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Private Equity Findings 2020 Foreword

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Private Equity Findings 2020 Foreword ISSUE 16 2020 £25 30 $35 PRI VATE DISTORTING MIRROR? The impact of subscription lines on fund performance DIMINISHING RETURNS Does a leap in fund size lead to worse performance? EQUITY LPA BLUES Do small LPs lose out in LPA negotiations? FINDINGS BIGGER SLICE, SMALLER PIE Insights from private equity research worldwide The venture capitalist’s share – how much is too much? UNFORESEEN CONSEQUENCES How private equity investments affect competitors, sector productivity, and public markets INCLUDING CONTRIBUTIONS FROM: BRIGHAM YOUNG UNIVERSITY LAW SCHOOL | CARNEGIE MELLON UNIVERSITY | GEORGE MASON UNIVERSITY TECHNICAL UNIVERSITY OF MUNICH | THE UNIVERSITY OF ARIZONA | UNIVERSITY OF ARKANSAS THE UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS | UNIVERSITY OF SOUTHERN CALIFORNIA MARSHALL SCHOOL OF BUSINESS CONTENTS 4 By the numbers 16 Unforeseen consequences Private equity growth outstrips public equity; Long-term funds on As private equity has grown in stature, so has its sphere of the rise; Europe has capacity to absorb a significant volume of influence. We speak to the authors of three academic studies private equity dry powder; Former private equity and venture capital looking at the indirect impact of private equity investments – investments make up nearly half of Nasdaq-listed businesses. on competitors; on public markets; and on sector productivity – and discuss their findings with two seasoned fund managers. Diminishing returns “If PE is successfully making productivity gains in its own 6 companies – and thereby encouraging productivity gains Private equity managers are raising ever-larger funds – in the broader market – regulators need to be very careful but at what cost to their returns? We examine recent research indeed about taking any steps that could hamper that.” that considers the relationship between fund size growth and Steven J. Davis, The University of Chicago Booth School of Business performance. The results may surprise some investors. “I hear about this problem – the relationship between fund size growth and performance – endlessly. It’s a favourite LPA blues theme of PE consultants and casual industry observers 24 because it’s readily measurable and intuitively explicable. How much influence do large investors have over fund terms in But that doesn’t make it determinative.” private equity? And can they be relied on to negotiate beneficial terms for all investors – or only for themselves? We examine Steve Moseley, Alaska Permanent Fund Corporation these issues with the author of a recent academic paper and a veteran private funds lawyer. 10 Distorting mirror? 28 Bigger slice, smaller pie Private equity firms are increasingly using subscription lines of What is the optimal split of equity between company founders credit – but is the practice distorting the picture for investors? and venture capital investors? How do different equity splits With the help of two new research papers, we consider the affect the eventual outcomes for portfolio companies? effects this form of debt has on fund performance measures. We catch up with the author of new research that looks at how the terms of VC investment contracts impact the ultimate value of start-ups. We also ask whether entrepreneurs should trade investor quality for less favourable terms. “A critical view is that VC firms – who understand contracts much better than typical entrepreneurs and have considerable bargaining power – may grab a larger slice of the pie, even if that shrinks the entire pie in the process.” Arthur Korteweg, University of Southern California Marshall School of Business 2 PRIVATE EQUITY FINDINGS 2020 FOREWORD look at the effect of SLCs on IRRs, on other performance measures, and on fund rankings. It asks whether SLCs are simply a useful tool for GPs and LPs, or whether they are being used to massage returns data. Negotiation is an essential skill for anyone making or taking PE and venture Professor Josh Lerner Jeremy Coller capital investment. Our final two articles Head of Entrepreneurship Department, Chief Investment Officer, explore how differences in the balance Harvard Business School Coller Capital of power at the negotiating table can affect the ultimate outcomes for PE stakeholders. he years since the financial As PE has grown, so inevitably have crisis have seen private equity fund sizes, with some managers taking In LPA blues, we showcase a theoretical grow significantly, both as an advantage of strong limited partner paper that asks whether large LPs can T asset class and as a source of appetite for the asset class to raise be relied on to use their bargaining funding for businesses. As a result, its ever larger vehicles. Should this be a power for the benefit of all investors in influence now spreads far and wide. In cause for alarm? After all, there is a a fund. We discuss the issue both with this issue, we take a look at the impact commonly held belief among many LPs the author of the paper and with a the industry has outside the companies that large step-ups in fund size lead private funds lawyer steeped in years it backs. In Unforeseen consequences, to lower returns. Using the findings of nitty-gritty negotiations. we draw together the findings of three of new research, Diminishing returns new academic studies that examine PE’s delves into whether there is a causal Bigger slice, smaller pie features an wider effects: on public companies; on relationship between fund size growth interview with one of the authors of a competitors to PE-backed businesses; and performance. The results are more new study that quantifies the optimal and on industry sectors more broadly. nuanced than suggested by a simple split of equity between VCs and business rule of thumb. founders. The article examines the Talking to the authors of this research extent to which the outcomes of contract and to experienced fund managers, We also focus in this issue on another negotiations can predict or determine we explore PE’s wider contribution to aspect of PE that has seen rapid growth the fortunes of a VC investment. the business, economic, and social in recent times – the use of subscription environment. The article also asks lines of credit (SLCs). While these loans We hope you enjoy this latest issue of whether higher levels of regulation and are ostensibly deployed to reduce the Private Equity Findings, which we believe oversight – something currently being number of capital calls from LPs and throws an academic spotlight on some of proposed by policymakers with negative to enable GPs to transact quickly in the most interesting issues currently being perceptions of the industry – might have a competitive market for deals, their encountered by industry practitioners. unintended consequences beyond the increased use has not been without As ever, we would welcome your feedback PE industry. controversy. Distorting mirror? explores or questions, and these can be directed two pieces of academic research that to: [email protected]. COLLER RESEARCH INSTITUTE 3 PE TRENDS AND STATISTICS BY THE NUMBERS Private equity growth outstrips public equity • Global private equity has grown much • The report notes that the number • This, McKinsey says, shows that faster than public equity over the of US PE-backed companies rose PE has gone from alternative to past two decades: its net asset value from around 4,000 in 2006 to 8,000 mainstream, as investors now view the (NAV) has increased by 7.5 times in 2017, while that of publicly listed asset class as essential to achieving since 2002, more than twice as much companies fell 16% from 5,100 to exposure to pockets of growth. as the market capitalisation of the 4,300 over the same period (and by world’s listed companies, according to 46% from 1996). a report by McKinsey, Private markets come of age. Growth of global PE NAV vs public equities market cap (indexed to 2002) Private equity NAV 900 • However, this growth is concentrated in 800 the years following the global financial 700 crisis. Between 2002 and 2006, PE 600 NAV growth closely matched that of 500 public equities market capitalisation, 400 Public equities market capitalisation yet from 2007 onwards, public equities 300 have all but stagnated compared with 200 the value of assets held by PE, which 100 0 has grown significantly. 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Sources: McKinsey Global Private Markets Review 2019, data from Preqin, World Bank, Coller Capital Long-term funds on the rise • The trend for private equity firms • This is a significant increase on the Is your firm considering raising a long-hold fund to raise funds with a longer life – proportion registered in the previous (around 15+ years in duration)? 15 years or more – appears to year’s survey, in which just 32% said be accelerating. they were considering a longer-life fund. 23% 26% • As many as 26% of PE firm • The most popular rationale for doing respondents to the 2020 Global Private so, according to the survey, is that it Source: Dechert/ Equity Outlook survey by Dechert and expands the available pool of investment Mergermarket, 2020 Global Private Mergermarket say they have already targets (30% say this), followed by 27% Equity Outlook established a fund with a life of 15 or who say that it aligns their interests with 51% more years. In addition, a further 51% those of limited partners and 18% who say they are considering doing so. say that it enables them to increase We’ve already established one returns by holding on to profitable Yes – we’re considering it companies for longer. No – we’re not currently considering it 4 PRIVATE EQUITY FINDINGS 2020 Europe has capacity to absorb a significant volume of private equity dry powder • The percentage of companies with Private equity is under-penetrated in most EU countries relative to the US in terms of companies owned revenues of between $500m and $5bn that are owned by private equity is lower 9.7% across most European countries than it is 6.6% in the US, according to analysis by Bain European average: 4.2% 4.4% 4.3% & Co.
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