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Master Thesis Identifying sub-categories within the Private Equity taxonomy for buyout funds Submitted by: Akshat Kshetrapal Student number: 11133295 Master in International Finance Supervisor: Dr. Jens Martin Submission Date: 31 August 2016 Amsterdam | 1018 GD | +31 683699797 | [email protected] Writn Acknowledgements ‘To end the work designed, a pair of hands needs but a thousand minds.’1 Indeed, it is hard to pay tribute to all who have helped me. Foremost, I would like to thank Prof. Jens Martin, whose passion for Private Equity, trust in my abilities and fantastic support motivated me throughout this process. Of my fellow students, I thank in particular Stanislav Butorin & Sander Tiemstra. Both of whom gave me the encouragement to stay the course. I would also like to thank the administrative department for their immense patience with me and my chaotic work-study-life balance. I am also indebted to the my superiors at PGGM Private Equity, who helped develop a more nuanced understanding of the field and gave me the motivation to use this thesis to answer some of the pertinent questions we face daily. Finally, I dedicate this work to my wife, who could have written this thesis in one night, using only her left hand and 5% of her mental capacity but instead she use this opportunity to teach me the values of hard work, dedication and artistic formatting. 1 Johann Wolfgang von Goethe’s words, adapted to meet my purpose: “To end the greatest work designed, A thousand hands need but one mind.” – Faust II, translated version published by Penguin Classics, London, 1959. Abstract This thesis investigates the taxonomy from Buyout funds with the objective of developing sub- categories within buyout funds. This thesis analyses IRRs of 217 funds within 4 identified sub- categories. We conclude that the 4 sub-categories are valid as they are sufficiently different from each other. We further establish that the dispersion within the sub-categories is lower in comparison to the main category. TABLE OF CONTENTS ACKNOWLEDGEMENTS 3 ABSTRACT 4 I. INTRODUCTION 1 II. LITERATURE REVIEW 4 A. REVIEW OF EXISTING RESEARCH 4 1. MACROECONOMIC IMPACT OF PRIVATE EQUITY 4 2. THE PRIVATE EQUITY FUND’S RELATIONSHIP WITH ITS INVESTEE COMPANIES 5 3. PERFORMANCE OF PRIVATE EQUITY 7 4. THE LP – GP RELATIONSHIP 7 B. IDENTIFYING THE GAP 9 C. INSTITUTIONAL BACKGROUND 12 III. DATA & METHODOLOGY 13 A. DATA 13 1. DATA SOURCE 13 2. DATA ATTRIBUTES 13 B. METHODOLOGY AND STRUCTURE OF RESEARCH 14 1. HYPOTHESIS BUILDING 14 2. CATEGORIZING FUNDS 16 3. NULL & ALTERNATIVE HYPOTHESIS 16 4. SELECTING THE SUITABLE VINTAGE 17 5. CONTROL VARIABLES 17 C. ANOVA 18 1. WHY ANOVA 19 2. SIGNIFICANCE OF THE FACTOR 19 3. A NOTE ON CAUSALITY 20 IV. VARIABLES & DESCRIPTIVE STATISTICS 21 A. DEPENDENT VARIABLE: IRR 21 22 B. INDEPENDENT VARIABLE: CATEGORIES 22 C. EYEBALLING THE DATA 24 1. TECHNOLOGY 24 2. HEALTHCARE 24 3. FINANCIAL SERVICES 25 4. DIVERSIFIED 25 V. ANOVA RESULTS & DISCUSSION 26 A. ANOVA RESULTS 26 1. DESCRIPTIVES OF THE RELATIONSHIP 26 2. TEST OF BETWEEN-SUBJECT EFFECTS 28 3. PARAMETRIC ESTIMATES 29 B. DISCUSSION OF RESULTS 30 1. 4 SUB-CATEGORIES HAVE A LOWER DISPERSION VIS-À-VIS THE MOTHER CATEGORY. 30 2. CATEGORY (TARGET INDUSTRY) HAS A SIGNIFICANT IMPACT ON IRR. 30 3. 4 SUB-CATEGORIES ARE DISTINCT FROM EACH OTHER. 31 VI. TESTING THE UNDERLYING ASSUMPTIONS 32 VII. CONCLUSION, LIMITATIONS AND FUTURE DIRECTIONS 34 VIII. REFERENCES 37 IX. APPENDIX 43 I. Introduction Private Equity has emerged as an important and rapidly growing asset class in the last 3 decades. Conceptually, Private Equity is a form of financing to which companies may turn during the course of their entire lifecycle. In the start-up stage, venture capital serves as one of the most crucial sources of funding. As the companies achieve scale, they seek growth capital from private equity. In mature stages of a company, private equity serves as a source of financing to middle-market firms and listed corporations. For corporations that are undergoing difficulties, the private equity market serves as an important source for turnaround capital that facilitates turnarounds. For each investment stage different private equity funds are raised by General Partners (GP) who are specialized in specific private equity market segments, the sources of capital are Limited Partners (LP) who represent institutional interests (such as pension funds, endowments) or high net worth individuals. PE funds are set up as limited partnerships between the fund manager and the main equity contributors. Such partnerships have a fixed life of about 10 years, with the possibility of extending them for about 3 more years (Kaplan and Stromberg, 2009). Typically, the fund invests its resources within 5 years of fund subscription and holds the target company for at most 5 to 8 years. This holding period and the resulting illiquidity truly differentiates private equity from other asset classes. PE funds usually acquire control, often the entire shareholdings, of companies. They target firms that are either already not-public i.e. their shares are not publicly traded, or firms that can be made not-public as the PE fund acquires such a significant shareholding to turn the firm private. Those activities require a long time horizon. Naturally, then, investments in those PE funds are therefore long-term and illiquid. Private equity offers relatively high expected return and low correlation to other asset classes, as a result PE can play a significant part in the portfolio allocation of diversifying investors. Average 1 yearly returns, measured usually as the internal rate of return (IRR), are usually estimated to be at least 10% (Gompers and Lerner, 2001; Jones and Rhodes-Kropf, 2003; Ljungqvist and Richardson, 2003; Kaplan and Schoar, 2005), and empirical studies suggest that investors should allocate between 5% and 10% of their portfolio to PE (Braun and Harhoff, 2005). However, the variance of returns on the level of the individual PE fund is quite high – the investors in these funds either receive very high returns or face a complete loss of investment (Weidig and Mathonet, 2004). It is crucial to reiterate: the high variance of returns from PE investments; and, the illiquid nature of the investment over a long time horizon These factors underscore the importance of carefully considered allocation to private equity by limited partners. The LP’s task is increasingly complex given the proliferation of various kinds of private equity funds. Private equity funds explain their investment style, strategy, geography and fund size in an objective statement, which is distilled into a fund objective category such as Growth, LBO, MBO, venture and geography specific attributes. These attributes are used by investors to assess and compare relative risk/return profiles and benchmarking. Private equity benchmark providers such as Burgiss grade fund performance by comparing the return earned by a fund with the returns of other funds in the same stated objective group. Academic research also uses the stated objectives for categorizing funds for various tests. This categorization based on investment objectives and classification implicitly assumes that funds of the same stated objectives are alike in their attributes. 2 These fund attributes – often limited to fund size, strategy and geography are often defined broadly and loosely (“that there is no bright-line distinction between ‘‘buyout’’ funds and ‘‘venture funds.’’ Importantly, large ‘‘buyout funds’’ can and do invest in small venture investments. Thus, the characteristics of the fund are the important distinguishing factors. These include the desire to syndicate and the use of connections. “ – Mark Humphery Jenner, 2003). Although there is quite a bit of literature of fund performance, the literature does not really attempt to categorise funds by type. The objective of this study is to develop sub-categories to the existing taxonomies of primary areas of concentration, and consequently evaluate if there are substantive similarities in the risk/return profiles and other attributes within these sub- categories. This thesis will attempt to develop new sub categories within the private equity asset class. We deem this a crucial contribution as it will facilitate better asset allocation within the private equity asset class. The LPs will be able to better organise their portfolios using the sub-category specific risk-return attributes and thus reap better risk adjusted returns. We hypothesize that specific and narrower sub categories can be developed from within the broad taxonomy that is presently applied to private equity. The sub categories would have lower dispersion of performance and therefore higher predictability. This thesis will further evaluate whether there exists a statistically significant difference within these categories so as to qualify them as different from one another. The rest of this paper is structured as follows: Section 2 presents a number of relevant studies. Section 3 provides details on the data, its attributes and our methodology for identifying and developing sub categories. Section 4 contains the main empirical results of the research, while Section 5 concludes. 3 II. Literature Review This section2 reviews and analyses the related academic literature on Private Equity with the objective of better placing this research in the context prior work and hence underlining its motivation. A. Review of existing research In my review, I found 4 emergent themes in the academic literature pertaining to Private Equity. These were (1) Macroeconomic impact of PE; (2) interaction between a PE fund and its portfolio companies; (3) Interactions between LPs and PE funds; (4) Performance of PE funds. 1. Macroeconomic impact of Private Equity Justifiably, the research in this field is split into research on either VC funds or buyout (PE) funds. This is because both kinds of funds have different macroeconomic impact. Venture Capital is nurtures start-up activity while buyouts target more mature organisations.

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