Coller Institute of Private Equity

FindingsINSIGHTS FROM THE WORLD’S BEST PRIVATE EQUITY RESEARCH ISSUE 2 SPRING 2010 / £25 $40 €30

INSIDE

PERFORMANCE QUIRKS Why some LPs do better -than others VC AND THE STATE -How can governments get it right? THE RETURNS DEBATE Does private equity really -outperform? JUST THE JOB? -How buy-outs affect employment ANNUAL SYMPOSIUM Examining alignment of interests

INCLUDING CONTRIBUTIONS FROM: HEC PARIS l LONDON BUSINESS SCHOOL l MIT SLOAN SCHOOL OF BUSINESS l STERN SCHOOL OF BUSINESS l UNIVERSITY OF AMSTERDAM l UNIVERSITY OF BRITISH COLUMBIA l UNIVERSITY OF CHICAGO l UNIVERSITY OF GREENWICH Contents

BY THE NUMBERS 4 Secondaries surge. Emerging markets steam ahead. The capital overhang mushrooms. The highs and lows of default figures

THOUGHT LEADER: THE VIRTUE OF PATIENT CAPITAL 6 Antoinette Schoar on the divergence of LP returns, why fund size matters and why investors continue committing to private equity

ANALYSIS: GREAT INTERVENTION? 8 Moderation is the key to government success in stimulating investment, according to World Economic Forum-led research

ROUNDTABLE: THE POINT OF NO RETURN? 12 Academics are in disagreement over whether private equity outperforms other asset classes. We spoke to a panel about why this is and what their experience tells them

BEYOND THE ABSTRACT: ANGELS OR DEMONS? 17 Do buy-outs create or destroy jobs? We highlight two pieces of research that show starkly different results

COLLER INSTITUTE OF PRIVATE EQUITY NEWS 22 Coverage of the Coller Institute’s third Annual Private Equity Findings Symposium, plus the new Institute website launch

2 Private Equity Findings Foreword

hether the industry likes it or not, private equity is becoming subject to even more public scrutiny. This trend has been playing out for a few years, but now the prospect Editorial Board ofW increasing regulation is looming across Europe and the US, the need for independent assessment of private equity’s impact on Jeremy Coller stakeholders has become greater. One of the Coller Institute of Private Equity’s key tenets is being Professor Francesca Cornelli a leading forum for the exchange of ideas among academics, Professor Eli Talmor practitioners, regulators, policymakers and other industry Professor Eli Talmor stakeholders. The Institute’s Annual Symposium is a key medium

through which we seek to achieve this. Private Equity Findings is Professor another important communication channel; a unique publication in Francesca Cornelli that it synthesises the world’s leading academic research in private equity into a format which is relevant and accessible to the broader community. This second issue of Findings focuses on three important and contentious areas: l Demystifying the conflicting evidence on the performance of Published by Bladonmore (Europe) Limited private equity portfolios at both GP and LP levels l Private equity’s effect on employment, companies and the Editor: Vicky Meek wider economy l Government’s impact on venture capital and investee companies Managing Editor: Sean Kearns Those reading the articles in this issue may agree with some points raised by contributors; they may also find plenty with which they Sub-editor Lynne Densham disagree. That is as it should be – stimulating a healthy debate will help inform the industry’s response to external events, such as the Art Director: Owen Thomas financial crisis and its impact on the spectrum of stakeholders. With new data sources being unfurled and more sophisticated Art Editor: Ivelina Ivanova methodologies developed, academic research into private equity is an evolving field. The Coller Institute of Private Equity will play a key role Production Manager: Andrew Miller in showcasing this research and making it accessible to the broader community as new research is released. We look forward to featuring Publisher: Siân Mansbridge new research in private equity in future issues. Thank you to those who have contributed to this issue. In Publishing Director: Sophie Hewitt-Jones synthesising academic research, we hope that Findings provides you with some valuable insights into the world of private equity. Group Managing Director: Richard Rivlin

T: +44 (0)20 7631 1155

E: [email protected] Steve Dell Professor Eli Talmor Professor Francesca Cornelli Chair, Coller Institute Academic Director

Illustrations: of Private Equity Coller Institute of Private Equity

Special Acknowledgements and thanks to Hans Holmen, Coller Institute of Private Equity, Executive Director Chris McDermott, Coller Capital, Head of Markets and Planning 3 By the numbers

Secondaries surge? l Specialist secondaries players have 62.3% to NAV and venture capital LPs’ motivations for selling fund positions had something of a fundraising funds at 60.6%. 80% bonanza over the past 18 months, with a record $22.9bn raised in l Yet the Preqin report suggests that 2009, up significantly from the 2010 may see a record number of 70% previous high in 2007 when transactions as discounts to NAVs $13.9bn was raised, according to improve. By the second half of 2009, 60% The 2010 Preqin Private Equity according to Cogent, discounts for Secondaries Review. The high buy-out funds had narrowed to 50% volume of fundraising reflects the 31.1% and for venture funds 24.6%. expectation among LPs and the As valuations continue to improve 40% players themselves that secondaries and as LPs increasingly feel the activity was set to take off last year as pressure of capital calls from GPs, 30% investors sought liquidity from their Preqin predicts that secondary deal private equity positions. activity will pick up substantially. 20% l “However, as 2009 unfolded, these l As the chart demonstrates, the expectations failed to materialise,” majority (63%) of LPs that are 10% says the report, citing the wide gap looking to sell in the secondaries between bid prices and fund NAVs market are doing so for liquidity 0% as the main reason for this. The reasons, with 40% saying they wish Liquidity Portfolio Exit poor Reduction in nadir was reached in the first half to rebalance their portfolios. Just rebalancing performing administrative of 2009, when, according to 18% said they wished to exit poorly funds burden Cogent Partners analysis, buy-out performing funds, according to SOURCE: Preqin funds were priced at a discount of Preqin’s late-2009 survey of LPs. Better returns from EMs? LPs are expecting emerging markets to outperform significantly their Dispersion of LPs’ 3-5 year net return expectations – overall private equity portfolios, according to the latest EMPEA/Coller EM PE vs global PE portfolios Capital Emerging Markets Private Equity Survey of 151 investors worldwide. As many as a fifth are expecting returns of 25% or more % from their emerging markets private equity exposure over the next 50 three to five years, while only 3% said they expected the same returns 50 from their global portfolio. 5040 l As many as 67% said they felt the 2006 and 2007 vintages for 40 emerging markets funds would be more resilient to the global 4030 downturn than funds in developed markets, up from 57% in 2009. % Respondents l  More than half (57%) said their new commitments to emerging 30 3020 markets private equity funds would accelerate in 2010 and 2011, up from 25% in 2009. The survey found that the median 20 2010 proportion of commitments targeted at emerging markets by LPs will increase from 6-10% of private equity allocations currently to 10 10 0 11-15% over the next two years. 0-5% 6-10% 11-15% 16-20% 21-25% 25%+ l China, Brazil and India occupy first, second and third places, Annual net PE return expectations 0 0 respectively, in terms of attractiveness for investment in emerging markets private equity, the same position as 2009, while Central Global PE Portfolio* EM PE Portfolio** and Eastern Europe has dropped two places on last year’s results, falling to sixth position. *Coller Capital’s Global PE Barometer **EMPEA/Coller Capital Survey

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10 Findings

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KEY AREAS OF INTEREST FOR LPs IN 2010 vs 2009 80 (top six results) 70 2010 $1.071trn 60 2009 The amount of capital that had been committed to private equity globally but not yet drawn 50 down by the end of 2009, according to 40 Bain & Co.’s Global Private Equity Report 2010. Bain’s base case that it will take until 30 2012 for activity to resume to 2004-05 levels and that leverage will revert to historic norms 20 at the same time suggests that it will take six 10 years to deploy this dry powder.

0 US European Growth Asian funds Distressed Secondary % middle-market middle-market capital debt funds funds buy-outs buy-outs funds SOURCE: Probitas Partners 2010 Private Equity Survey $378bn The survey was based on the responses of 291 institutional limited partners in October 2009, who were asked to choose up to four key areas they focused on most heavily in 2009 and which they expected to be of most interest for 2010. The global capital overhang at the end of Infrastructure funds, which ranked 11th for 2010, showed a marked increase, from 4.6% of responses in 2009 to 10.8% the last recession in 2001, according to in 2010. Emerging markets (excluding Asia) also jumped, from 1.5% to 6.7%. the Bain report.

% 19.5 18.6% 2.84% 6.17%

 The annual rate of defaults  The annual rate of defaults  Annual rate of defaults by  Annual rate of defaults by private equity-owned by similarly rated companies private equity-owned between 2008 and 2009 of companies as estimated by without private equity companies between 2008 and “similarly financed” companies ratings agency Moody’s in involvement, as estimated by 2009, according to Private (those not owned by private November 2009. This figure Moody’s in November 2009. Equity Council analysis of more equity and funded with high included voluntary transactions than 3,200 private equity- yield debt), as analysed by the to deleverage companies. backed companies acquired Private Equity Council. between 2000 and 2009 and held until at least 2008 to 2009.

5 Thought leader

The virtue of patient capital Leading academic Antoinette Schoar on why performance varies according to type of LP, why size matters when it comes to private equity funds and why investors continue to commit despite the illiquid nature of private equity.

Some of your latest research So how do investors that perform suggests that investment poorly tend to structure pay? performance varies by type of LP... “We often see that in public or “One of my recent pieces of research, private pension funds and alongside Josh Lerner, is on the differences companies, the investment professionals in performance of LPs investing in private are incentivised to deploy the money equity. It shows that there are persistent into private equity, rather than having differences in LP performance, as there remuneration based on the performance are in GP performance1. Foundations and of those investments. Therefore, you are endowments rank at the very top in terms forcing the professional to invest in the of finding and accessing the best funds, asset class, while putting less weight outperforming other investors in the on performance.” region of 20%. The banks and insurance companies rank very low, while public Antoinette Schoar But ignoring staff incentivisation, and private pension funds occupy the is good performance not just a middle ground2.” Widely recognised as an academic leader question of picking the right funds? in the area of private equity risk and “This is not just driven by the quality of Why is this? returns, Antoinette Schoar is professor of the funds that endowments select, but “The consistent differentiator that the entrepreneurial finance at MIT Sloan School also how they use information when research highlights is that foundations of Management. She was a keynote speaker renewing their investments. When and endowments use information on past at the Coller Institute’s Second Academic endowments reinvest, the performance fund performance very differently from Private Equity Symposium last year in which of the subsequent fund is usually very other LPs. They do not reinvest in GPs she discussed the dynamics of private equity good, whereas if they decide not to back that have poor performance. In contrast, returns and examined whether private equity the GP again, these funds are often many of the other types of LPs are much is an asset class in its own right. among the worst performers. So to an less sensitive to past performance. Her body of work includes Private Equity extent they are able to predict when “We believe that these results are a Performance: Returns, Persistence and partnerships are about to turn bad and function of a very different compensation Capital Flows, which she conducted in can withdraw their commitments.” structure and time horizon for endowment collaboration with Steve Kaplan (discussed in managers, who work much more over Roundtable, p12), Smart Institutions, Foolish How do they do this? the long term. It is also about how staff Choices?: The Limited Partner Performance “We think they are more careful in are incentivised. It is very difficult to Puzzle, with Josh Lerner and Wan Wong, and observing what is happening in private Cath Riley incentivise private equity investment staff, The Illiquidity Puzzle: Theory and Evidence equity firms, whether key partners are given the length of time it takes before from Private Equity, also with Josh Lerner. leaving, whether the business model will

Illustrations: you see returns from the asset class.” work going forward, and so on. Other

1. This is illustrated in Figure 1, which shows LP returns over the 1990s by category of LP.

2. The data used for this research does not include recent years and, as such, does not reflect the effects of the crisis. 6 Private Equity Findings

investors seem to be completely LP RETURNS OVER THE 1990s* You have also worked on performance-insensitive, and will Figure 1 liquidity and contracts simply write another cheque. This is between GPs and LPs. What are especially disconcerting if you think Banks your key findings here? about the management of people’s “One striking fact is that most pensions in public and private Advisers partnership contracts give the GP pension funds.” the right to veto or approve any Public pensions transfers or sale of shares from an Looking at your work on GP Insurance existing LP to a new one. This can performance, your figures show companies lead to situations in which LPs will forfeit their stake if they are unable that smaller funds show poorer Private pensions performance, whereas from to make a and are not $500m upwards the IRR curve Endowments allowed to sell to another investor. flattens. Why is this? “We were initially puzzled by this “This is not a causal relationship: -5% 0% 5% 10% 15% finding, since stakes in venture good funds are able to raise more capital and private equity funds are capital and thus are larger, so RELATIONSHIP OF CHANGE IN already very illiquid, so why would performance causes size and not the a partnership choose to make them other way around. But we do find IRR TO CHANGE IN FUND SIZE** even more illiquid? Our hypothesis that once a fund becomes too large, Figure 2 is that the imposed illiquidity is a returns are lower. We find that GPs Change in size device to attract only very long-term that grow their fund size very rapidly 1 2 3 4 5 6 and deep-pocketed investors to show declining performance.” 0 the fund – exactly those LPs that -20 will not need to sell in the middle How do you explain this? of a fund’s life for liquidity or other “Josh Lerner and I found that -40 reasons. This enables the GP to partnerships usually do not filter out investors that are not in it -60 proportionally add new partners for the long run, and is important when they have more capital in their -80 because of the large information fund, so there is evidence to suggest asymmetry between inside and -100 that GPs are stretched too thinly outside investors. % Change in IRR when fund growth is too fast3. “If an existing investor tries to sell “Some GPs explain this by saying out of a fund in the middle of the that they are unable to find enough fund life, outside investors might talented investment professionals to “When endowments reinvest, not be able to verify whether this expand their human capital. Others is due to a liquidity shock for the feel that it is difficult to manage the performance of the existing LP, or because the investor ever-growing teams of partners knows of some performance issues and maintain the same cohesion. subsequent fund is usually with the fund. However, the crisis The jury is still out as to why it is so very good, whereas if they has also shown that even very difficult for partnerships to grow. deep-pocketed investors can be hit “In addition, it seems that funds decide not to back the GP by liquidity shocks, so going forward that grow very rapidly migrate towards there will be increased concern a different stage of investment and again, these funds are often about liquidity management for larger investment sizes. This strategy investors in venture capital and drift can cause performance to drop.” among the worst performers” private equity.”

3. This is illustrated in Figure 2 which * SOURCE: Smart Institutions, Foolish Choices?: The Limited Partner shows a negative relationship between Performance Puzzle – Lerner, Schoar and Wang change in IRR and change in fund size (where fund size is measured as the log ** SOURCE: Private Equity Performance: Returns, Persistence and of capital committed). Capital Flows – Schoar and Kaplan

7 Analysis Great intervention? A recent study suggests that some level of state involvement in venture capital can improve exit prospects and returns, although too much risks political baggage. What does this mean for VCs? By Katherine Steiner-Dicks with additional reporting by Vicky Meek.

s governments grapple paper that explored the role of public globally with the issue of how finance in VC, Closing Gaps and Moving Up best to lift their countries out of a Gear: The Next Stage of Venture Capital’s recession, some are revisiting Evolution in Europe. the idea of providing funds As a result, any attempt to understand forA high-growth, high-innovation companies what makes a successful government through venture capital schemes as a venture capital (GVC) scheme is of means of boosting economic performance enormous import to both governments and over the longer term. The UK government, the venture capital community at large. 0.8 for example, launched its plans for a £1bn venture capital fund-of-funds last year. Surprise result 0.7 Of course, government support for So the academic analysis conducted as part 0.6 entrepreneurial businesses through venture of the World Economic Forum’s “The Global 0.5 capital is far from new. And, while there Economic Impact of Private Equity Report 0.4 have been some notable successes – 3i, 2010”, entitled Governments as Venture 0.3 for example – the results have been “Market distortion is a Capitalists: Striking the Right Balance, 0.2 mixed. “While government funding has makes interesting reading, particularly an important role to play in assisting the risk, the more political 0.1 because some of the results were rather formation of venture capital markets, funding unexpected (for summary, see p10). 0.0 is best led by the private sector,” says involvement you have in “Perhaps the most surprising result is that -0.1 Thomas Meyer, director at the European enterprises with moderate GVC support -0.2 Venture Capital & Private Equity Association a scheme” do better than enterprises with pure PVC -0.3 (EVCA), which recently published a white RORY EARLEY, CEO AND CIO, CAPITAL FOR ENTERPRISE [private venture capital] support,” says one -0.4 of the authors, James Brander. While the authors are careful to warn HOW GOVERNMENT VC AFFECTS EXITS about causal interpretations of such reports, 0.8 they felt this was a pattern that could not be 0.7 ignored. However, the analysis also found 0.6 that greater intervention by the state (in 0.5 which enterprises received 50% or more

0.4 from GVC sources) was associated with

0.3 weaker performance. “At high levels of GVC

0.2 support, additional government support

0.1 reduces success,” the report says. Germany Japan Canada 0.0 Moderation, it seems, is the key, even

-0.1 in instances where governments invest in US UK India ROW

China funds, rather than directly. “If our results

-0.2 France S. Korea Australia -0.3 are indicative of genuine causal effects, the model of having independent venture -0.4 capitalists who receive some government Agnes Decourchelle The coefficients show how the presence of a government venture capital programme in a particular country changes the likelihood of exit relative to the base case, where enterprises are financed by Capitalists: Striking the Right Balance Government as Venture investment would appear to have a better private VCs. A positive coefficient means that those with government VC outperform private VCs. It’s worth noting that Germany and Canada have substantial government involvement in VC. track record than government-owned SOURCE: Illustrations: venture capital funds,” the report says, 8 Private Equity Findings

adding: “The evidence suggests that which has a commercial focus and an GVCs may be helpful in providing aim of attracting private investors to certain kinds of support, including venture capital, has proved a success, financial support, but may become less its objectives now need fine-tuning, useful when they have actual control says the EVCA. Yet the proliferation of over business decisions...” politically-motivated finance schemes But what is it that governments can has seeded a large number of funds, provide above and beyond capital spreading the small amount of state and that PVCs and portfolio companies private capital available too thinly. could benefit from? Mentoring is one “Public money has increasingly, and suggestion that Brander comes up in many cases even exclusively, become with, while another explanation might “Often there is one the main source of financing for venture be that government involvement may capital,” says the paper. “This has, to a improve PVCs’ deal pipeline. overworked manager looking large degree, contributed to the sector’s “Another possibility,” adds Brander, uncompetitive state and reduced the “is that an enterprise that is good after the entire fund” ability of some of the best-performing enough to attract significant GVC funds to differentiate themselves to both funding and significant PVC funding is ANNE GLOVER, CO-FOUNDER AND CHIEF EXECUTIVE, investors and SMEs.” likely to be a better enterprise than one AMADEUS CAPITAL PARTNERS that has to be financed primarily by recently sold the business to Tyco The government perspective GVCs. But this is all speculative.” Electronics for $62m. It’s a point that’s not lost on some of In terms of government intervention the managers of government-backed The VC view at a VC level, many would agree that the schemes. The ECF Scheme, which is For VCs, the right kind of government risk of political bias creeping in has to be run by Capital for Enterprise (CfE), was support can be invaluable. Most better managed. “By putting the onus on set up with the objective of bridging the VCs believe that without financial policymakers to single out perceived areas funding gap for investments up to £2m. assistance from government, many of market failures – such as the stages of It provides investment for privately new technologies just wouldn’t get off company development or specific sectors,” managed VC funds that also attract the ground. “There is no economy says Meyer, “government intervention can private capital. “Market distortion is where governments are not involved in prove counterproductive by preventing a a risk, the more political involvement VC and the ‘innovation economy’,” says self-sustaining industry from emerging.” you have in a scheme,” says Rory Helmut Schüsler, managing director at While the selective approach of investors Earley, CfE’s chief investment officer TVM Capital. such as the European Investment Fund, and CEO. “We believe the best support And VCs acknowledge that government skills and connections in key areas can be very helpful. “One The investment-free approach area that isn’t addressed in the study but which is very important for companies Some believe that, while governments have a vital role to answer to the assessment of a business opportunity.” when VC money is scarce is direct play in fostering innovation, they should keep well clear He points to the Defense Advanced Research Projects government support for companies of any commercial aspects. David Gold, venture partner Agency (DARPA), the research and development office through initiatives such as tax breaks, at US-based Access Venture Partners, prefers a model for the US Department of Defense. As a by-product of its subsidies, interest-free loans,” says of government support through grants and investment research, it has spawned new industries. DARPA was Monique Saulnier, managing partner in early-stage R&D. US cleantech, a highly subsidised responsible for the development internet protocol, for and CFO of Sofinnova Partners. “If sector, is an example: “Let’s be clear: the government example, the means by which information is passed from you have a GVC investor involved, they is providing grants. Governments are horribly bad at one computer to another on the world wide web, as the might have a better knowledge of the making business decisions. But they can do a decent organisation sought a means of devising a computer type of direct support available, as well job at making decisions about technologies that may network resistant to nuclear attack. as a better network through which to have disruptive value when they do not need to consider “DARPA is successful because that is its sole focus,” access it.” a return on investment,” he says. “Governments have says Gold. “It doesn’t care about commercialisation. It She points to Sensitive Object as an ready access to people in federal laboratories and cares about creating disruptive technologies that serve example. The touchscreen technology universities who have significant technical expertise and the Department of Defense. Great technologies that evolve company was a 2004 spin-off from the can provide good technology diligence around an R&D from this process will find the private sector funding they French state-owned Centre National project. But they don’t have ready access to business need as they mature. Those that don’t, likely weren’t great de la Recherche Scientifique, which people who are willing and able to give a non-conflicted technologies to start with.” remained a shareholder. Sofinnova 9 Analysis

The research existing challenges,” says Glover. In fact, this is one of the areas Compiled as part of the World Economic Forum’s series companies are split into three categories: those financed that some UK government-backed of reports on private equity’s global economic impact, purely by private VC; those with moderate government VC schemes are currently grappling with. Government as Venture Capitalists: Striking the Right (ie, with some government support, but less than 50% of VC “We are looking at the issue of size,” Balance, by James Brander and Thomas Hellmann, both funding); and extensive government VC (more than 50%). says Earley. “The government wants to of the University of British Columbia, and Qianqian Du of l The report finds thatt hose companies which encourage investment in areas where Shanghai Jiao Tong University, is an attempt to assess the received moderate government VC appeared to others fear to tread – by definition that record of government support for venture capital. perform better than those purely financed by means smaller investments. You have ImpetusImpetus TrustTrust – – The research identifies government support across private VCs, particularly on the value creation and to strike the balance of having a large ImpetusImpetus Trust – three areas: full GVC – providing venture capital through innovation scores. enough fund that generates enough government-owned VC funds; partial GVC – investing l It also finds thatpartial GVCs have the strongest fees to be sustainable while at the same anan intelligentintelligent way way to to give give in independently managed VC funds that also rely on performance of the three types of government time not having too many investments anan intelligentintelligent way to give private investors; and indirect GVC – offering subsidies support, suggesting that independent VCs with some to be reasonably managed. We look Don’t hedge your bets when it comes or tax breaks to VCs. government investment have stronger track records very carefully at the economics of fund: WhyWhy donors donors givegive toto Impetus: Don’t hedge your bets when it comes Based on nearly 29,000 companies in 126 countries that than government-owned VC funds. we don’t want to skimp on fees, but WhyWhy donors donors give give toto Impetus:Impetus: Don’tDon’t hedgehedge your bets when it comes l then we have to make sure that fees 1. Accountability received VC funding between 2000 and 2008, the research The research notes that the countries with the 1. Accountability toto giving.giving. Invest Invest in in the the best. best. compares the performance of those at least partly financed highest levels of government VC activity – Canada don’t drag down returns for investors.” Funding1.Funding1. Accountability Accountability paid paid out out to to chari�eschari�es dependent toto giving.giving. Invest in the best. by government VC with those purely financed by private VC and Germany – do not perform well on the score of CfE is also looking at other areas onFundingonFunding performance performance paid paid out out milestones milestonesto to chari�es chari�es reached. dependent dependent measured by exits achieved, the return made (as a measure successful exits, compared to other countries with for improvement. Indeed, Earley onon performance performance milestones milestones reached. reached. of value creation), innovation and employment creation. The more modest programmes. participated in a recent Coller 2.2. Long-term Long-term impact impact ofof dona�ondona�on That’sThat’s what what we we do. do. Impetus Impetus Trust Trust works works to to break break Institute of Private Equity case study Funding2.Funding2. Long-term Long-term goes goes impact toimpactto capacity capacity of of dona�on dona�on buildingbuilding every That’sThat’s whatwhat we do. Impetus Trust works to break project1 conducted by Josh Lerner organisa�on,Fundingorganisa�on,Funding goes goes notto notto capacity capacitymerely merely buildingfundingfundingbuilding everyprojects. every thethe cyclecycle of of poverty poverty by by inves�ng inves�ng in in ambi�ous, ambi�ous, organisa�on, not merely funding projects. the cycle of poverty by inves�ng in ambi�ous, governments can give is providing of Amadeus Capital Partners. “Early, of Harvard Business School, Eli organisa�on, not merely funding projects. thehigh-poten�alhigh-poten�al cycle of poverty chari�es chari�es by inves�ngand and social social in enterprises ambi�ous, enterprises funding to private sector managers that regional and university challenge Talmor at London Business School 3.3. Leverage Leverage high-poten�alhigh-poten�al chari�es and social enterprises have the right skills and experience.” funds with between £5m and £10m and LBS MBA students Ananth Vyas £13.£13. Leverageof Leverage of funding funding = = £5 £5 inin valuevalue to chari�es, thatthat are are figh�ng figh�ng economic economic disadvantage. disadvantage. While it’s still too early to assess the under management have not worked Bhimavarapu and Thibaud Simphal, through£1through£1 of of funding funding pro pro bono bono = = £5 £5 exper�se in exper�sein value value to to andand chari�es, chari�es, thatthat areare figh�ngfigh�ng economic disadvantage. overall performance of many of the because they are just too small,” she which presented the challenges co-investment.throughco-investment.through pro pro bono bono exper�se exper�se and and UK’s more recent schemes, there are says. “Enterprise Capital Funds that faced by early-stage companies and co-investment.co-investment. WeWe useuse our our proven proven model model of of venture venture philanthropy philanthropy - - portfolio company successes from have been set up in the past few years, the ways in which CfE set out to 4.4. Proven Proven results: results: We use our proven model of venture philanthropy - 4. Proven results: We use our proven model of venture philanthropy - earlier programmes, says Earley. One most of which have over £30m under address these. “One of the reasons Impetus4.Impetus Proven por�olio por�olio results: chari�es chari�es increasedincreased givinggiving strategic strategic funding funding and and exper�se exper�se - to- to build build Impetus por�olio chari�es increased giving strategic funding and exper�se - to build of these is ScriptSwitch, which helps management, are likely to be more we were involved in this was because incomeImpetusincome by por�olioby 40% 40% per per chari�es annumannum increased (more(more than 1010 givingchari�es’ strategic capacity funding and help and themexper�se scale - up.to build �mesincome the by sector 40% per average) annum and (more the thannumber 10 chari�es’ capacity and help them scale up. medical general practitioners manage successful, but it’s too early to judge.” we want to encourage debate on how �mesincome the by sector 40% per average) annum and (more the than number 10 chari�es’ capacity and help them scale up. of�mes people the sectorthey helped average) by 56%and the- to numberover chari�es’ capacity and help them scale up. drug dosages, makes drug switch She says the debate is still out on the the model should evolve: should we of�mes people the theysector helped average) by and56% the - to number over 200,000of people people they helped in 2008/09. by 56% - to over recommendations and provides patient ideal minimum size of GVC funds, yet employ a different funding model for 200,000of people people they helped in 2008/09. by 56% - to over What’s the result? It’s simple. Chari�es can deliver 200,000200,000 people people in in 2008/09. 2008/09. What’s the result? It’s simple. Chari�es can deliver safety information. It received early- even funds at the £50m mark may still different types of fund, for example?” What’stheirWhat’s services thethe result? more It’s effec�vely, simple. Chari�es giving more can poordeliver stage funding from Midven’s Advantage be economically unviable. “It is all too That debate will likely continue for theirtheir services services more more effec�vely, effec�vely, giving giving more more poor poor Growth Fund in 2003, which includes often the case in the UK that there some time to come, but it’s interesting their services more effec�vely, giving more poor £29.39m people access to educa�on, skills and jobs. the European Investment Fund, is one overworked and modestly to see the lengths to which some £29.39m peoplepeople access access to to educa�on, educa�on, skills skills and and jobs. jobs. £29.39m£29.39m people access to educa�on, skills and jobs. the UK’s Department for Business paid manager looking after government-backed schemes are now Innovation and Skills, HSBC and the entire fund, which going to ensure they adopt the most Barclays Bank among its investors. It compounds the fund’s suitable approach. And they should FindFind out out more more about about making making Impetus Impetus part part of ofyour your giving giving was sold to United Health UK last year. find some comfort in the concluding FindstrategyFind outout thismoremore year, about and making about ourImpetus new Givingpart of Club.your giving “This was close to a home run for the remarks of the Brander et al report: strategy this year, and about our new Giving Club. £2.61m strategystrategy thisthis year, and about our new Giving Club. VC that invested in it,” says Earley. “But “We are cautiously optimistic about £2.61m£2.61m it has also delivered additional benefits the record and potential for moderate, £2.61m Impetus Trust, 20 Flaxman Terrace, London WC1H 9PN “Governments can make 03/04 08/09 ImpetusImpetus Trust, Trust, 20 20 Flaxman Flaxman Terrace, Terrace, London London WC1H WC1H 9PN 9PN to the wider economy as its service well-designed government support for 03/0403/04 08/09 ImpetusTel: +44 (0)Trust, 20 338420 Flaxman 3940; Email:Terrace, [email protected] London WC1H 9PN 03/04 08/09 saves the National Health Service decisions about technologies venture capital.” Tel:Tel: +44 +44 (0) (0) 20 20 3384 3384 3940; 3940; Email: Email: [email protected] [email protected] Impetus chari�es’ income growth Tel:www.impetus.org.uk +44 (0) 20 3384 3940; Email: [email protected] millions of pounds every year.” ImpetusImpetus chari�es’ chari�es’ incomeincome growth www.impetus.org.ukwww.impetus.org.uk that may have disruptive Impetus chari�es’ income growth www.impetus.org.uk A question of scale value when they don’t need 1. 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Find out more about making Impetus part of your giving FindFindFind outout out moremore more about about making making Impetus Impetus part part of ofyour your giving giving strategystrategy this this year, year, and and about about our our new new Giving Giving Club. Club. £2.61m strategystrategy thisthis year, and about our new Giving Club. £2.61m £2.61m£2.61m Impetus Trust, 20 Flaxman Terrace, London WC1H 9PN 03/04 08/09 ImpetusImpetus Trust, Trust, 20 20 Flaxman Flaxman Terrace, Terrace, London London WC1H WC1H 9PN 9PN 03/0403/04 08/09 ImpetusTel: +44 (0)Trust, 20 338420 Flaxman 3940; Email:Terrace, [email protected] London WC1H 9PN 03/04 08/09 Tel:Tel: +44 +44 (0) (0) 20 20 3384 3384 3940; 3940; Email: Email: [email protected] [email protected] Impetus chari�es’ income growth Tel:www.impetus.org.uk +44 (0) 20 3384 3940; Email: [email protected] ImpetusImpetus chari�es’ chari�es’ incomeincome growth www.impetus.org.ukwww.impetus.org.uk Impetus chari�es’ income growth www.impetus.org.uk

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Impetus ad resized.indd 1 19/5/10 12:15:03 Roundtable

Introduction by Chris Higson, London Business School

ow successful is private equity was remarkably enduring. So to be confident, in creating value, and how are we need the data to measure it, and to be sure returns shared between GPs and the result is generalisable and not just specific LPs? Economics faces a tough to a particular sample. It also needs to be challenge answering questions intellectually plausible. Applying this to private likeH this with confidence. Take another equity returns is therefore a challenge. question: it is now generally accepted that There is no active market for private equity corporate acquirers tend to destroy value for assets, with market prices. We have to wait a their shareholders. How do we know it’s true? decade or more for the underlying investments Researchers tested and retested the result to complete and pay out. Since the private for decades to be sure it wasn’t sample-related equity industry is relatively young, we do not or transitory. The result turned out to be have many vintages of those completed funds. sensitive to the merger cycle, but otherwise it Research is still dominated by the performance The point of no return? Does private equity provide the outperformance necessary to compensate institutional investors for the illiquidity inherent in the asset class? Academic studies are far from agreed on the subject. We talked to the authors of three studies, two LPs and a GP to gather their views. Chaired by Samuel Barton.

Roundtable participants

Antoinette Schoar Ludovic Phalippou Matthew MIT SLOAN SCHOOL OF UNIVERSITY OF AMSTERDAM Richardson MANAGEMENT STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

Schoar is professor of Phalippou is an associate Richardson is a professor of entrepreneurial finance at professor of finance at the finance at the Leonard N Stern MIT Sloan School of University of Amsterdam and a School of Business at New York Management. She received research fellow of the University, and a research the Fellowship of the George Tinbergen Institute. He holds associate of the National Stigler Center, 1997-99, and degrees from INSEAD (PhD in Bureau of Economic Research. the ERP Doctoral Scholarship finance), the University of He has also held the title of of the German Ministry of Southern California (Masters assistant professor of finance Trade, 1995-97. in both mathematical finance at The Wharton School of and economics), and Toulouse Business at the University University (BSc in economics). of Pennsylvania.

12 Private Equity Findings

“Private equity has such long-term is more comprehensive but mixes positions that one has to go a long way cash flow and accounting (NAV) data, requiring some assumptions to be back to get a full, consistent picture of made in the value of unrealised assets. So research into private equity comparable performance” returns is work in progress. Thus far, the evidence describes an economy LOUIS ELSON, MANAGING PARTNER, PALAMON CAPITAL PARTNERS in which buy-out investment creates value about where GPs scoop the pot and LPs get, at best, the market return. of funds initiated in the 1980s and and is unlikely to be repeated. But This result is economically plausible. 1990s. But that was early in the life of it demonstrates how difficult it is to It is consistent with a world in which the buy-out industry and the period generalise about the future from the financial intermediaries capture the was, in investment terms, benign. past without a lot of history to look at. economic rents. Mutual funds and We have learned that private equity We need to measure private equity hedge funds display a similar result. performance is strongly countercyclical returns using complete, timed data to the credit and equity cycles. In on cash flows between funds and Why do the results of research macroeconomic terms, the 1990s partners. Data availability is now much papers into private equity and early 2000s constituted the most better, but for a good part of private returns vary so much? The point of no return? stable period on record. Then came equity’s short life it was not fully in Schoar: “Firms are very private the global downturn. Let’s assume the the public domain. Ljungqvist and about their performance or implications for private equity returns Richardson got timed cash flow data, investments and there are no will be grim reading. Will it be fair to but they got it privately from a single standardised reporting regulations, include the crash in the narrative about LP. This raises the problem of selection so funds tend to have different ways private equity returns? Sceptics will bias, because one thing we have of measuring performance.” argue that it is part of private equity’s learned is that there are significant Elson: “The lack of a complete set of story, and that the financial collapse differences in performance and ability information provided by various parties was an accident waiting to happen. between LPs. Kaplan and Schoar, and can be a cause; also a data source Others will argue that it was a meteor Phalippou and his colleagues, used picked by one academic may be strike that no one could have predicted the Venture Economics database. This different from a pool of data chosen by

Robert Wadsworth Robert Coke Louis Elson HARBOURVEST PARTNERS THE WELLCOME PALAMON CAPITAL TRUST PARTNERS

Wadsworth is a managing Coke is a senior investment Elson co-founded Palamon director at HarbourVest. He officer, with responsibility for Capital Partners in 1999 and is joined the firm in 1986, with European and emerging managing partner and head of prior experience including markets buy-out investment, the operating committee. management consulting with at the Wellcome Trust. He Elson is also a member of the Booz, Allen & Hamilton. He is joined in 1999, having begun mid-market committee of the a graduate of systems his career in emerging market British Venture Capital engineering and computer fund management. He Association and is a member science and has an MBA from previously spent eight months of the BVCA’s Research Harvard Business School. training to be a priest. Advisory Board.

13 Roundtable

another. And private equity has such long-term positions that one has to go “The median is broadly in line with the a long way back to get a full, consistent public markets, but then you have to picture of comparable performance.” Phalippou: “I don’t see there is a take into account the added risk brought huge difference. If you’re positive in your assumptions, you find that about by illiquidity and leverage” private equity matches S&P 500 returns, as with Kaplan and Schoar. If ROBERT COKE, SENIOR INVESTMENT OFFICER, THE WELLCOME TRUST you are a bit less optimistic then it is around 3% below the stock market, as with my paper.” is the treatment of legacy assets from poor performers do much worse.” closed funds. The NAVs remained Phalippou: “There is a consensus on The Richardson paper shows unchanged for several years and there persistence. But in private equity, you private equity performing at were no cash flow activities for years, must be careful with the concept of a significant premium to the so they are unlikely to reflect the fair persistence, because funds overlap. public markets, which is not market value, therefore we exclude For example, a venture capital firm backed up in the other two them from fund performance. Kaplan had a 1989 fund which returned a papers. Why is this? and Schoar decided to treat these 200% IRR. Its next fund, in 1994, also Richardson: “Our data comes from NAVs as fair market value.” returned 200%. However, its 1999 the cash flows of a single LP, whereas Schoar: “Phalippou’s method is a vehicle returned -8%. When investors the other papers use self-reported conservative way of looking at returns had to decide on committing to fund data, so you may find that the best- but it is a good method. However, two in 1994, the performance of and worst-performing funds don’t there are some investments that have fund one was probably not yet clear, participate. Our paper also does not horizons of longer than three years whereas when they had to decide cover venture capital funds.” so one shouldn’t completely write about fund three, they had seen fund Phalippou: “Data taken directly from them off. In our research, we based one bank 200%. So how much of a an investor’s track record is good performance only on realised returns.” guide is past performance?” because the amount and timing of Elson: “If one excludes the unrealised the cash flows are precise. But it’s deals, the performance results will only What is the practitioners’ one investor who has been in private tell part of the story. The performance own experience? equity for 30 years, so it may not of many funds will remain unchanged Wadsworth: “We think outperformance be representative.” for several years, and then one or two of the stock market in the 500-600 Schoar: “This paper uses data from legacy investments reach an exit and basis points range is realistic. But we a top-quality LP, which was an early the figures jump.” endeavour to generate a return of well entrant into the industry, and therefore in excess of the mean for the industry. has been able to access good funds. One similarity within the Past performance tends to be an The sample also takes into account the papers is that GPs tend to indicator, but is not 100% correlated. boom years of the 1990s.” maintain their performance. Are For example, if some of the key Richardson: “Our LP was investing in the academics agreed on this? decision-makers who generated the private equity primarily for relationship- Richardson: “There is a consensus previous returns have left, there may be building. There was no selection bias on experience. First-time funds tend little correlation. There could be other towards the better-performing funds – to perform relatively poorly, and on issues, such as personal motivation of the only bias was a slight skew towards average performance improves with managers or strategy – an investment larger funds.” each subsequent fund.” strategy that worked a decade ago may Schoar: “There are three important now be inappropriate.” The Schoar and Phalippou points. First, there is a huge Coke: “Performance is dependent on papers are far closer in their heterogeneity in performance of picking the right GP. If you look at the conclusions, but still differ individual GPs. Second, there spread between the top quartile and despite using similar data. Does is a high level of persistence in the median or lower quartile, it’s all in this show that the analytical returns. And third, the industry is the manager selection.” process is highly subjective? highly cyclical – a rising tide lifts all Elson: “One of the leading indicators of Phalippou: “The primary difference boats, but in a down cycle, future performance is how well the firm 14 Private Equity Findings

did in its previous fund because it’s Given the recent economic crisis, The research indicative of the discipline of the firm, how much of a guide are historic its stability and its ability to execute to studies to future performance? In Private Equity Performance: Returns, Persistence and an investment plan. However, I have Schoar: “The general insights are still Capital Flows, Steve Kaplan and Antoinette Schoar found that also seen the super top performers useful: the heterogeneity in returns average fund returns net of fees were roughly equal to those in one fund showing up quite low in across GPs and the persistence within seen on the S&P 500. the successor fund, because the risk GPs. In bad times, the heterogeneity in The study was based on data provided by Venture they took to get that top performance funds is even wider.” Economics, which is obtained through voluntary disclosure by worked against them the next time.” Elson: “I don’t think they can be a GPs and LPs, and covers a sample period from 1980 to 2001. sure guide for the current vintages yet Venture Economics measured the internal rate of return, the This surely has serious because you have the problem that cumulative total value to paid-in capital and the distributed implications for LPs – you must private equity has such a long tail.” total value to paid-in capital, as well as collecting the select GPs wisely to deliver Coke: “It is a little bit of a guide, but quarterly cash flows in and out of each fund for its life. outperformance? not enough to be useful. The market The study also found that there was a large degree Phalippou: “You need knowledgeable has changed so much, and all these of heterogeneity among fund returns and a high level of practitioners, because you need to studies are using data built up when persistence across funds raised by individual private equity invest in top quartile funds. There is credit was cheap.” partnerships – those that performed well in one fund tended also a problem with timing. The top to do so again in their next. In addition, fund performance quartile funds are mostly from the Will a consensus on past increased with the experience levels of the general partners. same years, so you can’t just allocate a performance ever be reached? In The Performance of Private Equity Funds, Ludovic certain amount to the asset class each Richardson: “The data gets Phalippou and Oliver Gottschalg found that average net of year. Cycles in private equity are very better through time, and improved fees fund performance in private equity was 3% below that of pronounced, but investors very naively methodologies and analysis continue the S&P 500, with an adjustment for risk bringing this down follow past returns.” to emerge. However, I do not see a to 6% below. Schoar: “After bad years returns are consensus soon, as to achieve this The study was also based on data provided by Venture much better, partly because firms every private equity firm needs to Economics, containing the amount and time of all cash flows that are able to fundraise in bad years reveal its cash flows.” to and from limited partners, as well as quarterly NAVs, from are the top-performing investors. Elson: “The variations in the findings 1980 to 2003. However, Phalippou and Gottschalg’s data was However, if you’re saying that timing of research will iterate to a smaller and global, whereas Kaplan and Schoar’s was US-related only, is more important than choice of smaller difference. Will they become and Phalippou and Gottschalg chose to write off the residual fund, then I wouldn’t agree. Unless definitive? No. However, if you can NAVs of investments in closed funds where no change had as an LP you have enough scope narrow the output results, people been made to their carrying value for three years or more. and scale to invest in developing the will trust them more and use them Kaplan and Schoar accept the GPs’ valuation as a fair market human capital in-house, it’s better more, and that is crucial to LPs value. This study also finds a strong degree of heterogeneity not to invest in private equity.” for benchmarking.” among fund returns and a high level of persistence in the performance of individual GPs. If access to the best-performing Finally, do the panellists believe In The Cash Flow, Return and Risk Characteristics of managers is restricted, is a private equity can outperform Private Equity, Alexander Ljungqvist and Matthew Richardson new LP destined to deliver the market? found that private equity generates excess net returns of 5% poor performance? Elson: “Yes, most definitely on a gross to 8% over the S&P 500. Wadsworth: “By definition when you basis. The question is whether it can on This study was based on data from a single US-based start out you won’t be diversified – a net basis. What is tricky for LPs is that limited partner’s private equity investments during the when you make your first investments, they may achieve a certain return level period 1981 to 2001. The research claims to have been the you will have only one or two GPs. Our on the underlying investment portfolio, first conducted into private equity returns using actual cash view is that you have to be diversified but then they have to pay an unsuitable flows of buy-out funds. Ljungqvist and Richardson’s paper and you have to be perpetual.” amount of it back in the fee structure.” found that funds performed less well if more capital was Elson: “Getting it right doesn’t happen Coke: “The median is broadly in raised in the wider market during their vintage years, as well overnight and building a strong- line with the public markets, but as that first-time funds performed better than subsequent performing portfolio has to be done then you have to take into account funds. It also suggests that the timing of actual cash flows is from the ground up. Unfortunately, the added risk brought about by important in understanding fund performance, and that the many new LPs get burnt and pull out illiquidity and leverage. An index of excess returns identified may be considered a compensation too soon. As for today, access to the private equity is never going to be an for the extreme illiquidity of the asset class. top-performing managers is easier.” attractive place to invest.” 15 Perpetual motion.

MVision Private Equity Advisers is widely recognized as the world’s leading independent international alternative assets placement and advisory firm, focusing on private equity, real estate, real assets, credit and direct transactions, in both the developed and emerging markets.

www.mvision.com Private Equity Findings

Private equity’s record on employment in portfolio companies has been the subject of fierce debate between the industry’s critics and proponents. But what’s the real story? We look at two research papers with very different results. By Vicky Meek. Angels r demons?

hen Hugo Boss economy. Given these types of took the decision criticism, there is a clear need for to close its independent assessment of private Brooklyn, Ohio- equity’s employment record. based factory on “Independent research is very theW grounds that it was “no longer important,” says Wim Borgdorff, globally competitive”, its owners, managing partner of AlpInvest Permira, will have known that it was Partners, which manages more than going to spark controversy. Despite €40bn of private equity investments. talks with unions and discussions “It’s difficult to get a true, independent with the local governor, the company story from association-led research – was unable to make the numbers rightly or wrongly, people heavily work, making the factory’s 375 discount the information coming out of employees redundant. these organisations. If you really want Yet Permira is unlikely to have to influence society, the media and expected what came next: a letter politicians, you need independent from one of its limited partners, the studies conducted by people from Ohio Public Employees Retirement great universities.” System (OPERS), urging the firm to So an academic study that reconsider because the closure of the examines private equity’s effect on factory may have a “deleterious long- employment should be of great term impact on the city of Brooklyn as interest to the industry itself as well as well as an already depressed region of broader stakeholders. It was the state of Ohio”. The letter added completed by Steven J Davis of the that the OPERS board had concerns University of Chicago, together with about “future involvement” with John Haltiwanger of the University of Permira on the grounds of Maryland, Josh Lerner of Harvard underperformance of Permira IV and University and Ron Jarmin and Javier claimed that Hugo Boss management Miranda, both of the US Census had not bargained in good faith with Bureau. “There has been huge state and local community partners controversy over whether private over the closure. equity, principally buy-outs, destroys For critics of private equity, this kind jobs,” explains Davis. “I entered this iStock of story adds fuel to their argument project from a genuine position of that the industry destroys jobs and has curiosity to find out whether these

Illustration: a wholly negative impact on the claims were true. Over my career, I’ve 17 Beyond the abstract

conducted research that makes use of security by building more large-scale datasets on business sustainable businesses.” outcomes and so was in a good Yet not everyone is agreed that the position to determine the real story.” study’s findings are so positive for The result, Private Equity and private equity. A report put together by Employment (for detailed findings, see David Hall for the Public Services box on p19), finds that employment International Research Unit at the falls 2.7% at buy-out targets relative to University of Greenwich, which looks control companies in the first two into the Davis et al research points, years after buy-out transactions. Yet, takes issue with the concept of perhaps unsurprisingly, the research “creative destruction”. It suggests that demonstrates that the interplay private equity’s impact on companies is between buy-out houses and their of creating greater job insecurity. “In portfolio companies is rather more two years following a private equity complex. “One of the most surprising takeover, 24% of employees will have things to come out of the study was experienced their workplace being the magnitude of private equity’s closed, sold or reduced – double the creative destruction effect,” says uncertainty compared with a firm which Davis. “We found a big difference has not been the subject of a private between targets and controls in both “Private equity’s record equity takeover,” the report says. the nature of job creation and Janet Williamson, senior policy destruction and the scale of it.” of contribution to society officer at the Trades Union Congress, The findings present a picture of agrees. “Putting private equity’s private equity acting as dynamic overall is not bad at all. impact down to creative destruction is owners of businesses, taking them misleading,” she says. “Greenfield job away from less profitable areas and It just needs to ensure creation [the creation of jobs in new removing inefficiencies, while areas of business] doesn’t directing them towards higher-value that better and more compensate for the job destruction. segments. They confirm that the role Whichever way you look at it, private of private equity is often to reposition independent information is equity destroys jobs on a net basis.” companies. In the wake of a buy-out, The use of leverage is one of the targets shed jobs in parts of the available to support its case” main reasons for this, she says. “The original business only to create them funding model means that buy-out WIM BORGDORFF, ALPINVEST PARTNERS in new areas through organic growth, houses borrow heavily to finance deals acquisitions and disposals. and so it means that they and the “We found that private equity acts can’t because of conflicting demands management have a very different way as a catalyst for creative destruction,” from various constituents,” she says. of looking at the company,” says says Davis. “It’s a bit like capitalism on “Buy-out firms take companies and Williamson. “The urgency of having to steroids. Our evidence is broadly act to make sure they are fit for repay the debt encourages a slash- consistent with the view that private survival in a global economy. Some of and-burn mentality. The owners equity redirects resources from less the actions they take may not be see companies as a financial asset productive to more productive uses, popular, such as moving low-skill jobs rather than an organic, working which is good for the economy as a that shouldn’t be based in, for entity that has employees, customers whole. There are, of course, losers in example, Western Europe to lower- and suppliers.” the process, but if you want market cost locations. However, at the same However, for the industry itself, the forces to improve living standards by time, they create new, more highly issue of whether private equity creates encouraging efficient resource paid and highly skilled jobs.” employment or not is something of a allocation, then private equity is a She adds: “While this can be a red herring. No buy-out firms positive force on net.” painful transition, overall, it often contacted for this piece were prepared It’s a view shared by Katharina helps to put companies on a growth to comment publicly on the issue, Lichtner, managing director at Capital path. This not only allows companies which speaks volumes about the Lyndon Hayes Lyndon Dynamics. “Private equity quite often to create more jobs in areas such as political nature of this debate. But it is cleans out structural problems that R&D, sales and marketing, but also also indicative of firms’ views on the

Illustrations: politics should be dealing with but fosters long-term employment subject. As one executive said: “We’re 18 Private Equity Findings

not in the business of creating full Forum’s advisory board for its series of employment. Our job is to generate papers on the global economic impact Creative destruction at work? the best returns for our investors by of private equity, the first of which identifying the right companies and featured the Davis et al employment Private Equity and Employment, by Steven J Davis of the employing the right strategies for study. “They said they had never seen University of Chicago, John Haltiwanger of the University of them.” Another said: “It really an objective for private equity of Maryland, Josh Lerner of Harvard University and Ron Jarmin depends on the industry you are creating jobs – employment is just a and Javier Miranda, both of the US Census Bureau, set investing in and the nature of the derivative outcome of what private out to determine whether buy-outs (the target companies) business. In some cases, you would equity does. Exploring productivity in created or destroyed jobs relative to similar companies have a great job-creation story; in addition to employment is a more with no private equity ties that were similar in terms others, the strategy has to be to strip meaningful study of the impact private of size, industry and age (the control companies). They away layers of inefficiency. It’s equity has,” Borgdorff continues. analysed US transactions completed between 1980 and impossible to generalise.” The authors’ research on 2005, following 4,500 companies and more than 200,000 Indeed, as the Davis research productivity is still a work in progress, “establishments” (individual factories, retail outlets, suggests, employment is only one but early results suggest that private offices and other units where business takes place). aspect of the overall picture. It’s one of equity involvement increases An important part of the research was to track the reasons why Davis et al are now productivity growth rates. In the first employment at the company level and the establishments looking more closely at the issue of two years after a buy-out, productivity it operates both before and after the transaction to productivity. “When the employment grows by about 9% at target determine precisely what happens to jobs after the paper came out, many people made manufacturing companies as buy-out. The authors also looked at “greenfield” job comments about whether this was the compared with 7% at control creation, ie, the extent to which private equity creates right question to ask,” says Borgdorff, companies (those of a similar size, employment in new establishments. who is on the World Economic industry and age to the buy-out The study found that: targets), the research finds. Target l Employment growth at private equity-backed companies are much more likely companies was lower than controls in the two years to shut down factories with low before the buy-out deal. productivity, compared with l Employment outcomes differ greatly across other companies. While the industries in the wake of buy-out transactions. In the manufacturing sector, private equity-backed companies and controls have similar employment growth rates post buy-out. In the retail sector, private equity-backed companies shed jobs more rapidly than controls. l On average, and focusing on establishments in operation at the time of the buy-out transaction, employment shrinks more rapidly in buy-out-backed companies than at controls in the first two years after the deal – the employment growth difference is 4.6% in favour of controls. l However, buy-out-backed companies create more new jobs in new establishments than controls. Accounting for this additional new job creation at buy-out companies, the employment growth difference shrinks to 2.7% in favour of controls. “Private equity quite often cleans l Private equity-backed companies also engage in more acquisitions and disposals than controls, with the out structural problems that acquisition rate for the former at 6.8% and 4.7% for the latter. The disposal rate for targets is 5.5% and politics should be dealing with for controls 2.8%. (All figures are calculated on an employment-weighted basis.) but can’t because of conflicting l In short, the report says, “private equity groups act as catalysts for creative destruction”, accelerating both the demands from constituents” destruction of old jobs and the creation of new ones. KATHARINA LICHTNER, CAPITAL DYNAMICS 19 Beyond the abstract

The French example

While the US employment study, in the words of Wim Borgdorff, managing partner at AlpInvest Partners, “shows a more universal truth about the effect of buy-outs” because of the maturity of the market, it is still instructive to take a look at other countries to assess private equity’s effect on employment. Job Creating LBOs, by Quentin Boucly, David Thesmar, both of HEC Paris, and David Sraer of Princeton University, looked at the French market. Taking 830 deals completed in France between 1994 and 2004, the study compares them both before and after the deal with a control group. It found that, between the three years before the transaction and the four years following it, employment, assets and sales growth were 13%, 11% and 13% higher, “There are, of course, losers in the respectively, than at control companies. In order to counter the potential criticism process, but if you want market that the French market’s protective labour laws skewed the results, the authors examined forces to improve living standards targets in industries in which labour is more protected and found that these companies did by encouraging efficient resource not grow any faster. “The results surprised us,” says Thesmar. allocation, then private equity is a “They were in contradiction to previous studies on France, which looked at the 1980s wave of positive force on net” LBOs in France, but they were also very different STEVEN J DAVIS, UNIVERSITY OF CHICAGO from other studies done in the UK and the US. We were also surprised by how robust they were. study was unable to include 2008 was something in there for everyone,” “The second wave of LBOs in France from data, it examined deals done in the says Davis. “The critics honed in on the the late 1990s appears to have been less 1980 to 2005 time period against finding that net employment shrinks, geared towards cost-cutting.” says Thesmar. variations in the credit market. It finds while the private equity groups “The new model is clearly slanted towards that the productivity growth trumpeted the acceleration of new job creating long-term value through growing differential between buy-out-backed creation in the wake of a deal.” businesses either through build-up acquisitions companies and the controls is greater However, what is apparent is that, or internal growth.” in periods with an unusually high in general, private equity should have The authors also put forward the view that interest rate spread between AAA- a good story to tell. “Look at the whole private equity acts as a substitute for weak rated and BB-rated corporate bonds. picture of responsible investing,” says capital markets in France, providing expansion “The evidence is at least suggestive Borgdorff. “You find that 95% of capital to companies that would not otherwise that private equity targets are better practitioners believe that they are get funding. This would explain the strong than controls in making the difficult acting responsibly and are not there growth story in terms of employment, assets choices needed to restructure to rob a company, strip out its value and sales. businesses in times of financial and fire the employees. They are “Private equity in France appears to operate crisis,” the research says. there to create value. Yet 95% of the like a banking system, targeting small and Clearly, the picture that emerges of wider world perceives private equity to medium-sized companies with the potential for private equity’s impact on the economy be a negative force. I believe private expansion,” says Thesmar. “The results may is rather more complex than either the equity’s record of contribution to be very different in another market, such as critics or the proponents of the industry society overall is not bad at all. It just Germany, which has tight labour laws, but also tend to portray. This is reflected in the needs to ensure that better and more has efficient capital markets.” fact that the reaction to the Davis et al independent information is available employment study was varied. “There to support its case.” 20 “HOW DO YOU TURN AROUND A BUSINESS? PRIVATE EQUITY TAKEOVER, OR MANAGERIAL ?” Professor Eli Talmor Chairman, Coller Institute of Private Equity, London Business School

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2010 Private Equity Findings Symposium Sir Michael Rake, chairman, The Coller Institute’s third Annual Symposium focused on Guidelines Monitoring Group and BT the importance of alignment of interests in private equity

he Coller Institute held its not linked to performance. Lerner third Annual Private Equity concluded by calling for the industry and Findings Symposium on LPs to “take a step back and think about 12 and 13 May, which where business is going” and suggested delved into the topic of The that the future of the industry was likely TPrivate Equity Contract: Evolution or to see a combination of: a cyclical Revolution through a series of keynote recovery in which returns improve and speeches and panel discussions. LPs start committing once more to The Symposium examined the nature private equity and venture capital; and of the contracts within private equity and an exit by many newer LPs and by those whether the alignment, so often heralded with too much or too little committed to Daniela Barone Soares, chief executive, Impetus Trust as the driver of this superior form of the asset class. governance, remains intact. The theme of alignment of interest was Josh Lerner of Harvard University was examined further in a panel chaired by Eli The contract between GPs and the first keynote speaker and explored the Talmor of London Business School on the portfolio companies was discussed in a private equity landscape and prospects in contract between LPs and GPs. While panel session chaired by Francesca the wake of the global financial crisis. He panellists discussed alignment of interest Cornelli of London Business School. pointed to a study that suggested that fees between LPs and GPs, and the need for Panellists explored the issue of what can had “driven a wedge between net and GPs to rebuild relationships that may have be done to reincentivise management gross returns”. The 2009 research, suffered over the past few years, they also teams when their equity is underwater conducted by Andrew Metrick of Yale pointed to the potential for conflicts of and questioned whether, despite the University and Ayako Yasuda of UC Davis, interest among LPs in the same fund: support of their backers, more portfolio found that two-thirds of expected some need liquidity and are pushing for companies face trouble ahead. “We revenues in buy-outs and venture capital exit, while others prefer to wait to ensure have to ask if we are running out of funds come from fees and are therefore maximum return. safeguards,” said one panellist. “You can only have so many equity cures and A unique forum for debate – new Coller Institute website these have seen us through the last 18 months. But what happens next?” The Coller Institute of Private Equity is in a unique The new website features substantially improved Sir Michael Rake, in his keynote position to be a leading debating forum in the functionality over our old website. Some of these speech, explored the contract between field of private equity. Its London location places enhanced features are: private equity and broader society as it squarely in the centre of the world’s financial l research library and search – this includes pure he outlined the progress made by the markets and it benefits immeasurably from its home academic research, applied research and case industry in reporting to stakeholders on within London Business School, a world-leading studies from London Business School Faculty and its financial, social and environmental business school with best-in-class research and students and research from other institutions; performance. He emphasised that in teaching credentials. The Coller Institute endeavours l blog – featuring commentary by leading his role as chairman of the UK’s to connect the academic rigour and horsepower authorities in the field of private equity; Guidelines Monitoring Group, which

Richard Chambury of the School to the external community via its l news feed – the website will feature up-to-date oversees private equity’s compliance outreach activities – this publication, events and its news releases to keep users informed of the with the Walker recommendations, he new website. ever-evolving world of private equity. had seen highly positive progress in the

Photography: industry’s ability to communicate its 22 Private Equity Findings

UPCOMING EVENTS Upcoming events for the next academic year include the Annual MVision Roundtable, book launches and other events to showcase private equity research and to examine the key issues affecting the industry. The next Annual Coller Prize in Private Equity will take place in November, this time featuring a new category, which is open to PhD students around the world. This year’s event will see an exciting competition for the prize for the best student project in private equity with many Sir Andrew top-quality projects currently in the pipeline. Likierman, The due date for submissions is 31 July. Dean, London Business School PAST EVENTS ● ANNUAL MVISION ROUNDTABLE DATE: 25 NOVEMBER 2009 Don Sull, This academic year’s event featured a panel London Business School comprising Michael Phillips, Apax Partners, Juan Delgado-Moreira, Hamilton Lane and Michael Jacobides, London Business School. Moderated by Francesca Cornelli of the Coller Institute of Private Equity, the panel debated the key dynamics which will Conor Kehoe, head of European private influence the future of private equity firms. equity practice, McKinsey & Co. ● ROUNDTABLE: BRIDGING THE SME EARLY-STAGE FINANCE GAP of firms that have had either the agility DATE: 24 FEBRUARY 2010 or absorption (or both) to successfully A panel featuring Rory Earley, Capital for Enterprise, navigate the recent tumultuous times. Will Dawson, Amadeus Capital Partners, Pär-Jörgen Josh Lerner, Day two of the event saw the Harvard University Pärson, Northzone Ventures and Gilles Duruflé, presentation of the following academic president, Public Policy Forum on Venture Capital studies: The Organisation of Venture and moderated by Eli Talmor of the Coller Institute of role in the economy and its effect on Capital Firms, presented by Amitay Private Equity, assembled to discuss funding for the companies it backs. Alter, Washington University at early-stage SMEs and the role government is playing This relationship was examined St Louis; Monitoring Managers, Does it in addressing the finance gap. further in the third panel for the day, Matter?, by Francesca Cornelli; Risk chaired by Michael Hay of London and Expected Returns of Private Equity ● SPEAKER SERIES: GARY DUSHNITSKY Business School. The panel discussion Investments: Evidence Based on DATE: 10 JUNE 2010 delved into the balance and trade-off Market Prices, presented by Joshua Gary Dushnitsky has recently joined London Business between financial and social returns Pollet, Emory University; Diseconomies School as an associate professor of strategic and and the growing importance of the of Scale in Private Equity, by Ludovic international management and entrepreneurship. He consideration of non-financial issues in Phalippou, University of Amsterdam; spoke on corporate venture capital, an area that has the decision-making process. It became How and Why do Sovereign Wealth become a key component of the venture capital market. clear that the private equity model when Funds Tilt their Portfolios?, presented applied to the generation of social by Alexander Dyck, University of ● ROUNDTABLE DISCUSSION: REGULATION OF returns has proved to be successful. Toronto; Private Equity Industry PRIVATE EQUITY AND HEDGE FUNDS Don Sull of London Business School Performance and Cyclicality, presented DATE: 14 JUNE 2010 presented The Upside of Turbulence. by Per Strömberg, Stockholm School of The spectre of regulatory reform has placed the Demonstrating that turbulence is a Economics; and Incentives of Private industry in a position of uncertainty. This event constant not intermittent variable, Sull Equity General Partners from Future brought together a range of experts to discuss this highlighted how companies can seize Fundraising, by Berk Sensoy, Ohio highly topical area. the upside, citing a range of examples State University. 23 Coller Institute of Private Equity

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