Private Equity Fund Investments

Private equity (PE) is a sector of the financial industry that stands out due to the fast growth of the assets allocated to it. It has evolved from a ‘cottage industry’ [Cornelius et al., 2011, p. 12] to an asset class over a period of forty years [Sensoy, Wang and Weisbach, 2013]. Some professionals have experienced this transformation over the course of their career [Perkins, 2007; Brooke and Penrice, 2009; Draper, 2011].

Socially responsible investing 2 results have fallen short of expectations [Amenc and Le Sourd, 2008]. The influence of SRI criteria on listed companies is still rather limited, as the investment methods used by SRI fund managers rely essentially on stock filtering. The next possible target for SRI guidelines could be small and medium-size businesses through PE investing. Investors could ideally use SRI criteria on small businesses thanks to superior corporate governance and shareholder involvement. Direct PE 3 has been identified as a superior investment tool [BVCA, 2008; Gottschalg, Talmor and Vasvari, 2010], by promoting the alignment of interests between investors an managers thanks to efficient governance standards (at the portfolio company level [Chemmanur, Krishnan and Nandy, 2008; Katz, 2008]) and high level of shareholder involvement [Acharya, Hahn and Kehoe, 2010; Meerkatt et al 2008; Quiry and Le Fur, 2010]).

In a context of declining returns [Higson and Stucke, 2012; Harris, Jenkinson and Kaplan, 2012], PE fees are under fire. 2 As assets under management of PE funds have increased from USD 10 bn in 1991 to USD 180 bn in 2000 [Kaplan and Schoar, 2005] and an estimated USD 3 tn in 2012, 3 the question of the performance measurement of PEF returns is a recurring debate [Gompers and Lerner, 2000a; Kaplan and Schoar, 2005; Gottschalg, Phalippou and Zollo, 2004; Lerner, Schoar and Wongsunwai, 2007; Phalippou and Gottschalg, 2009; Aigner et al., 2008; Higson and Stucke, 2012; Harris, Jenkinson and Kaplan, 2012], fed by the lack of transparency [Higson and Stucke, 2012]. PEFs’ performance assessment is a determining stake for PEF fund raising and activity in PE. However, it remains difficult for at least three reasons.

Current and future solvency and prudential ratios use historical risk–return profiles of PE Funds (PEF). The resulting ratios are artificially high [for example EDHEC, 2010; Studer and Wicki, 2010, for European insurance groups]. Amending solvency and prudential ratios to take into account the specificities of investing in PE is difficult, for four reasons.

This research stands at the junction of asset management (the world of the LPs) and PE (the world of the GPs). Both worlds generate their own idiosyncratic and differing ways of thinking and analyzing facts and figures. These differences are amplified by regulations and an inadequate intellectual framework designed for liquid financial markets [Cornelius et al., 2013, p. 39]. The results of these differences lead to misunderstandings, generalizations through inadequate theoretical categories, and simplifications that harm relationships between PE principals and agents. They also result in the misallocation of capital, unbalanced cash inflows and outflows in PE, and behaviors ultimately prejudicial to the financing of small and medium-size businesses. Cornelius et al. [2013, p. 40] even wonder if it is ‘acceptable to forgo financial returns because the asset in question cannot be integrated in the traditional modern portfolio theory-based models’.