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Venture Capital and Private Equity Fund Management, Fund Raising, and Regulation

Venture Capital and Private Equity Fund Management, Fund Raising, and Regulation. Cumming & Johan (2013, Chapter 4). 1. Chapter Objectives. Part I: What do institutional investors care about? Who are institutional investors in venture capital and private equity funds,

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Venture Capital and Private Equity Fund Management, Fund Raising, and Regulation

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  1. Venture Capital and Private Equity Fund Management, Fund Raising, and Regulation Cumming & Johan (2013, Chapter 4) 1

  2. Chapter Objectives • Part I: What do institutional investors care about? • Who are institutional investors in venture capital and private equity funds, • Analyze economic and regulatory considerations factors relevant to VC/PE investment, • Distinguish between fund commitments and draw downs, • Distinguish between direct fund investment, direct company investment and fund-of-funds investment, • Consider expected rates of return from investment in venture capital and private equity, • Part II: Fundraising • Empirically consider the effect of regulation of institutional investors and private equity funds relative to market factors, among other things, on institutional investor capital allocations to private equity funds. • Part III: Specialized fund mandates • Socially responsible investment mandates in particular, • Empirically compare the importance of an institution’s internal organization structure versus legal and economic factors driving socially responsible private equity investment. 2

  3. Chapter 4. Part I What do institutional investors care about? 3

  4. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.3. Current allocation to private equity Yes 29% No 71% Illustrative Data: Dutch Institutional Investment in PE worldwide, 2004 4

  5. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Capital Commitments / Assets 5

  6. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Drawdowns, not Commitments – Important re Desired Exposure 6

  7. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.6. Current private equity allocation by type of investment Direct Company Investment 20% Fund of Funds Investment 40% Direct Fund Investment 40% Modes of Investment 7

  8. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.7. Current private equity allocation by region of investment R.o.W. 2% Asia 3% The Netherlands 22% U.S. 27% Europe Excluding The Netherlands 46% A Global Market 8

  9. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.8. Country breakdown by type of investment 70% 60% 58% 53% 50% 50% 50% 48% 47% 44% 40% 40% 36% Direct company investments Direct fund investments 31% Fund of funds investments 28% 30% 20% 9% 10% 6% 0% 0% 0% The Netherlands Europe Excluding The U.S. Asia R.o.W. Netherlands Mode of Investment Depends on Internationalization

  10. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.9. Future allocation to private equity (planned for 2006-2010) Yes 35% No 65% Growth in PE Investment 10

  11. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Data Capital Commitments vsDrawdowns Modes of Investment Globalization Growth & Institutional Investor Concerns Figure 4.10. Attractiveness of private equity segments within 2006-2010 4.1 Portfolio diversification 3.9 Increase of the relative return Balanced portfolio (looking at correlation of 3.5 private equity to other asset classes) Reaching a yearly positive return over the entire 3.5 period of the commitment 3.3 Risk diversification 2.2 Corporate objectives 2.0 Non-financial objectives 1.4 Others 1 2 3 4 5 Unimportant Important What Institutional Investors Care About 11

  12. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Targeted Returns Absolute Return Expectations Relative Return Expectations Return Benchmarks Performance Figures Return Expectations 12

  13. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Targeted Returns Absolute Return Expectations Relative Return Expectations Return Benchmarks Performance Figures Figure 4.11. Absolute return sought from private equity investments 35.00% 30.00% 25.00% 20.00% Percentage of Respondents 15.00% 10.00% 5.00% 0.00% 4 6 8 10 12 14 16 18 20 Targeted Absolute Return % Absolute Return Expectations 13

  14. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Targeted Returns Absolute Return Expectations Relative Return Expectations Return Benchmarks Performance Figures Figure 4.12. Targeted relative rate of return: private equity net of public equity returns (in basis points) 40.00% 35.00% 30.00% 25.00% Percentage of Respondents 20.00% 15.00% 10.00% 5.00% 0.00% 100 200 300 400 500 600 700 800 900 1000 Expected Private Equity Returns - Expected Public Equity Returns (in Basis Points) Relative Return Expectations 14

  15. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Targeted Returns Absolute Return Expectations Relative Return Expectations Return Benchmarks Performance Figures Figure 4.13. Private equity benchmarks Thompson Financial / Venture 33% Economics Benchmark Reports MSCI World 24% Others 15% Euro Stoxx 9% Internal industry Rating by Fund 7% Manager S&P 500 7% AEX (Euronext Amsterdam) 4% Nikkei Index 0% Hang Seng Index 0% 0% FTSE All Shares 0% 5% 10% 15% 20% 25% 30% 35% Return Benchmarks 15

  16. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics US Experience Dutch Experience 4.16. Capital Gains Taxes and Fundraising in the US (Source: Poterba, 1989a,b) 6000 0.4 0.35 5000 0.3 4000 0.25 Capital Gains Tax Rate VC Fundraising 3000 0.2 0.15 2000 0.1 1000 0.05 0 0 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 VC Fundraising ($US m) Capital Gains Tax Rate Regulation Matters - US Experience 16

  17. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics US Experience Dutch Experience Figure 4.15. Important changes in the Dutch legal and regulatory environment for private equity investment strategy The proposed new "Financieel Toetsingkader" (FTK) in 2006 by the 3.4 Pensioen & Verzekeringskamer The new International Financial 2.7 Reporting Standards (IFRS) Implementation of Basel II 2.2 Reform of Dutch bankruptcy laws in the 2.0 period from 1997 to 1999 Others 1.1 1 2 3 4 5 Unimportant Important Regulation Matters - Dutch Experience 17

  18. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.17. Experience among managers specifically assigned responsibility for private equity Department head's average years experience in banking, insurance or 10.9 investment management Department head's average years relevant private equity industry 4.8 experience Average number of persons 3.0 responsible for private equity Department head's average years 2.9 operational industry experience Department head's average number of 0.6 private equity exits 0 2 4 6 8 10 12 Institutional Investor Experience 18

  19. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.18. Important selection criteria for direct investments in private equity funds 4.4 Fund manager track record 4.2 Operational experience of management 4.1 Fee structure 4.1 Fund track record 4.1 terms of investment 4.1 Financial experience of management 4.0 Industry know how of management 3.8 Reporting quality 3.7 Operating value-added 3.6 Transparency in selection process of portfolio companies 3.6 Team breadth (number of professional) 3.5 Fulfillment of corporate governance requirements by the fund manager 3.0 Quality of co-investors 2.8 Offering of customized products 2.6 Image and degree of recognition of the fund 2.3 Possibility of using fund manager as sparring partner for own program 1.5 Others 1 2 3 4 5 Unimportant Important Direct PE Fund Investment Criteria 19

  20. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.19. Important selection criteria for investments in fund of funds 4.5 Existing network and access to exclusive, top-quartile funds 4.4 Fund of funds track record 4.3 fee structure 4.3 Fund of funds manager track record 4.2 Transparency in selection process of funds/fund managers 4.1 Terms of investment 4.1 Industry know how of management 4.0 Reporting quality 4.0 Operational experience of management 3.8 Financial experience of management 3.8 Fulfillment of corporate governance requirements by the fund manager 3.3 Offering of customized products 3.2 Image and degree of recognition of the fund of funds 3.2 Quality of co-investors in fund of funds 3.0 Possibility of using the fund of funds manager as sparring partner for own program 1.3 Others 1 2 3 4 5 Unimportant Important Fund-of-Funds Investment Criteria 20

  21. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.20. Risks and hurdles associated with private equity investment Illiquidity 3.7 Lack of performance transparency 3.7 Risk of default 3.7 Lack of own know-how 3.5 Governance (monitoring and managing) costs compared to other assetsEffort 3.4 to convinve internal committees (e.g., board of directors) Legal and contractual issues 3.4 Management time and resource consumption 3.3 Long-term commitment 3.2 3.2 Effort to convince internal committees (e.g., board of directors) Reporting and corporate governance 3.1 Others 1.2 1 2 3 4 5 Unimportant Important Perceived Risks / Hurdles 21

  22. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.21. Important approaches to reduce the risk of private equity investment Diversification through the number of 4.0 investments Diversification through investments in 3.7 funds Diversification through different 3.6 industries Diversification through investment in 3.4 funds of funds Diversification through international 3.4 investments Diversification through different 3.3 financing stages (VC, Buyout) Development of internal know how 3.2 Working together with advisors 2.8 Others 1.2 1 2 3 4 5 Unimportant Important What to do to mitigate risks? 22

  23. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Institutional Investor Experience Investment Criteria Risks / Hurdles Opportunities Performance Figure 4.22. Attractiveness of different private equity segments within 2006-2010 European Development/Growth/Buyout 3.1 Investments European Venture Capital Investments 2.8 Dutch Development/Growth/Buyout 2.7 Investments U.S. Development/Growth/Buyout 2.7 Investments Investments in Emerging Markets 2.7 U.S. venture capital investmebts 2.7 Acquisition of Secondary Positions 2.6 Asian Development/Growth/Buyout 2.6 Investments 2.5 Asian Venture Capital Investments Dutch Venture Capital Investments 2.5 Sustainable/Socially and Environmental 2.5 Responsible Private Equity Others 1.1 1 2 3 4 5 Perceived Investment Opportunities 23

  24. Sources of Funds Return Expectations Regulation Matters Risk, Return, Performance Statistics Summary • Managing a PE fund: need to consider what institutional investors care about • Global market • Regions • Direct company, direct fund versus fund of funds • Perceived risks, returns • Regulatory environment • Hurdles and strategies to overcome hurdles 24

  25. Chapter 4. Part II Fundraising: Economic and Institutional Effects 25

  26. Motivation • 2003 CALPERS disclosure lawsuit • Public pension funds must disclose venture capital and private equity returns, even on unexited investments • Implications for understanding determinants of, and reporting of, returns 26

  27. Objectives • Examine institutional investor behavior in response to a dearth of private equity regulations • Examine role of reporting standards (IFRS, as well as FTK and Basel II) in shaping institutional investor attitudes towards private equity 27

  28. Intermediation Issues for Fundraising Pension Plan Members (you and I) • Different Types: • Pension • Insurance • Bank • And Different • Countries Institutional Investor 2 Institutional Investor 1 Regulated (FTK, IFRS, BASEL II) (helps different types & from different regions) Returns Fundraising Venture Capital Funds Scantly Regulated (e.g., no reporting standards) (discourages institutional investors) Supply of Investments Demand for Investments Entrepreneurial Firms 28

  29. Venture Capital and Private Equity Regulation • No strict standards for valuing investments in unexited companies • Recent international developments [indirectly] relevant for private equity investments: • International Financial Reporting Standards (“IFRS”) (regulation of reporting standards and transparency) b. FinancieelToetsingkader (“FTK”) (regulation of portfolio management standards such as of matching assets and liabilities) (analogous to Prudent Man Standards Rule for Pension Funds in US (ERISA 1979), which greatly stimulated US PE investment) c. Basel II (regulation of risk management and disclosure standards) 29

  30. Research Questions • Does a lack of transparency in private equity disclosures inhibit institutional investors from investing in private equity? • Have the IFRS, FTK and Basel II facilitated • Investment in private equity? • International private equity investment? • The type of private equity investment (direct company, direct fund, fund or fund)? 30

  31. Main Findings • A comparative dearth of regulations, particularly in regards to reporting, inhibits investment in private equity • This effect is large: if institutional investors were 20% more confident in private equity with better regulations, then they would contribute an extra 1% of their total assets (to 2.44% from a current average of 1.44%) to private equity • IFRS, FTK and Basel II have partly facilitated institutional investor confidence in private equity, and stimulated international investment in private equity • This effect is also statistically and economically significant (details to follow…!) 31

  32. Data Empirical Tests Conclusions Data Sponsors for hand collecting data: AEI Brookings / Sciences Po Adveq 32

  33. Data Empirical Tests Conclusions Data • As discussed in Part I above, 100 participating Dutch institutions (approximately 10% of all Dutch institutional investors) • Extremely detailed data on their allocations to private equity, as well as other asset classes • Information in regards to their view on a dearth of private equity regulations, and the IFRS, FTK and Basel II 33

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  37. Data Empirical Tests Conclusions Empirical Tests 37

  38. Data Empirical Tests Conclusions Comparison of Means and Medians • Greater private equity investment where: • Lower rank on importance of dearth of PE regulations • High rank on importance of IFRS, FTK and Basel II • Higher assets, higher PE return expectations 38

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  40. Data Empirical Tests Conclusions Econometric Tests • Logit models of likelihood of PE investment • OLS models of extent of PE investment (relative to other asset classes) • OLS models of PE investment in different regions (Netherlands, Europe, US and Asia) • Various robustness checks 40

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  42. Data Empirical Tests Conclusions Conclusions (Part II) 42

  43. Data Empirical Tests Conclusions Comparative Dearth of PE Regulations • A comparative dearth of regulations, particularly in regards to reporting, inhibits investment in private equity • This effect is large: • 20% more confident in private equity with better regulations,  contribute an extra 1% of their total assets (to 2.44% from a current average of 1.44%) to private equity 43

  44. Data Empirical Tests Conclusions IFRS, FTK and Basel II • IFRS, FTK and Basel II have stimulated Private Equity investment • An increase in rank of importance of these factors by 20% affects: • Investment in PE: • Increases the probability of private equity investment by 16% • Increases the amount invested by up to 1% of total assets • International investment in PE: • Increases international PE investment by 0.8% of institutions’ assets • Mode of PE Investment: • Reduces direct fund investments by up to 0.8% of institutions’ assets • Increases fund-of-fund investments by up to 0.6% of institutions’ assets 44

  45. Chapter 4. Part III Specialized Fund Mandates: SRI 45

  46. Motivation • Increasing practitioner and academic attention on: • Socially Responsible Investment (SRI) • Corporate Social Responsibility (CSR) • Studies of SRI and CSR have focused on publicly traded companies • Publicly traded companies start as privately held firms! 46

  47. Venture Capital Intermediation Pension Plan Members (you and I) • Different Types: • Pension • Insurance • Bank • And Different • Countries Institutional Investor 2 Institutional Investor 1 Regulated (e.g., IFRS) Returns Fundraising Venture Capital Funds Scantly Regulated (e.g., no reporting standards) (discourages institutional investors) Supply of Investments Demand for Investments Entrepreneurial Firms 47

  48. Questions • When do institutional investors make SRI investments into PE/VC funds? • Does SRI in VC/PE depend on • Internationalization? • Legal and reporting standards? • Institutional and organizational structures? • Does the determinants of SRI for VC/PE differ relative to other institutional investments? 48

  49. New Data… New Insights • First direct look at institutional investor SRI investments in venture capital and private equity • New generalizable results as to when SRI takes place for a variety of asset classes 49

  50. Main Findings • SRI in VC/PE for institutional investors that have: • International investment focus • Adhere to the International Financial Reporting Standards (IFRS) • Individuals that work for the institutional investor do not compete for returns (i.e., the decision to implement SRI is centralized) • Direct investments (not fund-of-fund investments) • Similar determinants of SRI for VC/PE as for other asset classes 50

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