Private Equity Fund Investments: New Insights on Alignment of Interests, Governance, Returns and Forecasting

295 Pages·2015·5.83 MB·English

by  Cyril Demaria

Global Financial Markets
Global Financial Markets is a series of practical guides to the latest financial market
tools, techniques and strategies. Written for practitioners across a range of disciplines it
provides comprehensive but practical coverage of key topics in finance covering strategy,
markets, financial products, tools and techniques and their implementation. This series
will appeal to a broad readership, from new entrants to experienced practitioners across
the financial services industry, including areas such as institutional investment; finan-
cial derivatives; investment strategy; private banking; risk management; corporate
finance and M&A, financial accounting and governance, and many more.
Titles include:
Erik Banks
DARK POOLS, 2nd Edition
Off-Exchange Liquidity in an Era of High Frequency, Program and Algorithmic Trading
Erik Banks
LIQUIDITY RISK
Managing Funding and Asset Risk
Daniel Capocci
THE COMPLETE GUIDE TO HEDGE FUNDS AND HEDGE FUND STRATEGIES
Sandy Chen
INTEGRATED BANK ANALYSIS AND VALUATION
A Practical Guide to the ROIC Methodology
Frances Cowell
RISK-BASED INVESTMENT MANAGEMENT IN PRACTICE 2nd Edition
Jawwad Farid
MODELS AT WORK
A Practitioner’s Guide to Risk Management
Guy Fraser-Sampson
INTELLIGENT INVESTING
A Guide to the Practical and Behavioural Aspects of Investment Strategy
Michael Hünseler
CREDIT PORTFOLIO MANAGEMENT
A Practitioner’s Guide to the Active Management of Credit Risks
Roger Leeds
PRIVATE EQUITY INVESTING IN EMERGING MARKETS
Opportunities for Value Creation
Felix Lessambo
THE INTERNATIONAL CORPORATE GOVERNANCE SYSTEM
Audit Roles and Board Oversight
Ross K. McGill
US WITHHOLDING TAX
Practical Implications of QI and FATCA
David Murphy
OTC DERIVATIVES, BILATERAL TRADING AND CENTRAL CLEARING
An Introduction to Regulatory Policy, Trading Impact and Systemic Risk
99778811113377440000338833__0011__pprree..iinndddd ii 11//1144//22001155 1100::3300::1100 AAMM
Gianluca Oricchio
PRIVATE COMPANY VALUATION
How Credit Risk Reshaped Equity Markets and Corporate Finance Valuation Tools
Andrew Sutherland and Jason Court
THE FRONT OFFICE MANUAL
The Definitive Guide to Trading, Structuring and Sales
Michael C. S. Wong and Wilson F. C. Chan (editors)
INVESTING IN ASIAN OFFSHORE CURRENCY MARKETS
The Shift from Dollars to Renminbi
Global Financial Markets series
Series Standing Order ISBN: 978–1–137–32734–5
You can receive future titles in this series as they are published by placing a standing order. Please
contact your bookseller or, in case of difficulty, write to us at the address below with your name and
address, the title of the series and the ISBN quoted above.
Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire
RG21 6XS, England
99778811113377440000338833__0011__pprree..iinndddd iiii 11//1144//22001155 1100::3300::1100 AAMM
Private Equity Fund
Investments
New Insights on Alignment of Interests,
Governance, Returns and Forecasting
Cyril Demaria

99778811113377440000338833__0011__pprree..iinndddd iiiiii 11//1144//22001155 1100::3300::1100 AAMM
© Cyril Demaria 2015
Foreword © Olivier Carcy 2015
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 6–10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The author has asserted his right to be identified as the author of this work
in accordance with the Copyright, Designs and Patents Act 1988.
First published 2015 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries
ISBN: 978–1–137–40038–3
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
Demaria, Cyril.
Private equity fund investments : new insights on alignment of interests,
governance, returns and forecasting / Cyril Demaria.
pages cm. — (Global financial markets)
ISBN 978–1–137–40038–3 (hardback)
1. Private equity funds. 2. Investments. I. Title.
HG4751.D456 2014
332.63—dc23 2014026511
99778811113377440000338833__0011__pprree..iinndddd iivv 11//1144//22001155 1100::3300::1111 AAMM
Contents
List of Figures x
List of Tables xii
Foreword xiv
Olivier Carcy
Acknowledgments xvi
List of Abbreviations and Acronyms xvii
0 Introduction 1
0.1 Problem analysis 2
0 .1.1 L imited partners: irrational investors subject to
biases 3
0 .1.1.1 L imited partners: irrational investors 3
0 .1.1.2 C ontext of investment: intrinsic and
extrinsic factors 7
0 .1.1.3 C urrent regulations (until 2007) 10
0 .1.1.4 N ew regulations (from 2007) 13
0 .1.2 G eneral partners are not subject to effective
corporate governance 13
0.1.3 D eclining marginal returns: the defining moment
of LP-GP relationships 15
0.2 Research objective 16
0.3 Methodology 20
0.4 Terminology 21
0.4.1 Private equity: definition 21
0 .4.1.1 P rivate equity: sectors included 22
0 .4.1.2 P rivate equity: sectors excluded 23
0.4.1.3 P rivate equity funds 25
0 .4.2 L imited partners: definition 28
0 .4.3 L imited partners: categorization and motivations 28
0 .4.3.1 F amily offices and high net worth
individuals 31
0 .4.3.2 F oundations and endowments 37
0 .4.3.3 S overeign wealth funds and governmental
agencies 4 3
0 .4.3.4 F unds-of-funds and gatekeepers 46
0 .4.3.5 P ublic and private pension funds 48
v
99778811113377440000338833__0011__pprree..iinndddd vv 11//1144//22001155 1100::3300::1111 AAMM
vi Contents
0 .4.3.6 I nsurance groups 55
0.4.3.7 B anks 5 6
0 .4.4 G eneral partners: definition 58
0.4.5 C orporate governance: definition 60
0.5 Framework 62
0 .5.1 M arket inefficiencies in private equity 62
0 .5.1.1 G eneral inefficiencies of the financial
markets 6 2
0.5.1.2 I nefficiencies specific to private equity 63
0 .5.2 C orporate governance in private equity 63
0 .5.2.1 M oral hazards in private equity 64
0 .5.2.2 I nformal governance levers in private
equity 6 4
0.5.2.3 F ormal governance levers in private
equity: LPA and other mechanisms 67
0 .5.3 S election of general partners and motivations of
limited partners 100
0 .5.3.1 G eneral partners selection process and
evolution 1 02
0 .5.3.2 G eneral partner selection: agency theory
and critiques 105
0.5.3.3 C onsequences: LPs motivation, GP selection
and portfolio construction 106
0 .5.4 R isks in private equity 111
0 .5.5 L iquidity and time horizon 114
1 Suboptimal Risk–Return Profiles in Private Equity: The Case of
Minority Business Enterprises Investing 117
1.1 Research question 120
1.2 Method 124
1.3 Results and discussion 125
1.4 Conclusion and further discussions 1 33
1 .4.1 A necdotal confirmation of the conclusions 133
1 .4.2 E mpirical confrontation of the conclusions, and
rebuttal 134
1.4.3 F urther discussion: investing in underprivileged
markets 137
1.5 Summary and contribution to the research 1 38
2 Fee Levels, Performance and Alignment of Interests in
Private Equity 1 41
2.1 Empirical framework and literature 1 43
2 .1.1 P rivate equity returns: measures 143
2 .1.1.1 A bsolute measures of performances 143
2.1.1.2 R elative measures of performances 144
99778811113377440000338833__0011__pprree..iinndddd vvii 11//1144//22001155 1100::3300::1111 AAMM
Contents vii
2 .1.2 P rivate equity risks assumptions 149
2.1.3 L imits of current benchmarking methodologies and
indexes chosen 150
2.2 Data and methodology 153
2 .2.1 D rawdowns 154
2 .2.2 D istributions 154
2 .2.3 D ata description 156
2 .2.4 S election of indexes 156
2.2.5 D ata processing and methodology 157
2.3 Analysis and findings 1 63
2 .3.1 A nalysis of the paid-in to committed capital ratios 163
2 .3.2 A nalysis of the management fees and the carried
interest 167
2 .3.2.1 U S VC 1 67
2 .3.2.2 U S LBO 1 72
2 .3.2.3 E MEA VC 1 73
2.3.2.4 E MEA LBO 174
2.3.3 T op-quartile US VC, US LBO, EMEA VC, and EMEA
LBO funds 174
2.3.4 A nalysis of the performances of funds 174
2 .3.4.1 T he carried interest has no material impact
on the relative performance of funds 175
2 .3.4.2 A verage American funds have better IRRs;
indexes better multiples 175
2 .3.4.3 E MEA funds show a very distinct
performance landscape 176
2 .3.4.4 T iming of cash flows can explain part
of the performance of top-quartile fund
managers 177
2.3.4.5 A partial confirmation of performance
cycles in private equity 184
2.4 Conclusion, discussion and limits 1 84
2 .4.1 U se for academic purposes 184
2 .4.2 U se for practitioners 185
2.4.3 L imitations 185
2.5 Summary and contribution to the research 1 86
3 The Predictive Power of the J-Curve 189
3.1 Empirical framework and literature 1 91
3 .2 Data and methodology 192
3.2.1 I nterpretation of drawdowns 192
3 .2.2 I nterpretation of distributions 193
3 .2.3 D ata description and cycles identification 193
3.2.4 D ata processing and methodology 198
99778811113377440000338833__0011__pprree..iinndddd vviiii 11//1144//22001155 1100::3300::1111 AAMM
viii Contents
3.2.4.1 First step: data retrieval 198
3.2.4.2 Second step: sorting data 198
3.2.4.3 Third step: data aggregation in fund categories
(ideal types) and graphical illustration 198
3.2.4.4 Fourth step: determining the potential
predictive power of the J-curve of
performances 199
3.2.4.5 Fifth step: assessment of the reliability of the
J-curves to predict future performances 209
3.3 Analysis and findings 2 09
3 .3.1 A nalysis of the paid-in to committed capital
(PICC) ratios 209
3 .3.2 G raphical analysis of the J-Curves 210
3 .3.3 F irst predictor of performance: the time to
breakeven 215
3 .3.4 I deal-type categories need to be adapted to
each market 215
3 .3.5 R eading graphical representations is insufficient
for tentative performance predictions 216
3 .3.6 C orrelation analysis of the J-Curves 216
3 .3.6.1 U S VC 2 16
3 .3.6.2 U S LBO 2 17
3 .3.6.3 E MEA VC 2 22
3.3.6.4 E MEA LBO 222
3 .3.7 C orrelations first eliminate categories and then
indicate the closest comparable 223
3.3.8 T he predictive power of the J-Curve 223
3.4 Conclusion, discussion and limitations 2 33
3.4.1 U se for academic purposes 234
3 .4.2 U se for practitioners and regulators 235
3 .4.3 L imitations 235
3.4.4 F urther developments 236
3.5 Summary and contribution to the research 2 36
4 General Conclusion 2 38
4.1 Summary 239
4.2 Discussion 240
4 .2.1 C onsequences on extra-financial endeavors in
private equity 240
4 .2.1.1 A ddressing the extra costs associated with
additional extra-financial criteria 241
4 .2.1.2 A ddressing the signaling effect associated
with additional extra-financial criteria 242
4.2.1.3 A ddressing extra risks associated with
additional extra-financial criteria 242
99778811113377440000338833__0011__pprree..iinndddd vviiiiii 11//1144//22001155 1100::3300::1111 AAMM
Contents ix
4 .2.2 C onsequences for the treatment of private equity
under solvency and prudential ratios 243
4.2.3 C onsequences on the relationship between
LPs and GPs 246
4.3 Outlook 249
4 .3.1 C onsequences on the communication from GPs 249
4 .3.2 C onsequences on the behavior of LPs 250
4 .3.3 P erspectives for further academic and empirical
research 251
References and Bibliography 253
Index 265
99778811113377440000338833__0011__pprree..iinndddd iixx 11//1144//22001155 1100::3300::1111 AAMM