Private Equity Returns and Disclosure Around the World

1. Private Equity Returns and Disclosure Around the World Douglas Cumming and Uwe Walz Hofstra Conference on Private Equity May 2, 2007

2. Motivation: Worldwide Policy Debate • 2002 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 • Do we need mandated disclosure standards for VC and PE funds? • Biggest issue for VC/PE markets since collapse of Internet bubble • Regulation of VC and PE funds one of the biggest issues in UK Financial Times last week

3. Research Questions • What are the determinants of VC and private equity returns across countries? • Are unexited investment values over-reported to institutional investors? • Are biases in reporting unexited investments related to legal conditions? • Relative merits of alternative approaches to stimulating VC markets

4. Prior Research • VC / PE Returns • Cochrane (2005 Journal of Financial Economics) • Cumming and MacIntosh (2007 Cambridge Journal of Economics) • Hege, Palamino and Schwienbacher (2003 WP) • Lerner, Schoar and Wong (2006 Journal of Finance) • Ljungqvist and Richardson (2003 WP) • VC Exits • Cumming and MacIntosh (2003 Journal of Banking and Finance) • Cumming, Fleming and Schwienbacher (2006 Journal of Corporate Finance) • VC value-added • Cumming (2006 Journal of Business) • Gompers and Lerner (1999 MIT Press) • No prior paper on disclosures of unexited VC returns

5. New Contributions • First look at project-specific returns to VC and private equity across countries • Innovative application of econometric selection methods to measure VC returns • First look at biases in unexited returns and relations to fundraising • Policy implications: Reporting Standards needed in VC?

6. I. Theory and HypothesesII. DataIII. Econometric TestsIV. Policy Implications

7. Venture Capital Cycle Pension Plan Members (you and I) E.g., CALPERS California Public Pension Fund Institutional and Other Investors Why care? Distorted asset allocations, less overall fundraising Returns $ Reporting bias of unexited returns in annual reports? Venture Capital Funds • Cumming & Johan (2007 JBF) CD Howe Institute, AEI Sciences Po, Brookings, PWC, EVCA, NVCA, etc. They all care a lot! This Paper $ Returns (realized vs ‘expected’) 2-7 years before exit event (IPO, Acquisition, Write-off) Entrepreneurial Firms

8. 1. Advice, Monitoring & Returns • Monitoring/advice activities of VC are responsible for return of VC • Main focus on VC characteristic • Model with asymmetric information • Advice is not contractible • IRR must be sufficiently large to induce VC to undertake optimal level of advice/monitoring • The more productive the VC is, the higher the optimal advice/monitoring level  the lower the price of shares for the VC  the higher the VC returns

9. 1. Advice, Monitoring & Returns (Continued) Hypotheses: • The higher the intensity of monitoring and advice the higher the expected IRR of the VC • Convertible securities, syndication  higher expected rate of return • Co-investment:  lower returns • Smaller portfolios (# investments) / manager  lower returns • Better legal environment  more efficient advice and less information asymmetries upon exit  the higher expected returns

10. 2. Biases in Reporting Un-Exited Investments • Valuation take place against trade-off between • Fundraising concerns (higher valuations potentially facilitate fundraising in next round) • Reputational concerns (overvaluation damages long-run reputation) • Simple set-up: two projects, two VC types • Pooling equilibria may emerge (bad projects are overstated)

11. 2. Biases in Reporting Un-Exited Investments (Continued) Hypotheses: • Expected Fundraising Benefit > Expected Reputation Cost • Inexperienced VCs: overstate • Earlier stage and high tech: overstate • Syndicated investment: less likely to overstate • Co-investment: more likely to overstate • Legal environment increases costs of overstatement • Less stringent accounting rules: overstate • Sarbanes Oxley: less likely to overstate

12. I. Theory and HypothesesII. DataIII. Econometric TestsIV. Policy Implications

13. CEPRES Dataset • 221 venture capital and private equity funds • 72 venture capital and private equity firms • 5117 entrepreneurial firms (3826 venture capital and 1214 private equity) • 32 years (1971 – 2003) • 39 countries (North and South America, Europe and Asia) • Table 1 (see paper) defines the variables

16. Table 2. Summary Statistics and Difference Tests

17. Table 2. Summary Statistics and Difference Tests (Continued)

18. Table 2. Summary Statistics and Difference Tests (Continued)

19. Table 3. [Condensed] Correlation Matrix

20. I. Theory and HypothesesII. DataIII. Econometric TestsIV. Remarks

21. “Realized Returns Econometrics” • Multi-step Heckman correction to measure the returns to VC and private equity investment • Heckman selection corrections for • Unexited / Exited Investments • Partial / Full Exits • Statistical problems associated with OLS on a subsample of fully realized IRRs

22. 3-Step Heckman Correction • Probit: Exit / No Exit • Selection Corrected Probit: Full / Partial Exit, accounting for the selection effects associated with an actual exit (step 1) • Heckman Linear Regression IRR, accounting for both steps # 1 and 2 Contrast to Cochrane (2002): moves from step # 1 to step # 3 Contrast to Ljungqvist and Richardson (2003): OLS on restricted sample of realized returns

23. Table 4. Heckman Corrected IRR Regressions Continued…

24. Table 4. Heckman Corrected IRR Regressions (continued) Prior work: explains 1% (Cochrane, 2001) to 12% (Ljungqvist and Rihardson, 2003) of variation in VC returns

25. Unexited Reported IRRs (2000 – 2003)versus Predicted IRRs • Contrast reported unexited IRRs (as reported to the institutional investors) with predicted IRRs for unexited investments • Log(1+IRR Reported)-Log(1+IRR Expected) = Log((1+Reported IRR)/(1+Predicted IRR) = 143% • Regression evidence: quite remarkably(!) consistent with the proposition that more informational asymmetry is associated with more ‘lying’!

26. Table 6. Unexited Reported IRRs versus Predicted IRRs Dep Var = Unexited IRR – Predicted IRR from Respective Model # Continued…

28. Appendix: Compare Actual IRR to Prior Reported Unexited IRR(This is possible now in 2006!) • Subsample of 80 observations (investee firms) from 11 countries for which both the realized and unrealized reported IRR are known (Canada, Finland, France, Germany, Israel, Norway, Spain, Sweden, the Netherlands, the UK, and the US) • The correlation between out-of-sample average realized IRRs and our predicted IRRs is 0.45

29. Continued…

31. Overstatement of Unexited IRRs and Fundraising • Not possible to assess causality • but there is evidence of positive correlations between overstatement of unexited reported IRRs and fundraising

32. Correlations: Overstatement of Unexited IRRs and Fundraising

33. I. Theory and HypothesesII. DataIII. Econometric TestsIV. Policy Implications

34. Measuring VC Returns • Heckman selection effects are crucial • Misspecification of model without selection effects • Like Cochrane (2002), unlike Ljungqvist & Richardson (2003), unlike Brander et al. (2002) • Multidimensional selection effects are a useful new component introduced in this paper • VC value-added is crucial • E.g., portfolio size / manager • Enables us to explain up to 36% of the variation in returns • Cochrane explains at most 1% using market variables only; Ljungqvist & Richardson explain up to 13% with some fund variables, but no proxies for value-added • Legality is crucial for cross-country differences

35. Unexited IRRs Reported to Institutional Investors • Our findings are quite remarkably(!) consistent with the proposition that more informational asymmetry is associated with more ‘lying’! • for smaller ENTs, tech companies, higher earnings aggressiveness index, lower disclosure index • Positive correlation between fundraising and lying