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. This suggests that there is greater 3.7% 3.3% 2.9% 2.6% potential for strong deal flow for larger buyout funds in many European markets than in the US. Revenue between $500m - $5bn in either 2014/2015 and 2017/2018. *Excluding Iceland. Sources: Bain & Co., CVC, Orbis
• In the US, 6.6% of companies in this size 3.3%, 2.9% and 2.6%, respectively. • The Nordic countries – and Sweden bracket are owned by PE; in Europe, the This is despite significant growth in deal especially – are an exception. However, average is just 4.2%. PE ownership as a activity over recent years: deal value overall, the figures suggest that European percentage of companies is rather lower has grown annually by an average of markets have significant capacity to in Spain, the UK and Germany, at just 20% over the past five years. absorb PE’s increasing dry powder.
Former private equity and venture capital investments make up nearly half of NASDAQ-listed businesses 93% • Not only has private equity’s growth Former PE and VC companies on NASDAQ outstripped public markets, its The percentage of limited partners who contribution (venture capital included) Percentage of companies believe the difference in the quality of to building businesses that become general partners’ strategies and teams listed companies is significant. Nearly will lead to a significant divergence in half (44.8%) of current NASDAQ- private equity returns across managers listed companies were formerly in the next economic downturn, 44.8% backed by PE or VC, according to according to Coller Capital’s latest 55.2% PitchBook analysis in Private Markets: Global Private Equity Barometer. A Decade of Growth.
• In addition, these companies make up almost two-thirds (61.6%) of Percentage of market capitalisation 7% NASDAQ’s market capitalisation and include names such as Facebook, The remaining 7% of LPs are more Alphabet, Netflix, Kraft Heinz and sanguine, taking the view that the lululemon athletica. 38.4% industry has changed sufficiently since the financial crisis to avoid a major 61.6% • PitchBook adds that there were more divergence in returns. than 2,000 PE- and VC-backed initial public offerings in the US and Europe Taken together, the results suggest Source: between 2009 and 2019, and these PitchBoook, that LPs believe that GP quality and exits were valued at a total of $1.4trn Previously PE- or VC-backed Private Markets: selection still matter considerably in A Decade of on a pre-money valuation basis. Not previously PE- or VC-backed Growth the asset class.
COLLER RESEARCH INSTITUTE 5 ANALYSIS
6 PRIVATE EQUITY FINDINGS 2020 returns, and 5% of the variation in the case of VC funds – with the remainder DIMINISHING due to idiosyncratic shocks or chance. Rossi confirms these results. When he uses a simulation to account for RETURNS reversion to the mean in performance, or the tendency for fund returns to revert to the long-run average after a period of atypical outperformance, he finds that increased fund size is associated with a minimal decline in returns. The results show little evidence of a causal relationship between fund size and performance, leading him to say that any such claim is based on As private equity funds continue to grow in size, should “spurious evidence”. investors be concerned? We examine a new paper that A common misperception? asks whether raising a larger fund affects performance Given Rossi’s initial finding of declining – with some surprising results. By Vicky Meek. returns in larger successor funds, it’s easy to see why people might draw causal links between the two. “I hear lackstone’s recent $26bn In Decreasing Returns or Reversion to the about this problem – the relationship fundraising for its eighth buyout Mean? The Case of Private Equity Fund between fund size growth and fund illustrates a major trend in Growth, Rossi assesses the performance performance – endlessly,” says Steve private equity (PE): funds are, on of a series of funds raised by buyout and Moseley, head of alternative investments B at Alaska Permanent Fund Corporation. average, getting larger. The firm’s latest venture capital fund managers (with a offering is the biggest buyout fund ever 2011 vintage year cut-off to ensure “It’s a favourite theme of PE consultants raised and is significantly larger than its realised returns are measured). And his and casual industry observers because $18bn predecessor, which reached a initial findings appear to confirm the fears it’s readily measurable and intuitively final close in 2015. While not all fund of many LPs – when a firm raises a larger explicable.” But, he adds, “that doesn’t managers are seeking such significant follow-on fund, it tends to underperform make it determinative”. step-ups, the average size of funds raised the preceding ones. in 2018 grew to $363m – larger than the Indeed, to Rossi, a decline in returns $339m recorded in 2017 and the highest Yet Rossi wanted to see whether the after a previous fund has performed level since 2007. growth in fund size actually causes strongly is a perfectly logical outcome. poorer performance. Starting with the “You often hear LPs express But what is the impact of fund growth premise that firms with higher past disappointment that a follow-on fund on performance? New academic returns are more likely to raise larger has not performed as well as a previous research by Andrea Rossi, assistant follow-on funds, he draws on research very successful fund, and then point professor of finance at the Eller College of by Arthur Korteweg and Morten Sorensen to growth in fund size as the cause,” Management, The University of Arizona, (Skill and Luck in Private Equity he says. “Yet I’d argue that this is to sets out to test the widely held view that Performance). That research found that be expected from a statistical point of when a general partner increases its fund managerial ability, or skill, accounts for view – the lower returns are simply size, performance declines. around 14% of the variation in buyout a reversion to the mean.”
COLLER RESEARCH INSTITUTE 7 ANALYSIS
He gives an example to illustrate the They have time to prove me wrong, Yet even if fund size growth doesn’t, point. “One firm in my study had a but that looks to me now like a fund by itself, drive down returns, there are second fund that delivered an IRR of size that’s grossly mismatched with the plenty of investors who believe the best more than 40%, yet its subsequent, opportunity set. They’re hunting small opportunities lie in small and mid-sized larger fund achieved 15%. It was the game with a large-calibre weapon.” funds that don’t target large companies. same team managing those two funds, Moseley is one. “Our capital has greater it was just that the earlier fund This clearly means that LPs need to pay value to smaller funds than bigger ones,” happened to invest in a company that closer attention to the extent to which he says. “Our PE portfolio is heavily did very well. The disappointing GPs seeking to raise a larger follow-on weighted to smaller funds and this bias performance of the follow-on fund was fund are scaling up their operations and has enhanced returns. Net annualised simply expected reversion to the mean where they intend to invest. “Sometimes returns since programme inception on and had very little to do with fund size. you do get LPs walking away when firms our commitments to funds of less than I find this across managers.” raise larger funds, but that’s usually if $2bn is 20.4%; for those greater than there have been, say, three funds in $5bn, it’s 15.6%. This relationship is Bigger deals succession that have grown,” says almost linear for fund groupings in Rossi’s paper also argues that managers Tom Keck, partner and co-founder of between, and, while these figures don’t can mitigate the effects of raising more StepStone. “They’ll usually look at include our co-investments, we find the capital by investing in larger targets, whether the team has scaled same pattern there.” although there is a difference between commensurately, whether the firm is buyouts and VC. “On the whole, buyout developing new partners – you don’t More than luck? firms are able to scale up successfully. want to invest in a firm where Yet given that the private equity My research suggests that when performance has been driven by one industry raises funds on the back of managers invest in operations and hire or two personalities – and whether it is past performance – on the basis that people, and can make larger investments expanding into new geographies. If a managers have skill – how do the to limit the number of portfolio companies, fund is going into new areas where it paper’s assumptions around the role they can keep decreasing returns at bay,” can’t demonstrate past success, that’s of luck in returns stack up? he says. “The same is less true of VC, where LPs are more likely to get upset.” since there is only so much capital you Rossi points to the example of early can deploy in early-stage companies. investment in social networks to illustrate Raising larger funds inevitably means “IF YOU WERE IN A CASINO the role of luck. “When Facebook investing in more companies – and that AND HAD A 1% EDGE, THAT received VC backing, there were another can hurt returns. That’s why many VC WOULD BE ENOUGH TO GIVE 40 or so other similar players, all of firms limit their fund sizes.” YOU QUITE AN ADVANTAGE. which started to gain traction,” he says. SO IF YOU HAVE 14% OF “But then Facebook took over. It wasn’t This point is echoed by Moseley. RETURN VARIATION THAT clear at the point of investment that it “Fund size and change in fund size are IS NOT ACCOUNTED FOR BY would ultimately be the winner, but variables whose importance can vary IDIOSYNCRATIC FACTORS, Facebook investors achieved an IRR off from huge to negligible,” he says. “We THAT’S SIGNIFICANT.” the chart. This performance was less to look at these, but we tend to focus more do with the fund managers and more to on aligning the fund size with investment Tom Keck do with the opportunities available in the strategy and resources. Sometimes the StepStone market at that point. This explains why mismatch is obvious. Take Softbank’s funds that follow extremely successful Vision Fund [which raised $100bn]. ones tend to have lower returns.”
8 PRIVATE EQUITY FINDINGS 2020 He also suggests that for buyout funds, which are less focused on home runs THE RESEARCH than VC funds, credit and M&A market conditions can play an important role in In Decreasing Returns or Reversion to the Mean? The Case of Private Equity Fund determining returns. Because these Growth, Andrea Rossi of The University of Arizona examines whether growth in fund conditions are outside the control of the size affects returns to LPs. Using a dataset of more than 2,000 buyout and VC funds, fund managers and vary over time, this the author compares returns across funds operating in the same market environment. makes it difficult for buyout firms to He uses a statistical model to estimate the causal relationship between fund size replicate past performance. and performance. To account for macro-economic shocks and regional differences, he includes controls for vintage year and region. “The question of luck versus skill is the single most important question Running a naïve model, the research seems to confirm the conventional wisdom of we have to answer when looking at larger funds producing lower returns, finding a 1% increase in size associated with a managers,” according to Keck. Yet he decline of 5.1 basis points in IRR for buyouts and 8.7 basis points for VCs. But on closer also believes that if skill accounts for examination, this result appears to be a correlation, not a story of cause and effect. 14% of the difference in returns between sequential funds, this should Building on a more sophisticated model, reflecting the work of Korteweg and Sorensen not be seen as a low figure. On the (Skill and Luck in Private Equity Performance), Rossi is able to account for the impact contrary, it should be seen as evidence of reversion to the mean (the notion that returns tend to cluster at the long-run average that managerial capability and quality despite periods of outperformance) on investment success. The original Korteweg matter. “If the research suggests that and Sorensen analysis found that 14% of the variance in buyout fund returns (and 5% 14% of the performance difference of the variation in VC funds) can be explained by skill. But how much of the negative between two funds is due to skill, that’s relationship between fund size and returns remains after accounting for mean reversion? pretty good,” he says. “If you were in a casino and had a 1% edge, that Rossi finds that the effect of fund growth on returns for buyout and VC funds is would be enough to give you quite an statistically insignificant. By accounting for reversion to the mean, a doubling of fund advantage. There are many factors that size would lead to a decline of 0.3 percentage points in IRR for buyout funds and 1.1 make up performance, so if you have percentage points for VC funds – far lower than would be the case if larger follow-on funds 14% of return variation that is not caused lower returns. Instead, Rossi argues that funds that outgrow their predecessor accounted for by idiosyncratic factors, funds by the biggest margins were, on average, lucky in the past, and their lower that’s significant.” performance is simply an artefact of chance, not size.
“Skill exists,” agrees Moseley. “I’m sure there are lots of funds that get lucky, but “What we see is the paradox of skill affected more by what’s happening in the best data-driven argument I know at work: in a given market, the more the wider industry. for the existence and importance of skill skilled the players are, and the closer in PE is measurable performance to each other those skills are, the “Previous studies have shown that persistence across deals and funds.” harder it is to stand out.” when large amounts of capital are being raised in aggregate and Rossi emphasises that he is not So, overall, what should LPs draw from competition for investments increases, suggesting there is no skill in PE. the research? They should look at the performance suffers. This matters “Private equity fund managers clearly broader picture, says Rossi. “One of significantly more than how much an know what they are doing,” he explains. the key takeaways is that returns are individual manager is seeking to raise.”
COLLER RESEARCH INSTITUTE 9 FEATURE
10 PRIVATE EQUITY FINDINGS 2020 DISTORTING MIRROR?
The use of subscription lines of credit in private equity has come under increased scrutiny in recent times. Are they a benign cash flow management tool or returns-enhancing financing trickery? Two new research papers shed light on the issue. By Brendan Scott.
ubscription lines of credit investable cash on their balance sheets Cause for concern? (SLCs) – a form of bridge for a longer period of time. They also But is there any substance to these financing that allows fund enjoy less frequent and more predictable concerns? And what is the real impact managers to finance the equity capital calls. of SLCs on performance? Two recent S studies examine these issues, with portion of deals without the need to issue urgent capital calls to their limited Yet, their use can be controversial. When differing results. partners (LPs) – have become a widely using SLCs, GPs effectively delay capital used tool by private equity firms over calls, which reduces the amount of time The first study, Distortion or Cash Flow the past few years. A Preqin report over which LP capital is put to work. Management? Understanding Credit published in June 2019 demonstrates This has led some to question whether Facilities in Private Equity Funds, by how much their use has grown: just GPs may use SLCs to artificially boost Pierre Schillinger, Reiner Braun and 13% of pre-2010 vintage year PE funds a fund’s return in net IRR terms – the Jeroen Cornel, suggests that, under used SLCs, while 47% of post-2010 annualised, time-weighted metric widely normal circumstances, fear of returns vintage year funds used them. SLC used for performance comparisons. manipulation may be overstated. The use has even grown in venture capital This has the potential to move a fund authors use a simulation approach applied funds, increasing from 9% to 24% up the performance quartile rankings, to 100,000 hypothetical funds based on over the same period. which may make it more attractive to more than 6,000 buyout deals between investors. In response, the Institutional 1994 and 2013. After simulating each fund SLCs have a number of benefits. Limited Partners Association (ILPA) twice – once with an SLC and once without They enable general partners (GPs) to released best practice guidelines in – they find that the difference in net IRR transact at short notice, in what has 2017 to improve transparency around terms is “moderate”, with an average arguably become a highly competitive GPs’ use of SLCs and set out reasonable increase of 0.47 percentage points and a market, while allowing LPs to retain thresholds for their deployment. median increase of 0.2 percentage points.
COLLER RESEARCH INSTITUTE 11 FEATURE
“Given that it is such a prominent topic percentage points, regardless of the Distortion at play? in the industry, I would have expected pre-SLC IRR. In other words, the longer The second study, Distorting Private SLCs to have had an even more severe the term of the loan, the greater the Equity Performance: The Rise of impact on fund performance,” says IRR inflation. If maturities are stretched Fund Debt, by James F. Albertus Braun, one of the authors. “And GPs to two years, SLCs can significantly and Matthew Denes, takes an often say that SLCs are something alter fund rankings, with nearly half empirical approach, employing cash they have to use, otherwise they will (44.4%) of all funds moving up by at flows of recent funds that use SLCs be at a disadvantage when it comes least one performance decile, while to investigate the same question to performance and their future only 1.2% move down. as Braun et al. For each fund, the fundraising. Yet our results suggest authors estimate the impact of SLCs that this is not necessarily the case.” on performance by first computing “GENERAL PARTNERS the actual net IRR using the fund’s Their research also finds that the OFTEN SAY THAT SLCs ARE cash flows. They then compute an impact of SLCs on net IRRs depends SOMETHING THEY HAVE TO “unlevered IRR”, or the IRR for the on the fund’s performance – those USE, OTHERWISE THEY WILL fund if it had issued capital calls that underperform without SLCs see BE AT A DISADVANTAGE. instead of using SLCs. negligible, if any, improvement when OUR RESULTS SUGGEST THIS IS using SLCs, while the star performers NOT NECESSARILY THE CASE.” The study finds that, on average, using see the biggest gains. This implies that an SLC increases a PE fund’s net IRR it is not possible for industry laggards Reiner Braun by three percentage points. Looking to massage their performance by Technical University of Munich only at averages, however, masks how using these credit facilities. the effects of SLCs vary with fund age. The research finds that for “young Duration matters “If the maturities on SLCs are 12 months funds” (those with an age of five years However, one of the main concerns or more, then LPs should probably or less), the IRR gain rises to 7.3 expressed by some LPs is the duration take a closer look and exercise some percentage points, while for older funds of SLCs. As ILPA notes in its best caution, as the underlying rationale may this gain is only 2.1 percentage points. practice guidelines: “Today, fuelled be to boost IRRs rather than simply by low interest rates after the financial manage capital calls,” says co-author “Overall, it is quite a large gain,” crisis, subscription lines have evolved Pierre Schillinger. says Denes. “There’s an even more beyond a short-term bridging function, pronounced impact on funds that are to serve as a broader tool used to ILPA’s guidelines suggest that facilities relatively younger and there’s a larger manage the overall cash of the funds, should have a maximum term of 180 impact the more the fund uses debt, with repayment terms often extending days, yet the use of SLCs appears to which is intuitive because the more beyond 90 days.” vary considerably by GP. While one they’re using debt, the more they are industry participant noted that the delaying capital calls.” On this point, the Braun et al study Braun et al study assumption of a finds that SLCs can have a much six-month maturity equivalent to 25% The results point to two issues. The first more significant impact on fund of undrawn capital was “pretty robust”, is the quantum of debt being used by performance. While the results another suggested that 12 months was GPs. The Albertus and Denes study discussed above are based on SLCs more realistic. says there has been a “dramatic rise repaid over a six-month period, the in the aggregate use of SLCs from research finds that, for every quarter 2014 to 2019”. In their sample, the the loan is extended beyond this, total value of SLCs used, in real terms, net IRR is enhanced by around 0.42 rose from $151.4m in Q2 2014
12 PRIVATE EQUITY FINDINGS 2020 to $19.5bn in Q1 2019. In addition, “That can cut two ways,” he says. average. Our study found that, for the total credit employed by the “On one hand, obviously you can say 70% to 80% of funds, there was no average fund increased markedly, there’s a performance boost that is to real impact once the outstanding credit rising from $21.6m to $86.4m over the GP’s benefit. The flip side is that, line had been repaid. The remaining the same period. sometimes, obviously inflated interim 20% or so were great funds already performance is disregarded because – even without the SLC.” It should be The authors point out that the rise it is not realistic. You can end up with noted that the Albertus and Denes of SLCs may have an impact on how outsized IRRs when only a limited study does not report a median. much equity is being deployed by amount of capital has been drawn.” private equity managers over the longer term. The paper notes that the It’s a point picked up by Christoph “WE FIND EVIDENCE THAT proportion of equity being called for all Jäckel, a partner at Montana Capital FUNDS ARE USING SLCs funds using SLCs decreases by 3.3% Partners, who says that “LPs should TO DELAY CAPITAL CALLS after controlling for vintage year and be cautious when it comes to interim THROUGHOUT THE FUND fund age, yet when examining “young reporting because the performance LIFE, NOT JUST DURING THE funds”, the proportion of equity called of younger funds can be impacted INVESTMENT PERIOD.” decreases by 9.2%. substantially by the use of a credit line.” His firm conducted analysis on Matthew Denes The research also finds evidence that quarterly cash flows from 491 buyout Carnegie Mellon University SLCs delay capital calls throughout a funds with vintages from 1990 to fund’s life, which, says Albertus, 2007 using Preqin data, comparing “is hard to reconcile with the idea net IRRs with and without SLCs across LP views that funds are using SLCs to manage the funds’ full lifetime. In addition to While there may be a debate around capital calls for LPs – you’d expect the impact of SLCs on interim IRR, the the effect of SLCs on IRR, the ILPA them to be mostly used early in the research finds SLCs improve average guidelines recommend that GPs report investment period”. net IRRs by four percentage points net IRR both with and without the use over the life of a fund. of credit facilities. This should provide “Fund managers claim they are using some clarity to LPs, many of which SLCs to make it easier for LPs and to While this is largely in line with the have now become accustomed to the invest quickly,” says Denes. “Yet we findings in the Albertus and Denes use of SLCs, according to Maurice find evidence that funds are using SLCs study, Jäckel says his firm’s research Gordon, managing director and head throughout the fund life – as opposed also chimes with the Braun et al of private equity at Guardian Life to just during the investment period – findings about star performers. Insurance. “Understanding SLCs is and those using SLCs tend to call less In his firm’s study, the four now a normal part of the underwriting equity. That suggests that the debt is percentage-point gain is significantly process for LPs,” he says. “We like to being used to substitute for the equity.” skewed by outperformers in the follow the ILPA standards. Typically, sample, he says. For median a duration period of six months and Interim measures performers, the IRR gain drops to just 20% of committed capital seems to The second issue is the impact of one percentage point, and, for 25% of be reasonable. [But] I’ve not heard of SLC use on younger funds. As Adam funds, IRR declines when using an SLC. anyone declining to commit to a good Turtle, founding partner at Rede fund just because of SLC terms.” Partners, notes, this early distortion “The four percentage-point average is period – three to four years into the a little misleading,” says Jäckel. “What He also says that many LPs are in fund’s life – is exactly when managers you really need to look at is the median favour of credit lines, for a number of start raising capital for new funds. because a few outliers really drive the reasons. “The primary benefits is the
COLLER RESEARCH INSTITUTE 13 FEATURE
mean net multiples deteriorate only marginally, by about 0.02, when SLCs are used, while the decline in public market equivalents (PMEs) is close to zero. Albertus and Denes find a larger reduction of 0.22 in PMEs, which falls to 0.13 for relatively older funds. Yet for the total value to paid-in ratio, the Albertus and Denes study finds a smaller drop – just 0.0058.
“FROM MY VANTAGE POINT, IT WAS THE INFLUENTIAL LPs THAT SAW THE BENEFITS OF SLCs AND BEGAN ENCOURAGING GPs TO USE THEM TO OPTIMISE NET IRR”
Adam Turtle Rede Partners reduction in the number of capital calls Beyond IRR we have to manage,” he explains. “Also, Yet IRR is not the only measure of Given the variance in the results, it’s modest leverage in times of extremely performance used by the industry, clear that LPs need to consider several low interest rates can help to enhance although it is often the metric employed performance metrics when evaluating overall returns. And although this is not to calculate remuneration for GPs and, funds that use SLCs. “IRRs have been necessarily the case with us, some LPs’ as Gordon notes, some LPs. This, says criticised quite extensively in the past bonuses are linked to IRRs.” Johanna Barr, managing director couple of years,” says Braun. “SLCs and global co-head of limited partner may add to that, given the potential Indeed, contrary to popular belief, it may services at Advent International, is for manipulation. Right now, the best not even be GPs behind the recent rush where conflicts of interest can creep an investor can do is look at money to adopt SLCs. “From my vantage point, in. “Who’s pushing for SLCs and multiple, PME, IRR and direct alpha.” it is more LP-driven than GP-driven,” who isn’t?” she asks. “Some chief says Rede Partners’ Turtle. “One or two investment officers say they don’t like A temporary phenomenon? GPs started using them, but it was the them because, ultimately, they reduce But to what extent are SLCs a influential LPs that saw the benefits the cash-on-cash multiple.” temporary phenomenon? One of the and began encouraging GPs to do it to drivers of their use in recent years, optimise net IRR. So this hasn’t really The two academic papers analyse surely, has been low interest rates. been a case of GPs trying to get away multiples and market-based Even on this point, academics and with something that LPs were resisting. performance measures on the basis practitioners are divided. The Braun Obviously, there has been pushback that the interest and ancillary fees et al study, for example, found that from some investors who have a that must be paid on these loans eat the effect of SLCs on IRRs remained different opinion on it, especially where into the absolute cash returns on PE positive in both low and high interest the SLCs are used excessively.” funds. Braun et al find that median and rate environments, suggesting that
14 PRIVATE EQUITY FINDINGS 2020 THE RESEARCH
In Distortion or Cash Flow Management? Understanding Credit Facilities in Private Equity Funds, Pierre Schillinger and Reiner Braun (both of the Technical University of Munich) and Jeroen Cornel (BlackRock Private Equity Partners) examine the impact of subscription lines of credit (SLCs) on fund performance metrics.
The authors simulate 100,000 hypothetical funds using a proprietary dataset of 6,353 distinct buyout deals from 1994 to 2013. After making base-case assumptions about SLC terms, such as a six-month maturity equivalent to 25% of undrawn capital, the authors simulate each hypothetical fund twice: once without an SLC and once with an SLC. The difference between each fund’s net IRR before and after the SLC, or “delta net IRR”, measures the SLC’s impact on performance. The authors report average and median delta net IRRs of 0.47 and 0.2 percentage points, respectively, and conclude that SLCs have a “moderate” impact on performance.
However, the authors also find the impact of SLCs depends on fund performance and SLC maturity. On average, every one percentage point increase in a fund’s net IRR, before the use of an SLC, increases the change in net IRR due to the SLC by 0.16 percentage points – better-performing funds realise the largest gains in net IRR by using SLCs, while the worst-performing funds see smaller gains or a decrease. Duration also has a profound impact on performance: increasing the maturity of the SLC by one quarter increases its impact on net IRR by 0.42 percentage points. The authors find that if SLC maturities are extended to two years, 44.4% of all funds increase in ranking by at least one decile (based on IRRs), while only 1.2% move down in ranking.
Distorting Private Equity Performance: The Rise of Fund Debt, by James F. Albertus and Matthew Denes (both of Carnegie Mellon University), takes a different approach. The authors use actual fund-level cash flow data from 264 funds employing SLCs from 2014 to 2019 and calculate what each fund’s performance would have been if SLCs were replaced with capital calls. On average, the authors estimate that SLCs increase IRR-based performance by three percentage points. The study also finds that fund age matters. The effect of SLCs on the IRRs of young funds is 7.3 percentage points; for older funds it is only 2.1 percentage points. It should be noted that, while the Schillinger et al study covers the entire life of a fund, this research includes interim performance because the funds are more recent.
Both papers also examine whether SLCs can cause multiples and market-based performance measures to decline because of interest payments and associated fees. Schillinger et al (2019) find that, on average, the impact of SLCs on net multiples and public market equivalents (PMEs) is close to zero at -0.02 and 0.00, respectively. Albertus et al (2019) find that, on average, the use of SLCs reduces a fund’s TVPI (similar to a multiple, with the addition of the fund’s NAV to distributions) and PME by 0.0058 and 0.22, respectively.
their use will continue. “Our data are Yet there are others who would positively skewed, and this was pretty disagree. “I guarantee that if the surprising,” says Schillinger. “When interest rate went up to 8%, where you look at the decile improvement the hurdle rate is, no one would use gained by using SLCs, the risk/reward SLCs any more,” says a GP. “At that profile is essentially favourable across point, the numbers don’t make sense all deciles, from top to bottom and from a practitioner perspective.” across more than 20 vintage years. With interest rates remaining low for So, from a game theory perspective, the foreseeable future, we may have it seems rational for everyone in the some time to wait before we know industry to use SLCs sooner or later.” which view will prevail.
COLLER RESEARCH INSTITUTE 15 ROUNDTABLE
16 PRIVATE EQUITY FINDINGS 2020 UNFORESEEN CONSEQUENCES
As private equity has grown, its influence has touched more companies. But what are its effects on competitors, public markets and sector productivity? We explore the findings of three recent research papers that examine PE’s broader impact.
Private equity continues to grapple running public market companies. with a punishing perception problem Another examines the impact of a – many politicians and members of PE-backed player on competition the general public still associate the in its industry. A third studies PE’s asset class with company collapse and productivity improvement potential. job destruction. In polarised times, the industry’s ability to communicate The results of these research the benefits it brings, not only to the initiatives are important for businesses it backs but also to the policymakers trying to balance wider economy and society, has never being responsive to their constituents been more important. with promoting economic growth. We talked to the authors of the three Three recent academic papers delve studies and to PE investors about into exactly these issues, revealing what the findings tell us regarding that PE’s influence spreads well beyond the industry’s spill-over effects and its immediate portfolio companies. how these should influence any One explores how having PE experience future regulation. influences the behaviour of CEOs Chaired by Amy Carroll.
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Serdar Aldatmaz Scott Hsu Serdar is an assistant professor of Scott is an assistant professor in finance at George Mason University’s finance at the Sam M. Walton College of School of Business. His primary Business at the University of Arkansas. research spans PE, venture capital, His research interests include PE, VC, initial public offerings (IPOs), political connections and IPOs. entrepreneurship and innovation.
How would you describe public and by bad news stories. To much of the Serdar Aldatmaz: “There has certainly political perceptions of PE’s spill-over general public, PE firms are still locusts been a lot of negative publicity around effects today? and fat-cat financiers.” PE and its implications for the broader economy. Most recently, we have seen Neil MacDougall: “It’s hard to get In light of this, why are the findings of Elizabeth Warren’s ‘Stop Wall Street good press for PE at the moment. these research papers so important? Looting Act’, which is being pushed in Everything in the venture world is the US Senate. Senator Warren refers deemed to be wonderful, but buyouts Steven J. Davis: “The PE model has to PE firms as ‘looting companies’. are a far harder story to sell. Is that been controversial for many years, because the venture industry is doing primarily because in some quarters “This negative perception has been a great job of explaining what it does? it is seen as contributing to job around for some time. In 2015, Or do people just like the idea of destruction. But we also live in a time PE-backed casino operator Caesars novelty and growth, while PE is where there is a great deal of concern filed for bankruptcy and PE was only ever associated with financial about slow productivity growth. PE’s substantially blamed, not only for the engineering? It’s certainly something focus on managerial professionalisation collapse but also for downward pressure we all need to be concerned about. means it could be an important driver on its peers’ financials. How do we get our message across in of productivity. If so, it’s critical to a better and more compelling way?” understand why that is, so we can “At the same time, though, you have replicate those benefits, and also so Hertz, one of the biggest buyouts in Johan Van de Steen: “Sovereign wealth policymakers can have the information history. It was taken private in 2005 and funds and pension funds are increasing they need to make the right decisions then quickly sold back to public markets their allocation to PE. But broader around the asset class.” two years later. That deal attracted a public opinion continues to be defined lot of controversy, but PE made the
18 PRIVATE EQUITY FINDINGS 2020 Steven J. Davis Neil MacDougall Johan Van de Steen Steven is the William H. Abbott Neil is chairman at Silverfleet Capital, Johan is the partner responsible for distinguished service professor of having served as managing partner IK Investment Partners’ strategy, international business and economics at between 2004 and 2019. He has led operations and business control team. The University of Chicago Booth School many of the firm’s most successful He began his career at Siemens of Business and a senior fellow at the investments, including Finnish Chemicals before joining McKinsey & Company Hoover Institution. and Sterigenics, and was previously and later becoming an operating chairman of the British Private Equity partner at KKR Capstone. & Venture Capital Association.
company significantly more efficient. “There has not been a great deal of examined the PE investments against And, critically for our study, a lot of evidence to date about the asset class’s the baseline of the industry’s historical improvements were also seen in the car broader externalities, or side effects, performance, for example – and rental industry more broadly, particularly and so we thought this was important everything suggests that it isn’t how an among Hertz’s main competitors – to explore. We found that when PE industry is performing that attracts PE Avis Budget and Dollar Thrifty. invests in a sector, publicly traded capital. Instead, it’s PE coming in that companies within the same industry changes industry performance.” do significantly better in terms of labour “IF PE IS SUCCESSFULLY productivity, profitability, employment Neil MacDougall: “Yes, it’s what MAKING PRODUCTIVITY and capital expenditure. In other you would expect in a competitive GAINS IN ITS OWN COMPANIES words, there are positive spill-overs market: if somebody raises the bar, – AND THEREBY ENCOURAGING from the PE target onto public peer the competition needs to improve their PRODUCTIVITY GAINS IN companies in the same industry.” performance as well.” THE BROADER MARKET – REGULATORS NEED TO BE Is that a result of competitive Scott Hsu: “I agree. The findings make VERY CAREFUL INDEED pressures, or could it be that sense. PE firms bring cost-cutting and ABOUT TAKING ANY STEPS PE is good at identifying positive value-enhancing initiatives to targets. THAT COULD HAMPER industry trends? When those targets start to improve, THAT DYNAMIC.” their peers come under pressure to act Serdar Aldatmaz: “It could be argued and so the whole industry’s productivity Steven J. Davis that PE investors just have perfect and efficiency improves.” The University of Chicago foresight. But we did distinguish Booth School of Business between the two scenarios – we
COLLER RESEARCH INSTITUTE 19 ROUNDTABLE
Steven J. Davis: “When Walmart private. This poses a threat – or an Neil MacDougall: “But why do you started taking market share, everyone incentive – to public companies, get these differences in behaviour? tried to figure out what it was doing so encouraging them to do better.” Do these CEOs simply realise they they could imitate it. Those that couldn’t have the ability to make changes faster didn’t survive. What’s interesting, Scott, you found that one way that because they have done it in a private though, is that our study evaluates PE spills over into public markets is context? Does that, therefore, bring a productivity gains post-buyout, by through the PE experience of some feeling of greater operational freedom comparing outcomes to those of public market CEOs. How does that to their quoted situation? It may just control businesses. If this research experience manifest itself? come down to the fact that they realise is correct, it means we are probably they can make this level of change ‘under-scoring’ our productivity gains Scott Hsu: “We looked at the spill-over without destroying a business. They by not taking that spill-over effect into effect through a novel lens, by are less focused on quarterly results account. If PE is successfully making considering the human capital side because they take the view that if they productivity gains in its portfolio of the industry. In particular, we found get it right over four or five years, their companies – and thereby encouraging that PE effects spill over to listed shareholders will ultimately thank them.” productivity gains in the broader companies through public company market – regulators need to be very CEOs who have received on-the-job Johan Van de Steen: “Having sat careful indeed about taking any steps training while working for private equity on the board of public companies that could hamper that dynamic.” targets in the past. and having been involved in several take-private transactions, I have seen “We called these spill-over effects the benefits of bringing in PE-trained “REDUCING INVESTMENT ‘managing with PE style’, and that is CEOs. All else being equal, they bring AND EMPLOYMENT DOES NOT exactly what we found. We looked at more focus, discipline and sense of MEAN PUTTING THE BRAKES the job histories of public company urgency to value creation. They are also ON A BUSINESS. ON THE CEOs and found that those with a used to working in an environment of CONTRARY, THESE THINGS PE background – and in particular, transparency and accountability, and ARE OFTEN THE RESULT OF those who had previously held the are more compatible with more active IMPROVING LABOUR AND CEO position in PE targets – exhibit boards and investors.” CAPITAL EFFICIENCY – cost-cutting and value-creating A CRITICAL FOUNDATION characteristics within the public FOR FUTURE GROWTH AND companies they manage.” VALUE CREATION.”
Johan Van de Steen IK Investment Partners
Johan Van de Steen: “PE isn’t affecting public companies only through competitive pressure. It is casting its shadow over public markets in other ways as well. It is increasingly active in public markets, by acquiring significant minority positions with influence or taking underperforming companies
20 PRIVATE EQUITY FINDINGS 2020 One of the characteristics exhibited Why then does employment fall on the productivity margin. A plausible in PE transactions, however, is job following a take-private? hypothesis is that when credit is tight, reduction. Can PE really be positioned PE firms have to generate profits as a force for good in the wider economy Neil MacDougall: “Quoted companies through operational improvements, while the story around employment have the burden of quarterly reporting and are consequently more selective remains mixed? and the CEO has to look after in the deals they pursue and more numerous investors. When we sold focused on generating extra profit at an Johan Van de Steen: “Reducing investment a business to a US corporation, the operational level. The flip side of that, and employment does not mean putting buyer doubled the size of the finance however, is that when credit conditions the brakes on a business. On the contrary, department simply to deal with those are loose, more deals may take place, these reductions are often the result of tasks. PE has a much more direct and but investment decisions might not be improving labour and capital efficiency – focused communications channel and so wise and the focus on productivity a critical foundation for future growth and you can usually save money, thereby performance may not be as great.” value creation. PE’s objective is not to reducing the headcount. There will be starve a company of resources. Doing other factors at play as well, although Johan Van de Steen: “The availability, so would put the long-term viability of those will be more industry-specific.” or not, of cheap credit is an important a business at risk. On exit, PE owners factor in the effort required to generate need to demonstrate sustainable target returns. As credit becomes growth in revenues and profit margins. “WE FOUND THAT PE EFFECTS scarce or more expensive, PE owners Slash-and-burn tactics just don’t work.” SPILL OVER TO LISTED have to push harder on earnings COMPANIES THROUGH growth and cash generation to achieve Steven J. Davis: “It is important to PUBLIC COMPANY CEOs WHO similar returns.” remember that PE doesn’t have a single HAVE RECEIVED ON-THE-JOB narrative. For example, we saw very TRAINING WHILE WORKING Neil MacDougall: “It’s all about sweating large employment gains in the wake of FOR PE TARGETS IN THE PAST.” the assets.” private-to-private deals. Lots of these gains come through acquisitions, but even if you Scott Hsu Johan Van de Steen: “But I don’t agree strip them out of the data, those findings University of Arkansas that when credit is cheap, PE becomes still stand. That’s a positive story that less selective. When credit is cheap, everyone can be happy with. But there prices go up, so you actually have to be is no denying that the story is materially PE’s ability to drive productivity more selective to ensure you don’t pay different when it comes to other forms of is a common theme across the too high a price.” buyouts, particularly take-privates.” research. But Steven, you found that productivity gains varied, depending Scott Hsu: “The finding that target Neil MacDougall: “It is no surprise to on the macro-economic backdrop. productivity gains are larger for deals me that employment increases following What do you think is going on there? executed during tighter credit market private-to-private deals. If you are buying conditions seems to suggest that PE a family-run business, for example, the Steven J. Davis: “First of all, we found has positive effects in helping target owners will often have been perfectly average productivity gains of 8% over firms become more competitive – or happy simply taking out dividends, while two years. That is very significant. But survive – when economic conditions are the PE firm will be focused on growing yes, the results did vary when we dug less favourable. Overall, I am glad and the company, making it bigger and more down into different types of buyouts appreciate that the authors found these valuable. To do that you need people. and also different credit conditions. We important effects of PE, and I hope It’s the difference between investing for found that deals executed in years when that these findings will lead to a fairer growth and holding for yield.” credit was tight performed really well assessment of its impact.”
COLLER RESEARCH INSTITUTE 21 ROUNDTABLE
As PE ownership becomes more Johan Van de Steen: “The PE sector is extensive, do these findings not mean well aware of the risks of investing in “IF YOU ARE BUYING A that the asset class could potentially cyclical industries, such as the need FAMILY-RUN BUSINESS, THE amplify economic peaks and troughs? to get the timing right, the potential OWNERS WILL OFTEN HAVE negative impact on the holding period BEEN PERFECTLY HAPPY SIMPLY Steven J. Davis: “There is some for an asset if you have to sit out a TAKING OUT DIVIDENDS, potential for that. We see, in particular, downturn, or even more basic things WHILE THE PE FIRM WILL BE a lot of take-privates happening at the like the limitations of leverage as a tool FOCUSED ON GROWING THE top of the cycle, with high leverage for cyclical businesses. As a rule, many COMPANY, MAKING IT BIGGER adding strain when the cycle turns. PE investors do not invest in structurally AND MORE VALUABLE. TO DO That is a concern and it is something cyclical industries.” THAT YOU NEED PEOPLE. IT’S the tax and regulatory system should THE DIFFERENCE BETWEEN take into account. The tax system in Neil MacDougall: “I agree. That is INVESTING FOR GROWTH AND the US treats debt financing more probably three steps of logic too far. HOLDING FOR YIELD.” favourably than equity financing, and Given the level of PE activity as a this can encourage excessive leverage. percentage of overall economic Neil MacDougall It’s not that I am against debt financing, activity, I can’t imagine a variation Silverfleet Capital but I don’t see a good justification for significant enough to make a the corporate tax code to encourage difference to the cycle at all. greater levels of debt than would We see ourselves more as a cork on As the number of take-privates rises otherwise be the case.” the wave than a wave generator.” and public ownership falls, what does that mean for PE’s influence on the Do the results of these pieces of wider economy? “WE FOUND THAT WHEN research show that PE is intrinsically PE INVESTS IN A SECTOR, better at managing business than Steven J. Davis: “It’s an interesting PUBLICLY TRADED COMPANIES public markets? question because, as you say, we WITHIN THE SAME INDUSTRY have this long slide in the number of DO SIGNIFICANTLY Serdar Aldatmaz: “I think they do. listed companies, particularly in the BETTER IN TERMS OF It is clear that PE targets become US. That suggests that being listed LABOUR PRODUCTIVITY, more and more efficient. There is is less attractive than it once was. As PROFITABILITY, EMPLOYMENT some degree of financial engineering the industry has grown in prominence, AND CAPITAL EXPENDITURE.” involved in that, of course. Leverage it has shown that there is a different forces companies to behave differently way to bring managerial expertise and Serdar Aldatmaz because management has less free financial resources to bear. I do see George Mason University cash flow and because they are more PE as having a potentially positive closely monitored. But there is also social and economic function to play, operational engineering. Companies are partly because it takes people with a Serdar Aldatmaz: “I’m not sure that simply run in a different way that makes high level of managerial expertise and PE ownership could amplify peaks them more efficient. Now we know it spreads that expertise widely.” and troughs. In fact, research has also has broader implications for peer found that industries with high levels companies, and that is very important.” of PE ownership are less prone to market shocks.”
22 PRIVATE EQUITY FINDINGS 2020 Johan Van de Steen: “I believe PE ownership will continue to grow. THE RESEARCH As a result, there will be further professionalisation of companies and All three research papers attempt to quantify PE’s impact, not only on the businesses it management, a stronger focus on backs but on competitors, public markets, and the economy as a whole. value and returns, and higher levels of industry consolidation – all phenomena The Economic Effects of Private Equity Buyouts analyses thousands of US PE typical of PE’s buy-and-build approach. investments between 1990 and 2013, a period that experienced huge swings in credit market conditions and GDP growth. Its authors – Steven J. Davis (University of Chicago), “More PE ownership could mean John Haltiwanger (University of Maryland), Kyle Handley, Ben Lipsius (both University of slightly more short-termism as most Michigan), Josh Lerner (Harvard University) and Javier Mirander (US Census Bureau) – PE firms operate a finite fund life identify significant differences between the impacts of these deals, depending on their structure, typically holding companies nature and the economic backdrop against which they took place. for five years. But again, bear in mind that exit value and returns correlate Employment rises following acquisitions of other privately-owned companies and in strongly with creating sustainable secondary buyouts, but falls following divisional buyouts and take-privates. Meanwhile, value, so I don’t think greater levels of labour productivity increases in all cases, but particularly in periods where credit PE ownership are likely to lead to a availability is tight. slash-and-burn mentality.” A further paper, Private Equity in the Global Economy: Evidence on Industry Spillovers, Serdar Aldatmaz: “These pieces of by Serdar Aldatmaz of George Mason University and Gregory Brown of University of research show that thinking about PE North Carolina, explores the impact of PE investment on other companies operating in should not just focus on the target the same sectors and geographies. Its dataset covers 19 industries across 48 countries. company. Policymakers need to consider the broader implications. The research finds that, following a PE investment, productivity, employment and capital The sector helps industries to grow expenditure all rise in public companies operating in the same space. Furthermore, the faster and become more efficient, more intense the industry’s competitive dynamics, the bigger the effects. which will only increase societal welfare over the long term. Anyone thinking The research does consider whether the findings could be attributed to PE’s prowess about regulating or limiting the asset in pre-empting positive industry trends. However, it concludes that the results are more class should carefully analyse these likely to be explained by competitive forces. It specifically points to the buyout of Hertz in findings before making their decisions.” 2005, for example, which was followed by increases in employment, labour productivity and profit growth at competitors Avis Budget and Dollar Thrifty.
Finally, Managing with Private Equity Style: CEOs’ Prior Buyout Target Experiences and Corporate Policies, by Hung-Chia Scott Hsu, Tomas Jandik and Juntai Lu, all of University of Arkansas, investigates the impact of a chief executive’s PE experience on their managerial practices in the public arena. The research finds that CEOs with prior PE experience reduce investment by 34% and employment by 23%. This behaviour is particularly evident when the experience is recent and when it has been gained at a company prone to cost-cutting measures.
The research also finds that CEOs with PE experience are more likely to file patents, improve operational efficiency and, ultimately, improve the value of a business.
COLLER RESEARCH INSTITUTE 23 HEAD TO HEAD
LPA BLUES The terms under which investors commit to private equity firms are William W. Clayton often heavily negotiated. Yet to what William W. Clayton is an associate professor of law at Brigham Young extent can larger limited partners University Law School, having joined the really be relied upon to secure faculty in July 2018. He was previously robust protections for all investors? a corporate attorney at Wachtell, Lipton, By Vicky Meek. Rosen & Katz and at Simpson Thacher & Bartlett, and has held the position of executive director at the Yale Law School Center for the Study of Corporate Law. His research interests include investment funds, contracts, corporate governance and securities law.
s private equity has grown in size and stature – the net asset value of private A markets has grown more than sevenfold since 2002, according to a recent report by McKinsey & Company – so regulatory scrutiny of the industry’s practices has increased. In the US, the Securities and Exchange Commission (SEC) has highlighted a number of concerns in recent years and has attempted to shine a brighter light on PE governance practices.
One common counter-response from the industry has been to argue that limited partnership agreements (LPAs) are heavily negotiated, and therefore substantive critiques of their terms are unwarranted. For example, after the
24 PRIVATE EQUITY FINDINGS 2020 SEC issued pointed criticisms in 2014 Alternatively, the investor in Clayton’s value. As a result, even when investors and 2015, Steve Judge, who was at example could negotiate for a fee have MFN rights, negotiating for rights and the time chief executive officer of the discount that would bring it a $10 privileges through side letters will usually Private Equity Growth Capital Council benefit and reduce the GP’s profits by still lead to fewer free-riders than negotiating (now the American Investment Council), $10. Just as this investor would have a for changes to LPA terms. was quoted in a variety of publications strong incentive to negotiate for the fee as saying such agreements were “the discount – which exhausts the same Further, Clayton posits that the ability to result of highly negotiated terms between amount of bargaining power and brings negotiate for individualised benefits can sophisticated parties”, a characteristic of a larger individual benefit than the LPA make large investors less likely to walk the industry that created an “alignment term – similar incentives are likely to exist away from a fund with weak LPA terms. of interest”. Similar statements have been whenever large investors are deciding the “Counter-intuitively,” he says, “when large made by industry representatives in the points they wish to negotiate. investors can negotiate for individualised years since then. benefits that offset the harm caused “Large investors have finite bargaining by weak protections, it’s possible that In a new paper, William W. Clayton of power,” says Clayton. “The fact that other bargaining power actually makes them Brigham Young University Law School investors can free-ride on negotiated less sensitive to LPA terms.” questions whether the effects of LPA terms provides an incentive for negotiation and bargaining power in PE large investors to prioritise individualised However, Clayton is keen to stress that his funds are really that simple. In The Private terms when deciding how to use their purpose is not to argue whether there is an Equity Negotiation Myth, he examines bargaining power. Of course, this is one investor protection crisis in PE. “My paper is the incentives of larger investors in a of many considerations and is unlikely focused on whether the negotiation-based PE fund – those that typically have the to eliminate the negotiation of LPAs defence is, by itself, convincing,” he says. most bargaining power when a fund is altogether. But it is likely to have “Other process-based defences could be raising capital – and pushes back on a dampening effect that is difficult more compelling. It could be the case, for the assumption that they can always be to measure.” example, that the other investors actively expected to demand LPA terms that will compare LPA terms across the market, benefit all investors. giving GPs a market competition-based “JUST BECAUSE YOU HAVE incentive to offer high-quality terms.” Clayton argues that “individualised” LARGE INVESTORS ABLE TO benefits commonly included in side letters, NEGOTIATE TERMS DOESN’T He adds: “Some have argued in recent such as fee discounts and co-investment GUARANTEE OPTIMAL LPA years that PE should be opened up to retail rights, can dilute large investors’ incentives TERMS FOR ALL INVESTORS IN investors, and the SEC is considering this to negotiate LPA terms. THE FUND.” possibility. In response to investor protection concerns, some maintain that retail To illustrate this point, he offers an investors could free-ride on the demands of example of an investor with two options. GPs may counter that they sometimes large, institutional investors if the two groups “On one hand, this investor could give investors most favoured nation (MFN) are permitted to invest alongside each other negotiate for an LPA governance term rights, which entitle an investor to the same in PE funds. My paper shows why you can’t that would increase the fund’s profits by side letter terms granted to other investors make this assumption – just because you $10 and reduce the general partner’s in the same fund. Yet Clayton points out have large investors able to negotiate terms profits by $10,” he explains. “However, that a number of those do not receive doesn’t guarantee optimal LPA terms for all since the investor owns only a portion these and those that do are often entitled investors in the fund. Policymakers need to of the fund, it would enjoy a fraction of to receive only the side letter benefits take the whole ecosystem of investors into that fund’s increased profits – $1, for granted to investors that have made account before they can assume that the example, if it is a 10% investor.” commitments to the fund of equal or lesser LPA terms will be robust.”
COLLER RESEARCH INSTITUTE 25 HEAD TO HEAD
“From a theoretical point of view, the asset management,” he says. “However, arguments put forward in the paper make a this doesn’t apply to the two other main lot of sense,” says Jason Glover, managing areas of negotiation – transparency and partner of the London office at Simpson governance, which are arguably the most Thacher & Bartlett. “Yet I’d argue that the important areas of investor protection.” reality, certainly today, is quite different.” When it comes to transparency, investor If you look at the industry 20 years ago, requests are likely to be granted to all Glover says, extensive investor negotiation limited partners, on the basis that this of private equity terms was pretty rare. information is being generated anyway, Jason Glover “Yet much has changed,” he explains. says Glover. “And to the extent that side Jason Glover is managing partner of “Investors have become much more letter provisions relate to governance, the London office of Simpson Thacher sophisticated in their approach to PE as such as where certain individuals need & Bartlett and a member of the firm’s they have hired knowledgeable staff and to spend a certain amount of time on executive committee. He has advised their allocations have increased on both investments, or prohibitions on change on structuring complex global funds an absolute and relative basis. PE is an of control, this would naturally apply to all for many of the leading European and important investment for them, so they investors since it’s a behavioural change emerging market private equity firms take legal advice from some of the best that affects the whole fund.” and has been named Global Private in the industry.” Funds Lawyer of the Year seven times, There has been another significant shift including in 2019. He joined Simpson He points to the scale of negotiation in – the advent of the Institutional Limited Thacher & Bartlett in 2010 from Clifford today’s market – acting for a general Partners Association. Established by Chance, where he headed the global partner with a €10bn-plus fund, for mainly larger investors – which Clayton private funds practice. example, he estimates that on average, argues are the most likely to be able to his team spends 7,000 hours negotiating bargain for their own benefit – it has terms with limited partners and their legal given both large and small LPs a voice counsel. “That’s a vast amount of time, in global discussions on transparency, but it’s pretty typical,” he says. governance and alignment of interest between GPs and LPs. It has also “The paper rightly points out that published guidelines on best practice investors negotiate via side letters. This in a variety of areas, including fees, is because, unlike in other industries, governance and transparency. PE firms all investors are asked to sign the same that deviate from these guidelines are document – the limited partnership likely to encounter robust questioning agreement. Consequently, any specific by prospective LPs of any size. needs of a particular investor, such as reporting, must be dealt with separately.” And finally, he adds, investors often now work collectively when negotiating fund Yet he takes issue with the idea that this terms. “It’s not uncommon for a legal means large investors are generally the counsel to be working on behalf of seven sole beneficiaries of these negotiations. or eight investors,” says Glover. “There’s “It’s certainly true that large investors can a lot of collective bargaining.” negotiate for fee discounts that may not be available for all investors – but that’s the same in any industry, particularly in
26 PRIVATE EQUITY FINDINGS 2020 THE RESEARCH
In The Private Equity Negotiation Myth, William W. Clayton of Brigham Young University Law School questions the idea that large investors can always be expected to demand strong fund agreement terms for all investors in a private equity fund.
In the article, Clayton shows why the prevalence of “individualised” contracting through side letters can encourage large investors to prioritise the use of their bargaining power to negotiate for individualised benefits over terms in limited partnership agreements (LPAs).
Clayton’s analysis is based on the idea that, because investors have a finite amount of bargaining power, they are incentivised to use it to negotiate for terms that will maximise benefits for their own constituents. He shows that, because other investors typically free-ride on negotiated LPA terms, large investors have an incentive to prioritise individualised benefits when deciding how to use their bargaining power.
Clayton also suggests that, counter-intuitively, bargaining power can actually make large investors less sensitive to the quality of LPA terms than they would be if they lacked bargaining power. This is because bargaining power can be used to negotiate for individualised benefits that offset the harms caused by weak LPA terms. For the reasons above, Clayton concludes that LPs and regulators cannot simply assume that the presence of large investors with bargaining power will lead to LPAs that contain optimal terms for all investors.
COLLER RESEARCH INSTITUTE 27 THE LAST WORD
BIGGER SLICE, SMALLER PIE
Venture capital’s role in providing finance and support to fledgeling businesses is widely recognised. Yet entrepreneurs seeking early-stage and growth capital can baulk at the terms requested by VC investors. We speak to the author of a new study that examines how terms can affect investment outcomes. Interview by Nicholas Neveling.
ow much should entrepreneurs give up when they seek venture capital (VC) finance? For many, H the response is likely to be as little as possible. Yet the findings of a new academic study, Venture Capital Contracts, suggest this may not always be the correct answer.
Arthur Korteweg To investigate the relationship between Arthur Korteweg is the dean’s associate contract terms and deal outcomes, professor in business administration the authors collected information for and associate professor of finance and over 10,000 first-round VC financings. business economics at the University By combining their final dataset and of Southern California Marshall School outcomes with a novel theoretical model, of Business. He is a financial economist the researchers were able to assess how whose research interests include VC contract terms impact the average corporate finance, private equity, and value of a start-up. Their model suggests alternative assets more generally. that the optimal VC share of a company’s In his PE research, Korteweg focuses first round is 15% (or 28% when on investment decisions in alternative preferred terms are taken into account). asset classes such as venture capital, With lower ownership, the venture buyouts, real estate and art. capitalists don’t add sufficient value to
28 PRIVATE EQUITY FINDINGS 2020 the company and with higher ownership, the entrepreneur. However, a more How did you model the VC the entrepreneur is not sufficiently critical view is that VC firms – who contracting process? engaged and the company’s value understand the contracts much better declines. Yet the average share actually than your typical entrepreneur and have “Our model captures the way in which sold to (first-round) investors is 40%. considerable bargaining power – may VCs and entrepreneurs search for, grab a larger slice of the pie, even if that and bargain with, each other. Both Beyond the VC ownership amounts, shrinks the entire pie in the process.” parties have to search and find each though, the authors’ findings suggest other – and searching is costly. We find that start-up founders should also weigh What superior terms are VC firms able to that an entrepreneur of a given quality VC quality (the investor’s ability to add secure in your research? sometimes ends up being funded by a value to a firm using its experience and higher-quality VC, sometimes by a lower- networks). In some cases, entrepreneurs “They are typically able to negotiate for quality one. This gives some variation are better off giving up more equity to a higher equity share and board seats. in outcome in, for example, IPO rates attract a high-quality VC with a proven The best firms can also get participation or high-value acquisitions, that must be record of value addition. In this case, [a preferred equity pay-out and a due to the VC quality.” entrepreneurs get a smaller slice of a common equity claim]. Though these much larger pie – and therefore a larger terms do not help create value – in fact, absolute pay-off compared with backing they reduce the start-up’s total value – “I WOULD HAVE THOUGHT from a low-quality VC firm. they shift more of the value to the VC firm, THAT BOARD SEATS WOULD and therefore are attractive to the investor. BE VALUE-ENHANCING FOR We caught up with one of the paper’s START-UPS, BUT WE FOUND authors, Arthur Korteweg, to discuss “Our study does not allow us to say much THAT GIVING VCs A SEAT TENDS the findings. about the mechanism through which these TO MODESTLY REDUCE VALUE” effects happen, but one possibility that Why did you decide to research VC seems sensible is that venture capitalists contract splits? want the entrepreneur to take more risks Were you surprised by any of and go for an out-of-the-park homerun, the results? “The role of contracts in business value which is not necessarily a strategy that creation is a topic that has long interested optimises value creation – it’s not a likely “We tried not to harbour too many economists. Contracts have always been outcome – but if it is successful, then the expectations as to what we would find, thought to be particularly important in rewards can be great.” but our results on the effect of board the start-up world, where they should seats were a surprise to me. I would incentivise both entrepreneurs and VC What was your definition for a have thought that VC board seats would firms to work to maximise value. This high-quality VC firm? be value-enhancing for start-ups, but matters for society, as start-ups are an we found that giving a venture capitalist important source of job creation and “Our definition of VC quality essentially a seat on the board tends to modestly economic growth, so it’s crucial to get captures anything and everything reduce a start-up’s value. This is true this right. through which the VC firm raises the for all but the highest-quality venture value of the business, and, ultimately, capitalists who, by contrast, add value “The predominant ‘benign’ view in the probability of a successful outcome. if they are on the board.” academic literature is that contracts You can think of the VC firm’s added are set up to create as much value value as encompassing factors such as as possible – to grow the size of the its strategic advice, its ability to institute pie, so to speak – and to distribute it good governance, the size of its Rolodex, efficiently between the VC firm and and so on.”
COLLER RESEARCH INSTITUTE 29 THE LAST WORD
THE RESEARCH “A CRITICAL VIEW IS THAT VC FIRMS – WHO UNDERSTAND CONTRACTS MUCH Venture Capital Contracts, by Michael Ewens of the California Institute of Technology, with Arthur Korteweg and Alexander Gorbenko of the Marshall School of Business, BETTER THAN TYPICAL explores how VC contract terms predict the likelihood of start-up success. ENTREPRENEURS AND HAVE CONSIDERABLE BARGAINING The academics collected a dataset of 10,000 first-round VC financings between POWER – MAY GRAB A LARGER 2002 and 2015, and filtered down the data to between 1,695 and 2,581 contracts, SLICE OF THE PIE, EVEN IF THAT containing cash flow and control rights details. The research found that contracts SHRINKS THE ENTIRE PIE IN materially affect start-up values. Using a model that controls for VC and entrepreneur THE PROCESS.” quality, the study found, in line with other research, that there is an optimal equity split: a VC share of 15% (or 28% when preferred terms such as liquidation preferences are taken into account) maximizes the start-up’s value, while any increase in that What do you think this study means proportion reduces it. However, it also found that VC firms were able to negotiate to for entrepreneurs? receive much more favourable terms than the optimal split – with an average deal giving the VC firm a 40% share (or nearly half of the company’s value when preferred “Most entrepreneurs understand that if terms are included). This means the average deal is expected to generate 83% of the you go with a better VC firm, you will end value the start-up would have had, on average, under the optimal equity split. up agreeing to more investor-friendly terms. We do find that entrepreneurs still The research also examines other VC contract terms: participation (which offers benefit from going with a higher-quality the VC a preferred equity payout and a common equity claim); board seats; and firm because these investors add a lot of pay-to-play (which removes certain rights from the VC if it does not participate in value. In other words, the entrepreneur further financing rounds). The research finds that, when controlling for VC and gets a smaller slice of a much larger pie. entrepreneur quality, participation and board seats lower the chance that the This is worth more than a larger slice of company will succeed. Pay-to-play has the opposite effect. the smaller pie that a lower-quality VC firm would help generate. However, the research goes on to say that an entrepreneur is still better off with a high-quality VC. High-quality VC firms were found to deliver the best outcomes, even “However, I think the most important though they had negotiated away from the optimal contract split. While entrepreneurs take-away for entrepreneurs is to make received less favourable terms when working with a high-quality VC firm, the study sure they understand how the contract showed that they, too, received superior outcomes compared with start-ups receiving works and who gets what in different better terms from lower-quality managers. circumstances. It’s up to you to be informed.”
Can we go so far as to say that contract And what about VCs? terms predict deal success? “VCs are doing what is optimal for “Yes, we can – at least for your average point out that we cannot look at all them. But from a societal perspective, start-up’s first VC round. For example, VC/entrepreneur contract terms in what is optimal for the VC is not for your average entrepreneur and this context – in particular, terms that necessarily the best outcome for VC firm, participation and VC board are nearly always present, such as everyone. If impact on society is a seats tend to reduce business value, liquidation preferences, which, in our consideration for a VC, this may be while pay-to-play tends to be value- data, are almost always 1x for something to take into account.” enhancing. I should be careful to first-round financings.”
30 PRIVATE EQUITY FINDINGS 2020 PRI VATE Are there any questions from this study that you would be interested in EQUITY pursuing further?
“There is still a lot to be done. We FINDINGS would like to look at how characteristics of the VC firm and entrepreneur influence the contracts and their impact on a start-up’s value, as well as the Published by the Coller Research Institute, with the role of contracts in future investment support of Bladonmore and Bella Private Markets. rounds. We would also love to be able to say more about the role of invested amounts – for example, how much equity would an entrepreneur be willing Contributions from: to give up for another $10k in funding?” Brigham Young University Law School Carnegie Mellon University George Mason University “MOST ENTREPRENEURS UNDERSTAND THAT IF YOU Technical University of Munich GO WITH A BETTER VC, YOU The University of Arizona WILL END UP AGREEING TO University of Arkansas MORE INVESTOR-FRIENDLY TERMS. WE DO FIND THAT The University of Chicago Booth School of Business ENTREPRENEURS STILL University of Southern California Marshall School of Business BENEFIT FROM GOING WITH A HIGHER-QUALITY VC BECAUSE THESE INVESTORS ADD A LOT OF VALUE.”
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