University of Texas Roundtable on LP Perspectives on the State of Private Equity

In this wide‐ranging discussion among four limited partner investors in private equity, the LPs commented on the rates of return they expect from PE, the fees they pay their general partners, and the length of their time commitments to PE investments. After noting the enormous growth in the value of assets under private management, and the reduction in public equity investment by many large institutional investors, each of the four LPs said that their institutions expected to maintain or continue to increase their proportion of portfolio investment in PE. The LP panelists were virtually unanimous in expecting PE rates of return in the 9%‐11% range, as compared to 7%‐8% for public equities. The panelists also seemed to agree that although committing to PE investments for terms longer than the traditional seven to ten years could result in higher returns and lower costs, they were reluctant to make such commitments because they valued the financial flexibility afforded by shorter holding periods. Several LPs claimed that their institutions were scrutinizing the explicit and implicit fees charged by the GPs, and the level of fees was encouraging LPs to co‐invest in deals alongside the GPs. And in response to a closing suggestion that the recent flurry of IPOs could signify the beginning of a major reversal away from private capital, another LP expressed strong doubt, noting that “the private ownership model has clearly shown superior governance, and greater ability to manage leveraged capital structures and create value than public companies over the long term.”     

Private Equity: Accomplishments and Challenges

The authors provide an overview of the main accomplishments of private equity since the emergence of leveraged buyouts in the 1980s, and of the challenges now facing the industry—challenges that have been encountered before during three major growth waves and two full boom‐and‐bust cycles. In so doing, the authors review a large and growing body of academic studies responding to questions like these:

• (1) How have PE buyout companies performed relative to their public counterparts? And to the extent there have been improvements in operating performance and productivity gains, how have such gains been achieved? What role have PE firms played in this process?
• (2) Especially in light of the large fees and profit shares paid to the PE firms, or GPs, and the significant “control” premiums over market paid to the selling companies, how have the returns to the LPs that provide the bulk of the funding for PE funds compared to the returns earned by the shareholders of comparable public companies?
• (3) Apart from the high fees earned by its GPs, why is PE so controversial? Beyond their effects on productivity and benefits for investors, what are the employment and other social effects of buyouts and PE?
• (4) What are the prospects for future PE returns to their LPs, especially in light of the volume of capital commitments and high purchase multiples that were being paid, at least until the onset of the COVID pandemic? And what role, if any, should PE activity be expected to play in the recovery from the pandemic?

     

Morgan Stanley Roundtable on The State of Global Private Equity

In this discussion led by Alan Jones, Morgan Stanley's head of Global Private Equity, the University of Chicago's Steve Kaplan begins by surveying 25 years of academic research on private equity. Starting with Kaplan's own Ph.D. dissertation on leveraged buyouts during the 1980s, finance academics have provided a large and growing body of studies documenting the ability of private equity firms to make “sustainable” (that is, maintained over a three‐ or four‐year period) improvements in the operating performance of their portfolio companies, whether operating abroad or in the U.S. Even more impressive, the findings of Kaplan's new study (with Tim Jenkinson of Oxford and Bob Harris of the University of Virginia) suggest that these improvements have been large enough to enable PE funds raised between 1990 and 2008 to deliver returns to their limited partners that have averaged 300 to 400 basis points higher per year than the returns to the S&P 500. And given the “persistence” of PE fund returns—the tendency of the funds of the same PE firms to show up in the top quartile of performers year after year—that Kaplan has documented in earlier work, the performance of private equity seems notably different from that of mutual funds and hedge funds, where there has been little if any consistency in the returns provided by the top performers. Following Kaplan's overview of the research, four representatives of today's leading private equity firms explore questions like the following:

• ? How do the best PE firms, after paying premiums to acquire their portfolio companies and collecting large management fees, provide such consistently high returns to their limited partners?
• ? How did PE portfolio companies perform during the last recession, when many popular business publications were predicting the death of private equity—and what, if anything, does that tell us about how private equity adds value?
• ? What can PE firms do to avoid, or at least limit the damage from, the overpricing and overleveraging that tend to occur near the end of the boom‐and‐bust cycle that appears to be a permanent feature of private equity?

As Jones notes in his opening comments, the practitioners' answers to such questions “should help investors distinguish between the alpha that the firms represented at this table have generated through active management from the ‘closet beta’ that critics say results when private equity firms simply create what amounts to a levered bet on the public equity markets.”     

Should Asset Managers Hedge Their “Fees at Risk”?

Although the recent financial crisis afflicted all asset managers, the problem of general market exposure was in some respects worse for the long-only funds that rely almost completely on asset-based fees than for the “absolute return” and other kinds of hedge funds that also receive performance-based fees. While the revenue generated by performance-based fees is expected to be volatile, asset-based fees tend to be viewed as an “annuity” stream that involves little or no earnings risk. But, especially in the case of long-only funds, large shortfalls in asset fees were caused by the combination of significant redemptions and sharp reductions in assets under management that accompanied the plunge in asset prices. In this article, the author attempts to quantify the expected effect of market fluctuations on the asset fees and profitability of long-only asset managers. Having done so, he then argues that traditional long-only asset managers—managers whose only reason for being is their ability to generate above-market returns (or “alpha”) on a fairly consistent basis—routinely retain too much beta risk in their primarily asset-based fee structures. The author offers two main reasons for long-only asset managers to hedge beta risk: (1) it would reduce the need for fund management firms to hold liquid capital to ensure solvency and fund important projects during market downturns; (2) it would provide the firm's current and prospective clients with a clearer signal of whether its managers are succeeding in the firm's mission of generating alpha, as well as the possibility of more equity-like and cost-effective incentive compensation systems for those managers.     

Columbia Law School Roundtable on Public Aspects of Private Equity

The mandate of the broader private equity “ecosystem” goes well beyond earning competitive returns for the limited partners and their beneficiaries. After noting that PE investing is encountering ever larger “headline” and social risks, the panelists were in complete agreement that LPs should exert greater pressure on PE sponsors to take account of and try to address negative externalities when buying and operating their portfolio companies. Bain Capital's Double Impact Fund, for example, while always looking for ways of increasing profits and reducing risk, sets out to have a positive influence on its non‐investor stakeholders, including employees. To that end, Bain develops and tracks company‐specific metrics linked to positive outcomes, and then links those metrics to management compensation. And the director of ESG programs at the International Limited Partners Association points to ILPA's programs for diversity and inclusion as a promising model.     

Private Equity and Portfolio Companies: Lessons from the Global Financial Crisis

Critics of private equity have warned that the high leverage often used in PE‐backed companies could contribute to the fragility of the financial system during economic crises. The proliferation of poorly structured transactions during booms could increase the vulnerability of the economy to downturns. The alternative hypothesis is that PE, with its operating capabilities, expertise in financial restructuring, and massive capital raised but not invested (“dry powder”), could increase the resilience of PE‐backed companies. In their study of PE‐backed buyouts in the U.K.—which requires and thereby makes accessible more information about private companies than, say, in the U.S.—the authors report finding that, during the 2008 global financial crisis, PE‐backed companies decreased their overall investments significantly less than comparable, non‐PE firms. Moreover, such PE‐backed firms also experienced greater equity and debt inflows, higher asset growth, and increased market share. These effects were especially notable among smaller, riskier PE‐backed firms with less access to capital, and also for those firms backed by PE firms with more dry powder at the crisis onset. In a survey of the partners and staff of some 750 PE firms, the authors also present compelling evidence that PEs firms play active financial and operating roles in preserving or restoring the profitability and value of their portfolio companies.     

MANAGERIAL INCENTIVES AND CORPORATE DIVERSIFICATION STRATEGIES

Because the break-up of conglomerates typically produces substantial increases in shareholder wealth, many commentators have argued that the conglomerate form of organization is inefficient. This article reports the findings of a number of recent academic studies, including the authors' own, that examine the causes and consequences of corporate diversification. Although theoretical arguments suggest that corporate diversification can have benefits as well as costs, several studies have documented that diversified firms trade at a significant discount from their single-segment peers. Estimates of this discount range from 10–15% of firm value, and are larger for “unrelated” diversification than for “related” diversification. If corporate diversification has generally been a value-reducing managerial strategy, why do firms remain diversified? One possibility, which the authors label the “agency cost” hypothesis, is that top executives without substantial equity stakes may have incentives to maintain a diversification strategy even if doing so reduces shareholder wealth. But, as top managers' ownership stakes increase, they bear a greater fraction of the costs associated with value-reducing policies and are therefore less likely to take actions that reduce shareholder wealth. Also, to the extent that outside blockholders monitor managerial behavior, the agency cost hypothesis predicts that diversification will be less prevalent in firms with large outside blockholders. Consistent with this argument, the authors find that companies in which managers own a significant fraction of the firm's shares, and in which blockholders own a large fraction of shares, are significantly less likely to be diversified. If agency problems lead managers to maintain value-reducing diversification strategies, what is it that leads some of these same firms to refocus? The agency cost hypothesis predicts that managers will reduce diversification only if pressured to do so by internal or external mechanisms that reduce agency problems. Consistent with this argument, the authors find that decreases in diversification appear to be precipitated by market disciplinary forces such as block purchases, acquisition attempts, and management turnover.     

The impact of financial reporting flexibility on auditor risk judgement: Evidence from the implementation of FIN 46R

This paper investigates how auditors respond, in terms of their pricing and audit work, to a reduction of clients’ financial reporting discretion upon the implementation of FIN 46R, which requires firms to consolidate the variable interest entities (VIE) under their control. Using a difference-in-differences research design, we find that auditors charge relatively fewer audit fees and have shorter audit report lags for firms that are significantly affected by FIN 46R, compared to a group of control firms. This result concurs with the view that auditors react favorably to the reduction of clients’ financial reporting discretion. Our finding is concentrated among clients with higher accrual earnings management constraints, auditors with less client-specific knowledge, and auditors who have no recent experience of audit failures (e.g., severe client restatements). Our results are robust to alternative identifications of treatment and control samples, and our conclusion remains valid after controlling for the contemporaneous adoption of Sarbanes-Oxley (SOX) Act. We also show that the relatively reduced audit fees and audit effort do not lead to the deterioration of audit quality.     

Board 3.0: What the Private‐Equity Governance Model Can Offer Public Companies∗

The authors view board structures as an adaptive institution that responds to the key challenges faced by public companies: helping management solve the problems of production and organization of large‐scale enterprise; limiting managerial agency costs; serving as a delegated monitor of the firm's compliance obligations; and responding to the governance environment of changing shareholder ownership patterns. U.S. company board structures are shown to have evolved over time, often through discontinuous lurches, as particular functions have waxed and waned in importance. This article is part of a larger project that traces two iterations of the public company board, what the authors call Board 1.0 (the “advisory board”) and Board 2.0 (the “monitoring board”). The authors argue in particular that Board 2.0, as embedded in both current practice and regulation, now fails the functional fit test for many companies. First, it does not scale to match the dramatic increase in the size and complexity of many modern public corporations. Second, at a time of reconcentrated ownership achieved through institutional investors and increased activism, it does not have the expertise and commitment needed to resolve the tension between managerial or market myopia, or “short‐termism,” and managerial “hyperopia.” This article holds out an optional alternative, Board 3.0, which would bring to the public company board some strategies used by private equity firms for their portfolio company boards. Such “Portco” boards consist of directors who are “thickly informed,” “heavily resourced,” and “intensely interested.” Bringing such “empowered directors” to public company boards could facilitate evolution of the public company board model in response to dramatic changes in the corporate business environment. The authors also suggest possible routes for implementing Board 3.0, including the enlisting of PE firms as “relational investors” that would have both capacity and incentives to engineer changes in board structure.     

Private Equity in the U.S.: Building a New Future

Despite the recent downturn, private equity firms still have an important role to play in the global economy. At the same time, many PE firms may need to rethink their strategies. Practices that have been worked in the past may not produce acceptable returns in a future, particularly given the current constraints on financing and leverage. One source of PE's comparative advantage, as demonstrated during the recent crisis, has been the ability of the best and most experienced firms to reorganize their portfolio companies when they get into financial trouble. But in addition to their financial management skills, specialized operating expertise has become more critical to success, and those PE firms that have not acquired it are especially likely to find that past success in raising capital is no guarantee of success in the future. The authors begin by providing a brief overview of the past three decades of global private equity to identify how the market arrived at its current position. Using the findings of academic research together with case studies and interviews with PE practitioners in the U.K., the authors suggest a number of building blocks for the future that reflect the considerable success of the most reputable and experienced PE firms in increasing the value of their portfolio companies.     

The Future of Private Equity

A distinguished University of Chicago financial economist and longtime observer of private equity markets responds to questions like the following:

• ? With a track record that now stretches in some cases almost 30 years, what have private equity firms accomplished? What effects have they had on the performance of the companies they invest in, and have they been good for the economy?
• ? How will highly leveraged PE portfolio companies fare during the current downturn, especially with over $400 billion of loans coming due in the next three to five years?
• ? With PE firms now sitting on an estimated $500 billion in capital and leveraged loan markets shut down, are the firms now contemplating new kinds of investment that require less debt?
• ? If and when the industry makes a comeback, do you expect any major changes that might allow us to avoid another boom‐and‐bust cycle? Have the PE firms or their investors made any obvious mistakes that contribute to such cycles, and are they now showing any signs of having learned from those mistakes?

Despite the current problems, the operating capabilities of the best PE firms, together with their ability to manage high leverage and the increased receptiveness of public company CEOs and boards to PE investments, have all helped establish private equity as “a permanent asset class.” Although many of the deals done in 2006 and 2007 were probably overpriced, the “cov‐lite” deal structures, deferred repayments of principal, and larger coverage ratios have afforded more room for reworking troubled deals. As a result of that flexibility, and of the kinds of companies that get taken private in leveraged deals in the first place, most troubled PE portfolio companies should end up being restructured efficiently, thereby limiting the damage to the overall economy. Part of the restructuring process involves the use of the PE industry's huge stockpile of capital to purchase distressed debt and inject new equity into troubled deals (in many cases, their own). At the same time the PE firms have been working hard to rescue their own deals, some have been taking significant minority positions in public companies, while gaining some measure of control. Finally, to limit overpriced and overlev‐eraged deals in the future, and so avoid the boom‐and‐bust cycle that appears to have become a predictable part of the industry, the discussion explores the possibility that the limited partners and debt providers that supply most of the capital for PE investments will insist on larger commitments of equity by sponsors to their own funds and individual deals.     

Information sharing between mutual funds and auditors

This paper examines whether there is information sharing between mutual funds and their auditors about the auditors’ other listed firm clients. Using data from the Chinese market, we find that mutual funds earn higher profits from trading in firms that share the same auditors. The effects are more pronounced when firms have a more opaque information environment and when the audit partners for the fund and the partners for the listed firm share school ties. The evidence is consistent with information flowing from auditors to mutual funds, providing mutual funds with an information advantage in firms that share the same auditors. Our findings are robust to the use of audit-firm mergers and acquisitions (M&As) as exogenous shocks and several other robustness checks. We further find that auditors benefit by charging higher audit fees for mutual fund clients and by improving their audit quality for listed firm clients. Our study provides evidence of bi-directional information sharing between two important market intermediaries.     

How Much Do Private Equity Funds Benefit From Debt‐related Tax Shields?

In 2008 the German government enacted a measure designed to curb excessive leverage in LBOs by limiting tax‐deductible interest to 30% of EBITDA. And in the U.S., legislators are currently reviewing several regulatory measures, including limits on tax‐deductible interest, that are intended to reduce the leverage of portfolio companies in U.S. LBO funds. In their recent study of 56 German LBOs transacted after the tax law change in 2008, the authors analyze the importance of debt‐related tax savings and the economic consequences of their reduction for the PE business model. The study begins by confirming that LBO debt tax shields are a material component of LBO purchase prices, contributing as much as 20% of the average estimated total enterprise value. At the same time, however, the study finds that the effects on LBO fund returns of limits to the taxdeductibility of LBO interest payments are likely to be modest, in part because a large portion of the value from expected tax savings is effectively paid for upfront by the private equity firm in the form of higher LBO purchase prices. Moreover, the authors do not expect to see LBO funds change their business model in response to this change in taxdeductibility. Based on their findings, the authors expect neither a significant decline in LBO leverage nor a notable change in the pricing of PE deals. As finance scholars have suggested, there are significant benefits associated with the use of debt that have nothing to do with the tax shield provided by the deductibility of interest. The authors' results provide yet another piece of evidence suggesting that taxes have at most a second‐order effect on corporate financing decisions—and that the gains to private equity come mainly from improvements in operating performance.     

Do stressed PE firms misbehave?

For private equity (PE) firms, follow-on funds provide additional streams of management fees for a considerable time. When prospective investors evaluate the performance of PE firms' latest funds, they have to rely on valuations reported by PE firms. The link between PE firms' fundraising and performance evaluation is thus an area susceptible to manipulation resulting in potentially high stakes. We examine the relationship between PE firms' fundraising pressure and earnings management in portfolio companies, along with heterogeneity in behaviour by reputation and dry powder. To proxy for the degree of fundraising pressure, we develop an index based on PE firms' affiliations, stage in the fundraising cycle, and fundraising frequency. Results suggest that the fundraising pressure leads to more earnings management in portfolio companies, regardless of PE firm reputation. While the reputational effect remains unchanged under a change in funding pressure, dry powder exhibits a strong moderating effect under extreme funding pressure. The results are robust to alternative proxies for earnings management, alternative fundraising indexes, and various controls for endogeneity concerns.     

EQT: Private Equity with a Purpose

The primary factors driving the remarkable growth of private equity have been the industry's attractive and stable returns in combination with its active ownership model. Nevertheless, critics have been questioning whether the PE industry can maintain its historic returns, and challenging its fee and incentive structures as well as its notable lack of transparency and diversity. And the alleged systemic effects of the industry on social problems like income inequality and climate change have become large enough to create a perceived threat to PE's long‐term “license to operate.” In this article, the authors discuss the commitment of EQT, the publicly listed and Stockholm‐headquartered private markets firm (and eighth largest PE fundraiser in the world), to the “future‐proofing” of both its portfolio companies and the company itself. The company envisions itself as undertaking a “journey” toward sustainability and positive impact and, in so doing, furnishing a model that other PE firms might find useful in helping “future‐proof” the entire industry. As part of that commitment, EQT recently published a “Statement of Purpose” signed by its the board of directors that focuses a societal impact lens on its entire portfolio of companies and assets, reinforces its public commitments to diversity and other “clean and conscious” practices, and aims to leverage digital technologies to enhance financial returns and real‐world outcomes. Transparency and a mindset focused on achieving positive impact are the keys to PE's earning high and stable returns and to securing its long‐term license to operate.     

The effects of audit technology on auditor efficiency: Auditing and the timeliness of client earnings announcements

The organizational theory and sociology literatures have long been concerned with the concept of structure, both as a dependent and an independent variable. Relatively recently, auditing researchers have found that public accounting firms differ in the degree of structure their audit technologies exhibit, and that the voting pattern of the Auditing Standards Board appears to be influenced by its members' firm affiliations with respect to their structure orientation. To date, however, the influence of accounting firm structure on client financial reporting characteristics has not been to subjected study.The purpose of this article is to examine hypothesized relationships between the structure orientation of public accounting firms and client earnings announcement dates, expressed in terms of “early” vs “late”. In addition, the impact of the nature of information conveyed, expressed in terms of surprise “good news” or “bad news”, is studied. Empirical evidence drawn from the Wall Street Journal Index, COMPUSTAT and a prior classification of Big Eight firm audit technologies with respect to structure, suggests that systematic relationships do exist. Implications for future research and audit practice are discussed.     

CARE Conference Hong Kong Polytechnic University,June 9, 2014: Equity Financing for Early‐Stage Companies in China

Many of the smaller private‐sector Chinese companies in their entrepreneurial growth stage are now being funded by Chinese venture capital (VC) and private equity (PE) firms. In contrast to western VC markets, where institutional investors such as pension funds and endowments have been the main providers of capital, in China most capital for domestic funds has come from private business owners and high net worth individuals. As relatively new players in the market who are less accustomed to entrusting their capital to fund managers for a lengthy period of time, Chinese VCs and their investors have shown a shorter investment horizon and demanded a faster return of capital and profits. In an attempt to explain this behavior, Paul Gompers and Josh Lerner of Harvard Business School have offered a “grandstanding hypothesis” that focuses on the incentives of younger, less established VCs to push their portfolio companies out into the IPO market as early as they can—and thus possibly prematurely—to establish a track record and facilitate future fundraising. This explanation is supported by the under‐performance of Chinese VC‐backed IPOs that has been documented by the author's recent research. Although they continue to offer significant opportunities for global investors, China's VC and PE markets still face many challenges. The supervisory system and legal environment need further improvement, and Chinese funds need to find a way to attract more institutional investors—a goal that can and likely will be promoted through government inducements.     

Private Equity 4.0: Using ESG to Create More Value with Less Risk

A growing number of private equity firms have responded to the increased focus on climate change, social issues, and technology disruption by broadening their corporate mission to encompass all important stakeholders, as well as their limited partners. And in the process, the management of ESG risks and pursuit of ESG opportunities have become increasingly fundamental to the staying power and value creation potential of PE firms by reducing the risk of their investments, discovering new sources of growth, and increasing their resilience to changes in the political and regulatory environment. This article tells the story of how the Nordic PE firm, Summa Equity, has turned its ESG approach into a core competence and a source of competitive advantage that has enabled the firm to distinguish itself from its competitors and bring about significant improvements in the financial performance of its portfolio companies while providing benefits for their stakeholders. Using the U.N. Sustainable Development Goals to guide them, the firm invests in companies they perceive to be addressing major environmental or social challenges in an innovative and commercially successful way. This has led to investments in significant growth opportunities in areas such as health care, education, waste management, and acqua‐culture. And the firm's returns to its investors have been high enough—and the perceived social benefits large enough—that the firm recently closed its second fund (which was significantly oversubscribed) for 650 million euros, and received the ESG award at the 2019 Private Equity Awards in London.     

Institutional affiliation and the role of venture capital: Evidence from initial public offerings in Japan

The presence of venture capital in the ownership structure of U.S. firms going public has been associated with both improved long-term performance and superior “certification” at the time of the initial public offerings (IPOs). Many of the major venture capital firms in Japan are subsidiaries of securities firms that may face a conflict of interest when underwriting the venture capital-backed issue. In Japan, we find the long-run performance of venture capital-backed IPOs to be no better than that of other IPOs, with the exception of firms backed by foreign-owned or independent venture capitalists. When venture capital holdings are broken down by their institutional affiliation, we find that firms with venture backing from securities company subsidiaries do not perform significantly worse over a 3-year time horizon than other IPOs. On the other hand, we find that IPOs in which the lead venture capitalist is also the lead underwriter have higher first-day returns than other venture capital-backed IPOs. The latter result suggests that conflicts of interest influence the initial pricing, but not the long-term performance, of IPOs in Japan.     

Exploring the transitional behavior among value and growth stocks

Unlike the corporate funds in the US, mutual funds in many countries such as China and Germany operate under a different governance arrangement and are thus called “contractual funds.” The governance structure of contractual funds allows shareholders of fund management companies, rather than the fund investors, to be responsible for asset management decisions. Therefore, a fund’s governance attributes may be especially important in driving its performance. Using a comprehensive governance data covering Chinese mutual funds, this paper finds that the governance and organizational structures of Chinese fund management companies significantly influence the performance of their affiliated funds. In particular, while a larger stake from the top1 shareholder significantly improves the performance of affiliated funds, the presence of multiple largest shareholders reduces their performance. Moreover, fund management companies that offer fewer fund products and charge higher management fees tend to perform better. Finally, more institutional holding in a fund appears to function as an external supervisory surrogate for internal board governance to help improve fund performance.