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  • 1. Corporate Governance and Value Creation: Evidence from Private Equity Market Research Proposal to Inquire Europe by Dr. Viral Acharya Department of Finance London Business School Regent’s Park London NW1 4SA Tel: +44 (0)20 7000 8255 Email: vacharya@london.edu Home page: www.london.edu/faculty/vacharya In association with Conor Kehoe McKinsey & Co
  • 2. Executive Summary There is growing evidence illustrating the important role private equity is playing in the capital markets of Europe and the US (see Kaplan and Schoar, 2005, and Renneboog, Simons, and Wright, 2006). Whilst, on average, private equity funds have generated returns smaller than market indices such as the S&P500, there is evidence of strong persistence in the performance of these funds (Kaplan and Schoar, 2005, Phallipou and Zollo, 2005). In particular, it is not yet well understood what exactly contributes to the returns generated by the well-performing private equity houses, which typically tend to be the larger and the more mature players. This study plans to investigate the ways in which going private creates or destroys value, focusing on changes in operations, incentives and governance upon privatisation of firms. In essence, the project proposes to open up the “black box” of what the private equity form of organisation and governance does to privatised firms. The study will be conducted using a survey/question-answer based approach for over 300 deals during 1996-2005 in the US, UK and Europe. Research objectives and context There is growing evidence illustrating the important role private equity is playing in the capital markets of Europe and the US (see Kaplan and Schoar, 2005, and Renneboog, Simons, and Wright, 2006). In the UK, for example, venture capital and private equity-backed companies support nearly one in five private sector jobs, and in the US, the figure is around one in ten making it an important economic and political phenomenon. Pension funds are increasingly attracted by the superior returns generated by private equity. But the increasing profile, political sensitivities, particularly in some countries of which Germany is an example, together with the high returns generated by the sector, have led it to come under increasing scrutiny from financial regulators. Some argue that the perceived short-termism of the sector (attributed to private equity investors being interested only in the exit value of the firm) has potentially negative impacts on employment and for the less financially-sophisticated investor. And, so the private equity sector should be regulated in the same way that publicly-quoted companies are. Practitioners respond that heavy application of stringent regulation of the kind increasingly seen in the public markets will lead to increased costs, and, ultimately, negation of one of the key ways in which private equity-backed firms create superior returns. Other critiques of the sector argue that taking public firms private has reduced the diversification opportunities offered by stock markets to the less financially- sophisticated investor. This study aims to fill this gap in the literature. Its specific goals are to: • Uncover links between individual private equity fund (PE) performance and specific styles of PE operation by collecting deal-level evidence on management changes (and their intensity) undertaken during the 100-day plans for value creation put in place by the PE fund; • Importantly, examine successful as well as unsuccessful deals of each PE fund to allow an objective comparison between the less and more successful PE funds; • Understand from the firms within the PE fund’s portfolio, why they chose to use the private form of funding, the process of doing so and the associated governance changes; • Examine whether the process of going public again is efficient or affected by short-termism on part of the private equity investors, OR whether the process of going private in fact enables the firm to pursue long-run value maximization; and, finally, • Conduct a comparative analysis to understand to what extent are the answers to the questions raised above different between the US, the UK and the Europe. Data and Sample Size To achieve statistical confidence, as well as uncover trends, it is important that the study is based on a large cross-section of deals, as well as on time-series, ensuring that funds reveal information on all of their deals, not just their best. The survivorship bias should be avoided by first creating independently a list of deals over the past 10 -12 years (1995-2006) from which a representative sample set of deals for each fund will be selected. Alternatively, it will be ensured that the set provided by a participating fund fits well the overall sample in terms of an unbiased representation. In order to keep the data sample manageable and collection time reasonable, it is proposed that smaller deals will be excluded. On average, there will be approximately 20 large deals a year and 100-150 medium size deals (about $ 1 bln) a year and that it is these on which the project will
  • 3. focus. Ideally, the study would cover over 300 deals over 12 year period between the US, the UK and the Europe (France and Germany primarily). It is intended that detailed information will be collected on the “first 100-day plans”, included board composition changes, operational changes, performance/exit of the deal, etc., based on discussions and interviews with the firm (management and other involved officers), the involved private equity funds and their advisers (e.g. legal counselors, accountants, consulting firms etc) and also fund of funds. Data confidentiality would most likely require that we avoid identification of individual deals in the presentation of our research, a requirement that would be easily met given our overall perspective on the private sector. An exception will be sought in the case of two case studies to be undertaken as a part of the study. Research Methodology • The sample to be studied is intended to be large enough to present an overall sector perspective, relating the various changes undertaken in privatized firms, and their timeliness (relative to the privatization date), to the extent of value creation or destruction in the process of privatization. • The measure of value creation or destruction will be based on the exit performance of the firm. Given that some firms do not exit or may even fail to exit, the econometrics will be carefully adjusted using probit analysis and corrections for censorship of data. • Overall value creation will be related through regression analysis to size of deals and the past performance of private equity funds, with a special focus on the failed deals. • Furthermore, it will be investigated whether failure is due to poor privatization time, poor exit time, or poor execution during the private-phase? Such analysis will help relate the study to existing research on concentration of returns observed on private equity funds. More specifically, 3 broad categories of changes will be linked to value creation (or destruction) for each deal: 1. Governance and operational changes: i Incentives: Giving high-powered incentives as well as higher absolute pay to management. ii Turnover: Forcing “tough” management choices such as firing the CEO and altering the Board. Do private firms attract “better” Board members as a result of the lower risks of liability? How do the changes in top management and Board membership affect value- creation? Which governance changes are facilitated by these changes? Do the non-exec Board members subject management to tougher targets and goals post privatisation? iii Short-termism: Forcing the firm to move away from the short-term earnings “game” to please the stock markets, and, instead, to focus it on long-term value-creation. In particular, interim reports and cash flows of the privatised firm will be obtained so that earnings smoothing can be analysed, comparing its extent to that for public firms. iv Upgrading of systems and technology: This is often a difficult investment decision for boards and inflexible legacy systems leave many public firms at a competitive disadvantage. 2. Financial changes: i Leverage: To overcome reluctance by boards to create high leverage which may have financial (tax) benefits as well as operational (disciplining the management) benefits. ii Consolidation or divestitures: This might be intended at a repositioning in the product market and may thus also be associated with operational gains. iii Market arbitrage: To identify mis-priced stocks in the market (or sometimes mis-priced sectors) and create value through an arbitrage transaction. 3. Compliance costs: Indicate and quantify these costs and their effect on the decision to go private, to shed light on the burden imposed by jurisdictions such as Sarbanes-Oxley. References • Steven N. Kaplan and Antoinette Schoar "Private Equity Performance: Returns, Persistence, and Capital Flows" Journal of Finance, 2005, 60(4), pp. 1791. • Ludovic Phalippou and Maurizio Zollo, "What Drives Private Equity Fund Performance? " Working Paper, Universitat van Amsterdam, November 2005. Renneboog, L., Simons, T., and Wright, M. "Why do firms go private in the UK?" Journal of Corporate Finance, forthcoming 2006
  • 4. Collaboration with Conor Kehoe, McKinsey & Co. Taking account of the sensitive nature of data required for each PE deal, a research collaboration with Conor Kehoe, Managing Partner at McKinsey Co., has been agreed. This will particularly facilitate the data acquisition from PE houses. Conor Kehoe has worked on related issues in a small sample, confidential McKinsey study (Kehoe, 2005) of the drivers of PE performance. Resources required The major resources for this project are the data to be collected, and the time of research assistants in collecting and inputting the data. Timescale o Data collection to start : 1st January 2007 o Data collection to be completed by: 1st May 2007 o Submission to top-tier academic journal: Spring 2008 o First draft of the case studies for circulation: During Fall 2007 o Presentation at Global M&A Conference in April 2007 based on preliminary results. Outputs • A fact base that can be used by practitioners and regulators to debate the advantages and disadvantages of regulation and the economic impact of private equity funding. • Robust analysis, leading to: conference presentations (UK and abroad); and publication(s) in high impact-factor finance academic journals. • Two/three detailed case-studies: one UK-based, one US-based and one from France or Germany. Budget I have received financial support from the Centre for Corporate Governance and the Private Equity Institute at London Business School, to relieve me of some teaching duties in order to carry out this project. I have also made an application to the Leverhulme Trust and to Inquire UK for support for this project. I am looking for funds to meet some of the direct costs of the research, as detailed below. Total estimated costs of project, for which a contribution is sought: Cost Total Data collection by casual research assistants £27,000 Journal submissions £500 Conference Travel and Subsistence £2,500 TOTAL £30,000 Previous funded research projects 2006 Research & Materials Development Grant, London Business School, ‘Cross-country Variations in Capital Structure: The Role of Bankruptcy Codes’ 2005 Fondation Banque de France Grant, “Understanding Credit Spreads: The Role of Liquidity Risk and Recovery Risk,” with Yakov Amihud and Sreedhar Bharath. 2004 Fondation Banque de France Grant, - “Insider Trading in Credit Derivatives,” with Timothy Johnson (resubmitted). 2002 INQUIRE, UK, - “Understanding the Recovery Rates on Defaulted Securities,” with Sreedhar Bharath and Anand Srinivasan (being revised for resubmission)
  • 5. Viral Acharya CV Education 2001 Ph.D., Finance, Stern School of Business, New York University 1995 B. Tech., Computer Science and Engineering, Indian Institute of Technology Academic Appointments 2001- Assistant Professor of Finance, London Business School External Positions 2004 - Academic Advisor to the Bank of England Research Affiliate, Centre for Economic Policy Research (CEPR), Member- AFA, EFA, WFA Awards 2005 First recipient of the Lawrence G. Goldberg Prize for the Best Ph.D. in Financial Intermediation 2003 Outstanding Referee Award for the Review of Financial Studies 2003 NYSE Award for Best Paper on Equity Trading, WFA Meetings 2000 Lehman Brothers Fellowship for Excellence in Finance Research - First Prize Journal of Financial Economics Best Paper for Corporate Finance and Organizations, First (Jensen) Prize Publications “Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures,” with Tanju Yorulmazer, conditionally accepted, Review of Financial Studies. “Too-Many-To-Fail – An Analysis of Time-inconsistency in Bank Closure Policies,” with Tanju Yorulmazer, forthcoming, Journal of Financial Intermediation. “Information Contagion and Bank Herding” with Tanju Yorulmazer, forthcoming, Journal of Money, Credit and Banking. “Does Industry-wide Distress Affect Defaulted Firms? - Evidence from Creditor Recoveries,” with Sreedhar Bharath and Anand Srinivasan, forthcoming, Journal of Financial Economics. “Insider Trading in Credit Derivatives,” with Timothy Johnson, forthcoming, Journal of Financial Economics. “When Does Strategic Debt-Service Affect Debt Spreads?” with Jing-zhi Huang, Marti G. Subrahmanyam, and Rangarajan K. Sundaram, Economic Theory, Feb 2006, 1–16. “Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios," with Anthony Saunders and Iftekhar Hasan, Journal of Business, May 2006, 79(3), 1355-1412. “Optimal Financial-Market Integration and Security Design,” with Alberto Bisin, Journal of Business, 78(6), 2006, 2397-2433. “Asset Pricing with Liquidity Risk," with Lasse Pedersen, Journal of Financial Economics, 77(2), 2005, 375-410. “Is the International Convergence of Capital Adequacy Regulation Desirable?" Journal of Finance, 58(6), 2003, 2745-2781. “Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy,” Review of Financial Studies, 15(5), 2002, 1355-1383 with Jennifer N. Carpenter. “Pricing Credit Derivatives with Rating Transitions,” Financial Analysts Journal, 58(3), 2002, 28-44, with Sanjiv R. Das and Rangarajan K. Sundaram. “On the Optimality of Resetting Executive Stock Options,” Journal of Financial Economics, 57(1), 2000, 65-101, with Kose John and Rangarajan K. Sundaram. Invited Articles and Overviews “Private Equity and Hedge Funds: The Changing Face of Corporate Governance”, Presentation to the HM Treasury Group and London Business School Governance Center, October 2006. “Liquidity, Liquidity Risk and Credit Spreads: Some Open Questions,” for The Third Annual Credit Risk Conference organized by Moody's and Stern School of Business, New York University, May 16-17, 2006. “Understanding and Managing Correlation Risk and Liquidity Risk,” with Stephen Schaefer, International Financial Risk Institute (IFRI) Roundtable, 29-30 September 2005, CREDIT
  • 6. Conference in Venice, September 2006, RISK Magazine’s Credit Risk Summit (Europe), 2-3 October 2006. “Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios," Proceedings of the Federal Reserve Bank of Chicago Conference on Bank Structure and Competition, 2002, with Anthony Saunders and Iftekhar Hasan. “Competition amongst Banks, Capital Requirements, and International Spillovers,” Economic Notes, 30(3), 2001, 337-358. Working Papers “Finance and Efficiency: Do Bank Branching Regulations Matter?” with Jean Imbs and Jason Sturgess. “Is Cash Negative Debt? – A Hedging Perspective on Corporate Financial Policies” with Heitor Almeida and Murillo Campello (submitted). “Cross-country Variations in Capital Structure: The Effect of Bankruptcy Codes,” with Kose John and Rangarajan K. Sundaram (submitted). “Managerial Hedging, Equity Ownership, and Firm Value” with Alberto Bisin. “A Theory of Systemic Risk and Design of Prudential Bank Regulation." Work in Progress “Limited Expertise, Limits to Arbitrage, and Liquidity Spillovers”, with Tanju Yorulmazer. “Do Banks Help or Hurt During Crises? A Liquidity Perspective” with Denis Gromb and Tanju Yorulmazer. “Banks’ Choice of Liquidity: The Effect of Fire Sales and Entry” with Hyun-Song Shin and Tanju Yorulmazer. “Lines of Credit as Liquidity Insurance Contracts: Theory and Evidence” with Tanju Yorulmazer. “Is Liquidity Risk-Premium Time-varying? Evidence from Conditional Asset-Pricing Tests” with Yakov Amihud and Lasse Pedersen. “Understanding Credit Spreads: The Effect of Liquidity Risk and Time-varying Risk Premium” with Yakov Amihud and Sreedhar Bharath. “Bankruptcy Codes and Firm Leverage: A G-7 Comparison" with Rong Leng and Rangarajan K. Sundaram. “Bankruptcy Codes and Innovation” with Krishnamurthy Subramanian and Rangarajan K. Sundaram. “How Important is Entrepreneur to the Success of a Business? Evidence from a Field Experiment” with Antoinette Schoar. “Corporate Governance and Value Creation: Evidence from the Private Equity Market” with Conor Kehoe of McKinsey. Academic Awards Journal of Financial Economics Best Paper for Capital Markets and Asset Pricing, First (Fama/DFA) Prize, 2005 – “Asset Pricing with Liquidity Risk” First recipient of the Lawrence G. Goldberg Prize for the Best Ph.D. in Financial Intermediation, 2005 Outstanding Referee Award for the Review of Financial Studies, 2003 NYSE Award for Best Paper on Equity Trading, WFA Meetings, 2003 - “Asset Pricing with Liquidity Risk.” Best Student Paper Award at FMA European Conference, 2001 - “Is the International Convergence of Capital Adequacy Regulation Desirable?” Journal of Financial Economics Best Paper for Corporate Finance and Organizations, First (Jensen) Prize, 2000 - “On the Optimality of Resetting Executive Options.” Lehman Brothers Fellowship for Excellence in Finance Research - First Prize, 2000 (Awarded to a graduating student across MIT, Harvard, NYU, Columbia, Wharton, and Chicago) - “A Theory of Systemic Risk and Design of Prudential Bank Regulation.” L. Glucksman Institute Research Awards, NYU - First Prize (2002-2003, 1998-1999), Second Prize (2000-2001), and CDC Working Paper Awards, NYU - First Prize, 2003, 2000, 1999 Harold W. MacDowell Award for Outstanding Achievement in Doctoral Program, Stern School of Business, NYU, 2001 Refereeing American Economic Review, Journal of Political Economy, Review of Economic Studies, Rand Journal of Economics, Journal of Economic Theory, Journal of Law, Economics and Organization,
  • 7. Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Review of Finance, Management Science, Journal of Banking and Finance, Journal of Financial Intermediation, Journal of Money, Credit and Banking, The B.E. Journals in Theoretical Economics, Review of Derivatives Research, Mathematical Finance, Journal of Derivatives, Journal of Financial Services Research, Bank of England Working Papers, Economic Theory, European Economic Review, Journal of the European Economic Association, Economic Notes. Book review of “Credit Risk – Pricing, Measurement, and Management” by Darrell Duffie and Kenneth J. Singleton, for Economica, 2004. Scientific Committee – Second Annual Credit Risk Conference organized by Moody’s and London Business School, May 2005, CREDIT Conference (Venice), 2006. Program Committee – WFA, 2006-2007, EFA, 2002-2005, Financial Intermediation Research Society – 2004-2006, Corporate Finance of Financial Intermediaries (Wharton) – 2006.

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