Disclaimer

1. Challenges for Private Equity From An Academic ViewpointUlrich Hege - HEC ParisThe Argentum Conference “Value of Private Equity”Bergen - September 5, 2012

2. Disclaimer • Academic research looks backwards. But in difficult times, searching in history can offer comfort

3. Reputation and Credibility • Reputation inside the industry: how important is it in private equity? • How credible is the private equity model for • investors • portfolio companies and their stakeholders • public opinion, policy-makers and in the reshaping of the financial industry?

4. Overview • Reputation: Experience and Risk-Taking • Credibility: Economic Effects • Credibility: Investor Relations • Systemic Risk and Leverage in a Post-Crisis World • Transparency • Conclusion

5. I:Reputation: Experience and Risk-Taking

6. Reputation: Experience • Reputation of PE funds prominent in academic research. Distinction between high- and low-reputation funds • Quantitative measures of reputation by AUM, league tables, past performance, age • Distinction between experienced and novice funds • Reputation-building is slow: fully established only after the third fund (Giot, Hege, Schwienbahcer, 2012)

7. Does Reputation Matter? • Yes, experienced and novice funds invest differently: • novice funds make larger investments • they tend to invest at a slower pace • they are less able to pick industries and timing (Gompers, Kovner, Lerner, Scharfstein, 2008) • they tend to pick up SBOs(Bonnini • High-reputation funds have access to better deal flow, e.g. to syndicated deals (Ljungqvist, Hochberg, Lu, 2007; 2010) • Evidence for performance persistence of top-quantile funds (Kaplan and Schoar, 2005; Phalippou and Gottschalg, 2009)

8. Are PE Funds Risk-Takers? • Regulators seem concerned and incentive effects like carry and clawbacks. • Giot, Hege and Schwienbacher (2012) use variation in implicit incentives: novice funds have a reputation to build (e.g. `grandstanding’; Gompers, 1996) and little to lose  more prone to risk-taking • Findings: novice funds less diversified. But driven by access rather than risk-taking: they invest slowly, increase their pace, make large investment in VC not PE, underperform more with large investments • Probably an issue of lack of access to best (small) opportunities, not risk-shifting

9. II:Credibility: Economic Effects

10. Economic Effects: Economic Value Creation • Evidence is positive: PE-backed firms add economic value while under PE control (e.g. Harford and Kolasinski, 2010) • PE-backed firms that are taken public outperform other IPOs (Cao and Lerner, 2009) • In divested businesses, strong increase in enterprise value compared to listed peers, and more on those firms for which they bid aggressively (Hege, Lovo, Slovin, Sushka, 2012)

11. Economic Effects: Productivity and Investment • Evidence suggests positive effects on operating performance and investment • Private equity leads to higher investment and to growth in operating performance in USA (Kaplan, 1989; Lichtenberg and Siegel, 1990; Harris, Siegel, and Wright, 2005), but recent effect significantly weaker in p-to-p deals (Guo, Hotchkiss, and Song, 2011) • Positive investment effects in financially constrained small firms in France (Boucly, Sraer and Thesmar, 2011) • PE-backed firms invest in higher value R&D (Lerner, Sorensen, and Stromberg, 2011)

12. Economic Effects: Employment • In the US and UK, studies mostly show a decline in employment (e.g., Lichtenberg and Siegel, 1990; Arness and Wright, 2007) • Positive employment effects in France (Boucly, Sraer and Thesmar, 2011) • Creative job destruction: disaggregating by business units shows modest overall decline in US (1%); but large reductions in declining segments almost offset by increases in growth segments (sum 13%) (Davis, Haltiwanger, Jarmin, Lerner, Miranda, 2011) • Overall: the economic impact is overwhelmingly positive

13. III:Credibility: Investor Relations

14. LP Returns and Conflicts of Interest • Overall performance probably disappointing for investors (Phalippou and Gottschalg, 2009) • Academic research showing outperformance for LPs suffers from selection bias (or suspicion thereof) (Harris, Kaplan, Jenkinson, 2011; Robinson and Sensoy, 2012) • Surprising homogeneity in fund compensation terms, hard to rationalize (Metrick and Yasuda, 2010; Robinson and Sensoy, 2011) • Clawbacks lead to perverse incentive effects • Half of LPs say they have zombie funds in portfolio (Coller Capital survey, 2012) • transaction fees and conflicts of interest

15. LP Relations: Fees • Funds are expensive for LPs: most expensive alternative asset class • Management fees on invested capital (in basis point), not including carry, according to pension fund managers in US and Canada : Source: Andonov, Bauer, and Cremers, 2011

16. IV:Systemic Risk and Leverage in a Post-Crisis World

17. Boom and Bust in LBO Debt • Research shows that the use of LBO leverage is opportunistic: e.g., it changes dramatically with the credit spread (Axelson, Jenkinson, Strömberg, Weisbach, 2011) • Buyout boom until 2007 fuelled by mispriced debt, largely driven by securitization and thriving on opacity • Sudden halt in the securitization machinery in 2007/2008, and a drastic repricing of risky LBO debt

18. Risky Debt: Pre-Crisis Run-Up Structure of loans in European LBO transactions Source: Standard & Poors LCD

19. LBO Yield Spreads LBO yield spreads, Tranche B + C Source: Vernimmen (2011)

20. Deleveraging: Slow Progress • Private sector debt has hardly decreased since 2008, in Eurozone and Japan Source: McKinsey Global Institute 2012

21. Is LBO Debt a Systemic Risk Factor? • Anecdotal evidence suggests: restructuring of LBO debt since 2009 has worked relatively smoothly • unclear which part of LBO debt is definitely restructured, which part is merely extended • Default rates of LBO-backed companies substantial, but fewer bankruptcies than feared • PE funds are bankruptcy experts (Hotchkiss, Smith and Strömberg, 2012) • Pricing of LBO debt indicates relative normalcy: Leveraged Loan average price indices maintain price level above 90% of par

22. PE Funds and (Systemic) Risk • No evidence of any contribution of the private equity industry to systemic risk during the crisis • low beta estimates (1 to 1.3) reassuring (Franzoni, Nowak, Phalippou, 2011). But ignores systemic risk effects • Lack of data prevents more thorough research, on leverage, debt overhang effects, restructuring • Deleveraging obliges PEs to look for true economic value • New disintermediation creates a trade-off for PE: banks drop out as loan arrangers, but less bank-centered financial system creates many opportunities

23. V:Transparency

24. An Image Problem • (will we see the tax releases before November?)

25. Transparency: Governance and Taxes • “NY attorney general Schneiderman probes private equity tax strategy”, FT September 2, 2009, incl. Bain Capital, KKR, Apollo • Little knowledge on the true value of corporate tax shields in PE (Kaplan, 1989) • As large PE groups evolve into diversified financial services firms, • questions about governance of the business group and relationship between listed and unlisted parts of it

26. Transparency: Data • Still no definite view about the overall performance of the PE industry, nor about its economic impact • The lack of reasonable data is largely to blame • Many measurement and pervasive data problems (Harris, Jenkinson, and Kaplan, 2011) • It is increasingly clear that the commercial data bases are being manipulated (Thomson – One Banker) • We need a Nordic sense of transparency in data availability

27. Conclusion • PE funds need to look for sources of economic value beyond leverage • Disintermediation trade-off from the PE perspective • Credibility of PE model under siege. Nordic-style mandatory transparency on performance data, portfolio company financials, taxes, governance would help to r(re-)establish credibility