006”. There are many 2015 vintages. Widening the sample to all relative performance. This is an ways in which this statement is PE funds yields PMEs of 1.07 and 0.99 extraordinary wealth transfer and another misleading, if not wrong. respectively, using Cambridge Associates puzzle that has still to be addressed. data. This implies that PE investments First, the analysis is misleading because outperformed stocks of similar size by he chooses an unusual time period between 0% and 2% per year depending over which to measure performance

26 PRIVATE EQUITY FINDINGS 2021 – vintages from 2006 to 2015. One might for 2006 to 2015 vintages is 1.05; for Gourier and Phalippou (2018) find that have picked post-Global Financial Crisis 2000 to 2015 vintages, it is 1.10; and, “large buyout and VC funds have vintages or post-2000 vintages. It turns post-GFC, for 2009 to 2015 vintages, it is provided substantial diversification out that 2006 to 2015 is probably the 1.11. This is an alpha of 3% per year and benefits to investors; most real asset worst performing set of vintages one could shows again that, when we use the correct funds, overall, have not”. choose. In that period, an investment analysis, PE outperforms. in PE returned slightly less than an So, Phalippou’s claim that PE has not investment in the S&P 500. The public Phalippou’s article also makes an unusual outperformed or has not provided a market equivalent (PME) is 0.99. In other choice of benchmark equity indices. benefit to investors does not survive words, $1 in PE returned 1% less than the Buyout, growth and VC funds invest in scrutiny. The historical evidence that S&P 500 over the life of the funds raised companies that are smaller than those in PE has outperformed is arguably in the period. the S&P 500. The most commonly used overwhelming. There is no guarantee, small-cap index is the Russell 2000. however, that it will continue to do so, Yet if we look at 2000 to 2015, the result Phalippou does something unusual by and Phalippou argues that it will be flips – the PME goes to 1.05. And if we using the S&P 600 for a small-cap index: difficult. According to his calculations, look at 2009 to 2015, the same thing it is not nearly as commonly used and PE-funded companies will need to grow happens – the PME goes to 1.04. it outperformed the Russell 2000 from earnings organically at 11% per year In fact, for any contiguous choice of 2006 to 2019. When we apply the Russell for the capital invested to increase by a vintages between 1996 and 2015, the 2000 to the 2006 to 2015 vintages, we factor of 2x in four years. His calculations, only choice that does not outperform is get a PME of 1.11 for buyout, growth however, make the conceptual error of 2006 to 2015. Most observers would and VC funds (versus 1.05 for the S&P not accounting for company earnings. conclude that PE has outperformed, and 500). We even get a PME of 1.03 if we If annual earnings are applied to paying Phalippou is disingenuous in making the include the real estate and other funds down debt, earnings have to increase by one possible choice of vintages that gets that Phalippou inappropriately includes a far less daunting 2.4% per year. a different result. (compared with 0.99 for the S&P 500). Again, when we use the correct analysis, There is one final point on PE’s broader Second, he defines PE as leveraged PE outperforms. social consequences. Phalippou looks buyouts, growth equity, venture capital, exclusively at the gains shared by LPs real estate, real assets, natural resources The fourth issue is that Phalippou and general partners, ignoring the fact and infrastructure. Most analyses of PE ignores the fact that limited partners that GPs usually have to pay a premium separate the true equity PE – buyout, increasingly co-invest in PE deals at lower to selling shareholders. Some of the value growth and VC – from the others because or no fees. Some estimates suggest that GPs create, therefore, goes to sellers. they behave differently. Real estate PE co-investment accounts for around tends to move with the real estate market, 25% of PE investment today. Given that PE has clearly outperformed historically and natural resource PE tends to move co-investment decreases the amount for its investors. This is a major reason with energy markets. Notably, both real of fees LPs pay, if they co-invest in an why assets invested in PE have increased estate PE and natural resource PE, like average-performing deal, the true net so much. PE also has created additional the underlying real estate and energy performance is substantially higher. value for sellers and the economy. That markets, underperformed the S&P 500. is not to say that PE will outperform going The different types of PE should therefore A fifth concern is that Phalippou ignores forward. Increased capital puts pressure have different benchmarks. diversification benefits. Even if PE were on future returns. But if that capital to generate similar returns net of fees as underperforms public markets and fails When we appropriately exclude real public equity, it would remain valuable if to provide diversification benefits, we are estate, real assets, natural resources it provided a way for investors to diversify. likely to see capital move to other assets. and infrastructure, the pooled PME even In fact, in a previous paper, Goetzmann,

COLLER RESEARCH INSTITUTE 27 THE LAST WORD

SHOOTING THEMSELVES IN THE FOOT

Early-stage investing has long been a male-dominated arena, and allegations – often anecdotal – of gender bias are common. A new study asks the questions: Are early-stage investors really gender-biased? And if so, how does this affect their choice of investment opportunities? By Vicky Meek.

iversity and inclusion has The gender question However, the research did find that risen up the agenda over Against this backdrop, academics female-led start-ups in which male recent years, driven by Michael Ewens and Richard R. Townsend investors expressed interest were likely to D societal pressure and research sought to determine whether gender outperform male-led start-ups in which demonstrating the value that a variety of bias exists in investors’ early-stage male investors expressed interest. “Our experience and background can bring investment screening. Using data drawn results do seem to suggest that, among to teams. McKinsey & Co, for example, from internet-based platform AngelList, male early-stage investors, the bar is set recently found that companies in the top the authors analysed, by gender, higher for female founders than it is for quartiles for gender diversity and ethnic the interactions between potential their male counterparts,” says Ewens. diversity were, respectively, 25% and seed-stage investors and those seeking “Where a male investor shared information 36% more likely to have above-average funds. Overall, they found that both men on, or requested an introduction to, a profitability than those in the bottom and women were more likely to share start-up, those led by females were more quartile for each dimension. the profiles of, or request an introduction likely to have a successful exit or to raise to, founders of the same gender. follow-on capital, and less likely to fail, But what of venture capital and However, given that 92% of investors than those led by males.” early-stage investing? Where does it active on the platform were male, stand in terms of gender diversity? this preference is potentially of far more Redressing the balance As a PitchBook/NVCA report found in concern for female-led start-ups than it In contrast, the research did not find Q1 2020, just 6.7% of the total value of is for male-led ones. the same pattern in female investors’ US VC deals went to businesses founded interactions with male-led start-ups. by female teams. The figure is only 2.8% The authors then turned their attention to Indeed, Ewens suggests that the by number of deals, a percentage that why this same-gender preference exists. same-gender preference among female has barely changed since 2010. It’s They investigated whether potential investors may be “a result driven by true that female founders account for a differences between men and women female investors having a deliberate lower proportion of the overall number relating to risk attitudes or industry objective of being female-focused” of start-ups, yet recent Crunchbase data experience might explain the apparent in their investments to redress the suggests that this has been rising globally, bias. They found that neither of these gender imbalance. from 10% in 2009, to 20% in 2019. explanations was supported by the data.

28 PRIVATE EQUITY FINDINGS 2021 The results clearly point to bias, says bias. While this is most likely to be Growing new talent Ewens. “One of the interesting things unconscious, people being more Part of the answer, the researchers about the research is that it doesn’t look interested in those they feel more suggest, may lie in fostering more female at whether people are writing cheques, comfortable with doesn’t necessarily investors, although the fact that many it’s simply looking at whether someone lead to better investments and returns. of these – in the US, at least – tend will ‘press a button’ [ie, express an Staying in your comfort zone is not to be drawn from the pool of former interest in a start-up] or not,” he explains. helpful if you want to deliver results.” entrepreneurs, which is itself currently “And, after controlling for almost mostly male, makes this a difficult everything else, we found evidence of solution. So they also suggest the gender bias even in such low-stakes facilitation of crowdfunding as a key tool actions with no cost to investors.” for changing the equilibrium.

No surprises Turner, however, disagrees. “If men This may come as little surprise to many are urged to invest more with female women in the early-stage investment entrepreneurs, one of my concerns is community. But, as Sarah Turner, CEO that they end up backing businesses and co-founder of angel network Angel in areas where women already perform Academe, says: “I’m very glad to see relatively well, such as fashion and research being done in this area, as it’s beauty,” she says. “This is partly why I a question that isn’t asked enough.” don’t think crowdfunding is the answer “CROWDFUNDING IS GREAT FOR – it’s great for consumer businesses, She goes on to explain why she was CONSUMER BUSINESSES, AND and many women have had success motivated to create her network, which MANY WOMEN HAVE HAD raising capital through this route. But aims to bring together people from a SUCCESS RAISING CAPITAL you are not going to get more complex variety of backgrounds to make angel THROUGH THIS ROUTE. BUT businesses, such as deep technology or investing accessible, transparent and YOU ARE NOT GOING TO GET enterprise software, funded this way.” collaborative. “I established Angel MORE COMPLEX BUSINESSES, Academe because I could see, SUCH AS DEEP TECHNOLOGY At EIP, there has been a deliberate first hand, what the paper claims is OR ENTERPRISE SOFTWARE, attempt to address gender balance: 36% happening,” she says. “When I started FUNDED THIS WAY” of the firm’s staff are female, and women angel investing, I was often the only make up 21% of professionals at vice female in the room and often felt Sarah Turner president or partner level. The firm also patronised – I was often mistaken for Angel Academe measures ethnic and racial diversity. the event organiser, for example.” “You need to look further afield and It’s an experience that Nazo Moosa Ewens agrees, while emphasising be more creative when you hire,” says – managing partner, Energy Impact that the research does not measure Moosa. “It can be difficult, but if you Partners (EIP) and a 20-year veteran returns directly; rather, it measures the really want to find the people best suited of early-stage technology investment – probability of success. “A high proportion to the job, you have to realise they don’t knows only too well. “There are so few of early-stage investments will fail, but always come from Harvard or MIT, and women on both the entrepreneurial our findings suggest that male investors many of us probably have to build out and investment sides, especially in may be leaving money on the table,” new networks instead of relying on the technology,” she says. “This research he explains. “They may be lowering same channels.” is welcome because it helps bring their probability of successful outcomes more attention to the issue of gender because of a gender bias.”

COLLER RESEARCH INSTITUTE 29 THE LAST WORD

THE RESEARCH

In Are Early Stage Investors Biased Against Women? Michael Ewens (California Institute of Technology) and Richard R. Townsend (University of California San Diego) study the private interactions between investors and fundraising start-ups to determine whether a gender bias exists when screening investment opportunities.

The research uses data from the AngelList platform, which connects angel “THERE ARE SO FEW and VC investors with seed-stage companies, to analyse expressions of interest WOMEN ON BOTH THE among investors (either by sharing a start-up profile with others or by requesting ENTREPRENEURIAL AND an introduction to the founder) according to the gender of the investor and of the INVESTMENT SIDES, founder. The paper finds that female-led start-ups – 21% of those listed on AngelList ESPECIALLY IN TECHNOLOGY. – experience significantly more difficulty garnering interest and raising capital from THIS RESEARCH IS WELCOME male investors compared with similar male-led start-ups, and that this holds true even BECAUSE IT HELPS BRING where the business does not focus on female-centric products or services. MORE ATTENTION TO THE ISSUE OF GENDER BIAS” The paper also finds that, for a given male investor, the male-led start-ups in which he expresses interest underperform the female-led businesses in which he expresses Nazo Moosa interest (performance being measured by: the probability of an exit via an initial public Energy Impact Partners (EIP) offering or acquisition; the probability of failure; and the probability of raising a follow-on VC round). This suggests that female-founded companies are subject to a higher “quality bar” among male investors than their male-founded counterparts. Subtle influence Moosa also points to limited partners The authors conduct the same analyses of female investors – comprising 8% of as being instrumental in this, especially investors with some activity on AngelList. They find that women are more likely to given that they are the ultimate express interest in female-led start-ups than similar male-led ones, but they do not beneficiaries of the returns generated find evidence of investment underperformance for female-female pairings compared by fund investments. “LPs have a subtle with female-male pairings. The paper concludes that the evidence is consistent with form of influence here,” she says. “It can gender biases in both sexes, but since the vast majority of early-stage investors are be the inclusion of diversity questions male, this is of more concern for female-led start-ups than male-led ones. in due diligence questionnaires or it can be more systemic. In the US, a number of LPs have established emerging practices that make more funding professional roles, the fact that they tend manager programmes that are designed available to under-represented founders. to be at the junior level – with the to encourage under-represented groups However, few expect progress to be exception of firms like EIP – means there to raise first-time funds – and the idea is rapid. “Resolving the issue of gender bias is still a long way to go. As Turner says: starting to be adopted in Europe. I think in early-stage and VC investment is not “We are seeing some change, but I think this could be very helpful.” an easy thing to do, because you can’t we are 10 years away from a significant just displace a whole set of people in shift in the gender balance of VC teams Change is happening. For example, what is still a small industry,” says Ewens. and entrepreneurs. In the meantime, a new group, Diversity VC, launched however, we can start to rebalance a standard in September 2020 And while venture capitalists might be investment at least with more women encouraging the use of tools and increasingly recruiting women in more participating as business angels.”

30 PRIVATE EQUITY FINDINGS 2021 PRIVATE EQUITY FINDINGS

Published by the Coller Research Institute, with the support of Bladonmore and Bella Private Markets.

CONTRIBUTIONS FROM: California Institute of Technology Boston College Carroll School of Management Erasmus University Rotterdam Harvard Business School MIT Sloan School of Management The Ohio State University Saïd Business School University of Oxford The University of Chicago Booth School of Business The University of Illinois at Chicago University of North Carolina

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