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2014 | OriginalPaper | Buchkapitel

3. Objectives and Minimum Return Requirements

verfasst von : Mark Broere

Erschienen in: Decision-Making in Private Equity Firms

Verlag: Springer Fachmedien Wiesbaden

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Abstract

This part of the thesis concerns the objectives of private equity firms and the minimum rates of return they require from new investments. Following a review of existing literature, I develop exploratory survey questions and formulate testable hypotheses. The ensuing empirical analysis is based on the survey data of 136 private equity firms located in the United States of America, Canada, and Europe.

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Vorheriges Kapitel Data

Nächstes Kapitel Success Measures and Decision Metrics

The importance of reputation in private equity is emphasized by many other authors, too (see, e.g. Fenn, Liang, & Prowse, 1997, pp. 43–46; Nahata, 2009; Neus & Walz, 2005, p. 255; Sahlman, 1990, p. 500)

Of course, such reputational and liquidity objectives do not necessarily imply a multi-objective function and might also be regarded as a means to achieve a longer term profitability objective (as appears to be implied by Lerner and Schoar’s reasoning)

Lerner, Hardymon and Leamon (2005, pp. 212–214) appear to take a similar view; they criticise the use of such a fudge factor in the venture capital method and recommend a thorough analysis (and adjustment, if necessary) of the financial projections, instead

These results stand in some contrast with the results of a study of 73 investee (private equity) funds of one large U.S. institutional investor by Ljungqvist (2003a). In a cross-sectional regression analysis of excess fund IRRs, Ljungqvist does not find evidence that either idiosyncratic risk (proxied by various measures of concentration) or market risk (proxied by aggregated portfolio betas) have a statistically significant impact on excess fund IRR

Ruhnka and Young (1991) contrast the internal risks with “external or market-determined risks such as the emergence of competitors, technological shifts, or economic downturns that slow market growth or prevent initial public offerings” (p. 125)

Statements sourced from the respective company websites (www.bcpartners.com/bcp/aboutus/ and www.apax.com/en/aboutus/index.html) as of August 2010

For example, lacking market prices for private company investments

The size of effect was smallest for the paired sample Returns and Reputation Among Investors (d = 0.43). The analysis of Wilcoxon signed ranks for this pair of objectives shows that roughly two thirds of respondents attributed equivalent importance ratings (tied ranks) to these two objectives

Other responses were “[reputation in] political circles / interest groups”, “build solid and high-performing companies”, “make robust portfolio – [1 lucky investment not sufficient]”, “[reputation] among staff of firm”, and “[generate] high risk adjusted returns”. One respondent noted that generating high current income is little important

The existence of such “market inefficiencies” is used to explain the existence of private equity firms: private equity firms can mitigate information asymmetry and reduce agency costs by “intensively scrutinizing firms before providing capital and then monitoring them afterward” (Lerner, et al., 2005, p. 5)

Controlling for firm type, the relationship is significant only for venture capital firms at alpha = .10 (rs = .200, p = .085, n = 75)

The group of respondents who had not specified that outside investors provided the majority of their firm’s fund capital also includes one respondent who had specified that the majority of their firm’s fund capital is provided by capital markets, as well as four respondents who had specified that the majority of their firm’s fund capital is provided by other parties (e.g. institutionals and private investors). Exclusion of these respondents increases the effect size, but the subsample of 14 respondents for the group of firms without outside investors is rather small

It has to be noted that the validity of these additional test results are possibly compromised by the low counts of some cells in the respective contingency tables

Prior to the regression analyses, the data were screened for linearity, outliers, normality, multicollinearity, and homoscedasticity of residuals (see Appendix I for a table of correlations between predictor variables). Aside from a rather strong correlation between Ln Age and Funds, indicating a certain degree of multicollinearity, none of these analyses gave rise to serious concern. Additional tests, in which either one of the two correlated variables were removed, did not lead to changes in the statistical significance of the two coefficients

At a sample size of n = 106, a chosen alpha level of .05 and required statistical power of .80, the tests will reliably detect significant models with medium and large effect sizes, that is, f² > .128 (or R² > .113) for the model in Panel A, and f² > .118 (or R² > .106) for the model in Panel B

Other responses were “private placement memorandum”, “overall risk of investment”, “competitive environment and barriers to entry”, and “acquisition price preferred of less than $20 million”

These findings are largely consistent with earlier results of Dixon (1991)

Additional exploratory analyses show significant connections between the MRR type Discount Rate and CAPM-relevant MRR factors, such as Beta Coefficient (rs = .34, p < .0005, two-tailed, n = 134), Inflation Rates (r _s = .24, p = .005, two-tailed, n = 137), and Industry Sector (r _s = .22, p = .01, two-tailed, n = 134), suggesting that at least some private equity firms attach importance to the capital asset pricing model

Such an effect would possibly be compounded by the generally lower risk of mature investments in comparison with early stage investments

Assuming that the associated variance of risk is larger for private equity firms with an industry specialisation strategy than for private equity firms without an industry specialisation strategy, because private equity firms without an industry specialisation strategy only rarely venture into high-risk industry sectors, such as internet or bio-tech

Gompers and Lerner (2004, pp. 160–161) describe staged financing as “the meting out of financing in discrete stages over time”; staged financing reduces the financing risk for venture capital firms and “keeps the owner/manager on a ‘tight leash’”. As a consequence of staged financing, the total duration of a venture capital firm’s commitment to a portfolio company investment can vary (by definition) in discrete steps

An additional test result supports this reasoning: Respondents from venture capital firms with comparatively high IRRs (equal to or higher than 30%) rated the importance of the MRR factor Fundraising Environment significantly lower than other venture capital firm respondents (Mdiff = .88 t = 2.22, df = 31, p = .034, twotailed, d = 0.88; Mann-Whitney u = 80; p [exact, two-tailed] = .025)

The data did not permit meaningful multivariate statistical analyses due to non-normal distributions (multiple regression) and low cell counts (logistic regression). A post-hoc power analysis shows that, based on a minimum required statistical power of .80 and an alpha level of .05 (one-tailed), the independent samples ttests were sensitive enough to detect at least medium effect sizes (d > 0.46 and d > 0.47 for Capital Intensity and Quality Of Management, respectively)

This difference is less pronounced for the subsample of venture capital firms – this is most probably a result of the widespread use of the venture capital method for evaluating investments in the venture capital industry

Titel: Objectives and Minimum Return Requirements
verfasst von: Mark Broere
Verlag: Springer Fachmedien Wiesbaden
Buch: Decision-Making in Private Equity Firms
Print ISBN: 978-3-658-03779-6

Electronic ISBN: 978-3-658-03780-2

Copyright-Jahr: 2014
DOI: https://doi.org/10.1007/978-3-658-03780-2_3