UNIVERSITY OF BIRMINGHAM

     MBA IN INTERNATIONAL BANKING AND FINANCE 2001/2002



A dissertation/thesis submitted in pa...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                           A Risk and Monitoring Manag...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                           A Risk and Monitoring Manag...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                         A Risk and Monitoring Managem...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                           A Risk and Monitoring Manag...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                     A Risk and Monitoring Management ...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                      A Risk and Monitoring Management...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                       A Risk and Monitoring Managemen...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                      A Risk and Monitoring Management...
The Information Deficiency Problem of Private Equity Fund-of-Funds:
                        A Risk and Monitoring Manageme...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
The Information Deficiency Problem of Private Equity Fund-of ...
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  1. 1. UNIVERSITY OF BIRMINGHAM MBA IN INTERNATIONAL BANKING AND FINANCE 2001/2002 A dissertation/thesis submitted in part fulfilment of the requirements of the degree of Master of Business Administration in International Banking and Finance The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Student: Gregor Diem, ID 459139 Supervisor: Kean Ow-Yong Department of Accounting and Finance Word count: 12040 words
  2. 2. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Acknowledgements I am grateful to my supervisor, Kean Ow-Yong, who provided a great deal of help in crystallising my ideas and keeping me encouraged. Special thanks to Thomas Meyer from the European Investment Fund who not only suggested the idea of studying the Information Deficiency in Private Equity but also supported me in every way. I am especially thankful to the contacts whom Mr Meyer could provide me with and to his helpful conversations, hints and encouragement. I seem to have spent a good deal of time on the telephone or on e- mail trying to find interviewees. I have to thank the various people who were willing to participate in this research and I am very grateful that these people gave me a chance. 2
  3. 3. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Abstract Risk and monitoring management of Private Equity investments has become increasingly important due to the malaise of the equity markets and the perception of Private Equity as an attractive investment alternative by institutional investors. This dissertation starts with a consideration of the theoretical background to the information deficiency problem and the particularities of Private Equity investments within a literature review. The empirical part of the study is based on 14 semi-structured interviews covering risk and monitoring management peculiar to Private Equity: Initially the present state of Private Equity monitoring management from of a Fund-of Funds perspective is explored. This is followed by a discussion of the monitoring requirements of these investment vehicles. Finally potential improvements, especially regarding Information Technology and Electronic Data Interchange as sources of potential improvement are discussed. The conclusion puts forward some recommendations to advance the maturity of the asset class by means of improved automation and the establishment of common standards within the industry, which presupposes improved intra- industry co-operation. 3
  4. 4. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Content 1 Introduction .....................................................................................................................6 1.1 Definition of PE Specifics and Delimitation to other Asset Classes ...............................8 1.2 Definition of Information Deficiency ..........................................................................9 1.3 Presentation of the Information Deficiency Problem in the PE Industry....................... 10 2 Literature Review and Theoretical Framework ................................................................. 13 2.1 Data Availability and Opacity of this Asset Class....................................................... 13 2.2 The (Double) Agency Problem and Asymmetric Information...................................... 15 2.2.1 Transaction Cost ............................................................................................... 15 2.2.2 Adverse Selection ............................................................................................. 16 2.2.3 Moral Hazard.................................................................................................... 17 3 Assumptions, Research Method and Research Evaluation ................................................. 19 3.1 Assumptions ............................................................................................................ 19 3.2 Research Method ..................................................................................................... 20 3.2.1 Research Design ............................................................................................... 20 3.2.2 Conceptual Framework: Qualitative Method and Semi-Structured Interviews ....... 21 3.2.3 Data Collection and Studied Interviewees........................................................... 22 3.3 Research Evaluation................................................................................................. 23 4 Empirical Findings / Data Analysis .................................................................................. 25 4.1 Status Quo............................................................................................................... 25 4.1.1 Monitoring Policies and Process......................................................................... 25 4.1.2 Monitoring Factors............................................................................................ 29 4.1.3 Interaction between LP and GP and Standards .................................................... 30 4
  5. 5. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 4.2 Requirements .......................................................................................................... 32 4.2.1 Reporting ......................................................................................................... 32 4.2.2 Monitoring Factors............................................................................................ 34 4.2.3 Interaction between LP and GP and Standards .................................................... 37 4.3 Improvements.......................................................................................................... 39 4.3.1 Monitoring Policies and Process......................................................................... 39 4.3.2 Monitoring Factors and Particularities of the PE industry..................................... 42 4.3.3 Interaction between LP and GP and Standards .................................................... 43 4.3.4 Introduction of Potential Improvements and Automated Reporting....................... 45 5 Conclusions and Recommendations ................................................................................. 49 Bibliography ..................................................................................................................... 53 Appendix .......................................................................................................................... 58 5
  6. 6. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 1 Introduction Private Equity (PE) as an asset class has experienced a dramatic growth over the last 20 years throughout the world and is now broadly accepted as established asset class (Bance 2002). In the US, PE funds investment grew from $5 billion in 1980 to $175 billion in 1999 (Lerner 2000b). In Europe €121.7 billion was raised from 1996 to 2000 alone (Bance 2002). Investing into PE offers the investor the chance to generate higher absolute returns and at the same time improve the diversification of his portfolio (Bance 2002). It is expected that PE will continue to out-perform public equity benchmarks by 3% to 5 % (Maxwell 2002)1 . However, notwithstanding the extraordinary development in the PE industry, disquiet has shown itself about declining returns, unknown performance and obscure fee structures. A recent study of AltAsset, a specialist UK PE research and publishing group, has revealed in a PE study that two-thirds of respondents consider the lack of transparency - in particular the lack of standardised and comparable data - to be the biggest obstacle to investing in PE (Campbell 2002). 2 Fund-of-funds investments , however, seem to be an attractive alternative to participating in PE without the concern of diversification and the need to have specific PE knowledge for selecting, managing and monitoring the investment. In 2001, fund- of- funds, which accounted for 12% of the total, continued to be a major contributor to PE fundraising (EVCA 2002b). During the last decade, Fund-of-Funds investing experienced the highest growth of all PE capital sources (Lerner and Hardymon 2002) and it seems that this trend is continuing. This development is also the reason why this research adopts a Fund-of-Funds perspective 3 . Recently a paradoxical situation has arisen in which criticism (i.e. the transparency) of PE as an asset class among institut ional investors is growing although the proportion of investments made in this asset class is significantly increasing (Tassel 2002). 1 Please refer to Appendix Figures 1 and 2. 2 Private Equity funds whose principal activity consists of investing in other Private Equity and Venture Capital funds. 3 To my knowledge there is no academic study which specifically addresses specifically Fund-of-Funds investing. Some PE information providers such as AssetAlternatives and Venture Economics, however, cover the development of fund-of fund investing in special publications. 6
  7. 7. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective The emphasis on personal relationships in this industry is a predicament for large PE players since with the increase in the number of engagements, risk and monitoring management is becoming more and more difficult to handle without an advanced information management system. Thus, large PE players, in particular on the Limited Partner (LP) side, require an improved transparency and structures to make the numerous investments in various PE funds (the General Partner, GP) manageable. It is important to note that there are three aspects which need to be distinguished: one is methodological, which is concerned with the semantics of PE monitoring management, i.e. information management in terms of content, frequency, granularity, quality etc.; the second aspect is technical, which considers aspects of the use of data exchange formats, platforms and applications. These two, however, cannot be seen completely independently of each other, since the methodological aspect determines the requirements of the technical aspects, i.e. the degree of granularity, for instance, will to some degree determine technical aspects; the third dimension which needs to be considered reflects the attitudes of the players in the industry, which comes back to the opaqueness and the agency problem in this asset class: improving the management of qualitative and quantitative monitoring in this asset class implies that the distribution of investment returns and associated risk will move closer to the asset class average. Thus the main objective of this study is to determine the driving forces, attitudes and requirements of the players in the market place concerning improved reporting by means of improved monitoring standards and the use of Information Technology (IT), including industry-wide Electronic Data Interchange (EDI): Firstly, it aims to highlight the information deficiency problem in this asset class, addressing data availability and the agency problems produced by asymmetric information. Secondly, it aims to determine the current status of monitoring, explore common requirements and to derive the potential characteristics of an improved monitoring mana gement. This research is structured as follows: in the introduction and the literature review information is provided to create a theoretical framework for the information deficiency problem. The empirical part of this research which is derived from 14 semi-structured interviews is based on this knowledge and has three major sections: in section one the 7
  8. 8. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective status quo regarding the monitoring of the industry is presented; section two looks into the requirements of the interviewees in order to bring out common needs and requirements for potential automated reporting; and section three presents possible approaches and limitations concerning the introduction of a potential standard and automated reporting in this asset class. 1.1 Definition of PE Specifics and Delimitation to other Asset Classes PE is considered as a form of alternative investment including buyout/in investing, mezzanine debt/equity investing, venture capital and finally special situation investing 4 . Very broadly speaking, PE can be defined as “investing in securities through a negotiated process” (Bance 2002), which emphasises the non-standardisation of the investment process 5 . Thus, PE refers to a wide range of alternative investments when capital is made available to companies or investors but not publicly available by means of a stock market quotation; so far, the average individual investor has not generally had access to PE because it requires a very large investment. The characteristic of PE is in some aspects quite different from other asset classes (Erturk, Cheung and Fong 2001). Firstly the investment horizon is long-term orientated (normally 10 years) and investments cannot be revoked during this time, i.e. PE investments are illiquid. Thus the investment style is limited to a buy and hold strategy. Investments are normally made by the determination of a committed sum, which consequently will be requested or drawn down at a later stage on a deal-by-deal basis. Furthermore risk and return characteristics are quite different from ordinary capital market investments. Due to the unavailability of standardised and public available information, traditional risk measures such as volatility or correlations are not easy to obtain and thus it is difficult to objectify the quality of an investment. Additionally, PE investments show a J-Curve return characteristic due to negative cash flows during the 4 Please refer to Appendix Figure 3. 5 The term Private Equity might be misleading, since it tempts one to think merely in accounting terms, i.e. funds contributed by stockholders through direct payment. This assumption may be wrong since “...private equity is not an ideal term, and can cause some confusion. Using the word “equity” suggests it excludes the very important role that providers of debt and other forms of “non-equity” finance play” (Temple 1999, 5). 8
  9. 9. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective first years of fund initiation (i.e. a negative return in the first years is over- proportionally made up in subsequent years) and the at-cost approach of reporting, which emphasises the long-term perspective of this asset class 6 . For this research, definitions of the European Venture Capital Association (EVCA) are used 7 . Institutional investors typically focus on the organized PE market, in which professional management is provided by intermediaries, as opposed to “angel capital” or the informal PE market where funds are provided by private persons (Fenn, Liang and Prowse 1995). This research paper focuses on the formal PE market. 1.2 Definition of Information Deficiency Investors can choose among various asset classes, each of which has its specific characteristic concerning, for example, risk, liquidity and potential return. In order to optimize the utility for the investor, an optimal asset mix for the investor must be identified. As shown, PE investments have some unique characteristics which clearly differentiate this asset class from other asset classes. The evident differences, however, imply that the decision- making process needs also to be different from orthodox investment appraisals 8 . 6 Please refer to Appendix Figure 4. 7 EVCA defines Private Equity as the equity capital of enterprises which is not quoted on a stock market and is used for the following purposes: to develop new products and technologies; to expand working capital; to make acquisitions; or to strengthen a company’s balance sheet; resolve ownership and management issues; for succession in family-owned companies; or for the buyout and buying of a business by experienced managers. This definition includes venture capital, which is used to finance high-risk and potentially high-reward projects of start-up and growth firms which require substantial capital and are unlikely to receive bank loans or other debt financing (Lerner 2000a). Thus Venture Capital can be seen as a subset of Private Equity, which is limited to investing in companies which have undeveloped or developing products or revenues with a particular emphasis on entrepreneurial undertaking in less mature businesses, i.e. equity investments made for the launch, early development, or expansion of a business (EVCA Glossary). It can be described as the “business building of businesses” (Bance 2002). 8 Orthodox investment decisions such as investments in stock exchange listed equity or bonds can be reduced to two dimensions, namely risk and return, since there are well developed mechanisms for residual investment decision variables. For the most popular exchange traded investments, insufficient liquidity does not expose the investor to risk since established mechanisms such as the market maker reduce the illiquidity risk. In addition, the stock exchange listing of an asset reduces the transaction costs if the investor concludes that he or she has to change the investment constituency to remain optimally invested. Next, for every investment decision information is needed about the investments for appraisal. Stock-listings do not only reduce liquidity risk and transaction cost but also provide various frameworks 9
  10. 10. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Relevant information can be defined as information which is able to influence an economic decision likely to be made by the user of that information. To be relevant, information must have the qualitative characteristics of timeliness and must either have predictive value or act as confirmation or correction of earlier expectations (www.xrefer.com, 30/06/02). Information deficiency therefore can be defined as informational uncertainty and informational asymmetries which arise for investors in respect to the assessment of the investment . The uncertainty aspect refers to the potential existence of information which is not foreseeable (i.e. its state of outcome is unknown) and therefore not included in the investment decision9 . The informational asymmetry aspect, which is different from the uncertainty aspect, refers to a situation where one party (here the entrepreneur or the GP) has more information than the investor and thus prevent the investor from allocating the funds most efficiently; hence, information asymmetries can disrupt the PE market10 . 1.3 Presentation of the Information Deficiency Problem in the PE Industry Since the start- up investments cannot be realized in the form of IPOs and returns in two- to three-digit value increases, investors have expressed their discontent about the transparency of the asset class and its opaque return and performance measurement to a high degree (Tassel 2002). Currently a few in the industry conceive that the evolution of this industry - in particular if a wider range of investors is thought to be addressed – can only take place if investing prerequisites in terms of transparency and investor protection are comparable with those in other existing asset classes. In practitioners’ journals, discussions about the missing standards highlight the deficiency in the reporting of this asset class: “IRR are inconsistent and misleading. Since IRRs are based on valuations of privately held companies, two funds can calculate different valuations - and different IRRs – for the same investment. A cash- in and cash-out for the respective asset class so that every investor has in theory a fairly good chance to be equally well- informed in order to come to an investment decision. 9 as opposed to known risks, for example, the liquidity risk of the investment which are included in the investment decision and accepted due to a known degree of compensation. 10 For example, the entrepreneur may take detrimental actions which investors cannot observe: an undertaking might be a riskier alternative then initially indicated (Gompers and Lerner 2002). 10
  11. 11. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective reporting standard could eliminate those inconsistencies with a simple and transparent method of calculating the returns” (Richard Hayes in: Braunschweig 2002). This shows that, in contrast to the situation in well-developed asset classes, in PE the requirement for improved transparency is merely to become an issue. The reason for the lack of transparency is multi- layered: a private investment is exempt from registration with authorities such as the SEC registration in the US, which basically implies that due to the lack of scrutiny by the authorities the pressure by regulatory entities is less. Thus the development of standards for investor protection is not primarily driven by legislation. Secondly, until the late 1970s, PE investments were mainly undertaken by investors investing directly in issuing firms, which monitored their investments directly. The development of limited partnerships with general partners and limited partners arose from the need for greater institutional participation (Fenn, Liang and Prowse 1995). Institutional investors need intermediaries who specialize in finding, structuring and managing the equity investment in order to diversify their investments by investing in several PE investments. By doing so, the use of the limited partnership as an investment vehicle might overcome some of the information asymmetries in connection with equity investments due to the special knowledge of a go-between; the investor, however, is exposed to so-called agency problems, which may result in conflicts between entrepreneur and GP and between GP and investor i.e. the LP. Thus, one has actually to acknowledge that the investor, in particular the Fund-of-Funds investor is exposed to multiple agency problems. The agency theory assumes that the nature of human behaviour is self- interested, subject to bounded rationality and risk adverse (Eisenhardt 1989). Due to an existing conflict of interests (e.g. about fees) and information asymmetry, it can be argued 11 that the agent is only willing to disclose information if this information reveals him or her in a favourable light. Since the asset class is opaque and therefore benchmarking with other investments in this asset class is very difficult, the agent might fear that further disclosure of 11 Even so it is not empirically proven, although indications from various discussions point to this direction of argument. 11
  12. 12. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective information might lead to prying further into the management of the investments and, in consequence, the discretionary power might be pruned. Thus since it is difficult to justify out-performance (due to the peculiarities of this asset class) because the agent in the stage in question (i.e. the entrepreneur, the GP of the Venture Capital Funds or the management of the fund-of-funds) is not willing to disclose any information more than the minimum, as a result of the bargaining power between agent and principal. It is obvious that this industry structure does not promote the development of standards which would then prevail 12 . In the long run, nonetheless, an improved transparency will be merely necessary due to a higher exposure of institutional investors in this asset class. Since institutional investors are subject by law to higher monitoring standards, further exposure will inevitably require improved monitoring in this asset class, which is only attainable by relevant uniformly applied standards in this asset class 13 . Some of the PE representatives have already recognized this and have proactively tackled the impediments to the development of the asset class: “We felt the industry should set its own standards before they are dictated to us” (Jose Sinai: in Burns 2002)14 . 12 Whereas three years ago the main concern in the industry was the lack of availability of attractive investments, now it is the increasing scrutiny of institutional investors who are debating whether to continue to inject additional cash streams. In particular, additional follow-up financing is needed in order to keep start-up investment alive and lower valuation is apt to startle institutional investors. Nevertheless, the fact that institutional investors have discovered this asset class as a means to increase their portfolio returns and diversification alleviates the pressure: Funds continue to flow in (though at a lower level) regardless of the unease at declining returns, transparency and fees (Tassell 2002). 13 For instance, due to the lack of risk classification methodology under the new Basle II Accord, PE would be classified as high-risk, which would imply that banks have tied up more of their own capital funds than they could bring into a PE investment. In consequence, the financing for this asset class would be an unattractive proposition for banks and thus this source of funds, which after all represents 22% of all PE financing, might not be available for the PE as an asset class (EVCA 2002a). 14 Mr Sinai is a member of the Standard Board for the PE industry. 12
  13. 13. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 2 Literature Review and Theoretical Framework Information deficiency problem in respect to: 2.1 Data Availability and Opacity of this Asset Class Information on the PE investment is difficult to obtain from public sources. Unlike mutual funds, PE is typically exempt from laws which require companies to publicly disclose their portfolio structure and investments in annual reports or filings with the authorities. Thus, information on both invested companies and limited partnerships is difficult to identify (Gompers and Lerner 2002). Currently, two major professional information provider services are available: VentureOne and the Venture Intelligence database. VentureOne 15 , a unit of Reuter’s, collects data on firms which have obtained venture capital financing 16 . Venture Intelligence 17 offers a similar service to retrieving PE data. However, Gompers and Lerner (2002) found that some of these are not completely accurate. Thus the opacity problem of this asset class stems from the lack of reliable market information. Another problem area is the disclosure of financial information. Entrepreneurs and GPs tend to limit the information made available or tend to be extremely reluctant to disclose information. The availability of information makes it difficult for investors but also for investment managers to monitor and manage their investments. Additionally, the information available is limited in explanatory power due to the unknown underlying assumptions and methodology used. In order to improve the transparency of this asset class, the industry can adopt a common set of valuation guidelines and disclosure standards (Beaudoin 2002). 15 Please refer to http://www.ventureone.com. 16 VentureOne's research tracks the business progress and financing plans of venture-backed entrepreneurial companies. VentureOne conducts both primary and secondary research on organizations which are primarily VC companies. In addition, they carry out research resulting in a quarterly survey of venture capital and private equity firms. First one has to acknowledge that information retrieved by interviews is strongly driven by the interviewer-interviewee relationship which potentially has problems of bias. Especially in this context, the interviewee may not tell the truth or may over- or understate certain facts and thus information retrieval in PE is exposed to elements of uncertainty. 17 Please refer to http://www.venturexpert.com. 13
  14. 14. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective This however, does not address the whole of the problem, since mere comparability is insufficient. Additionally, the industry needs to consider how mechanisms can be established for the provision of comparable data in order to determine a PE investment performance. It is plausible to argue that sophisticated IT will form their basis in achieving this objective. The use of information technology may form such a basis, but the major success factor for improved monitoring in PE will be determined not by the use of technology, but by the willingness of all participants to indeed remedy the opaqueness, which might be the most important obstacle to the maturing of this asset class. This is due to the so-called prisoner’s dilemma: each participant in the investment chain (i.e. the entrepreneur, the GP, the LP and finally the investor in the case of fund- of- funds) is acting in its own self- interest. What is unknown, however, to each participant is the action and reaction of the others, which often leads to the strategy of non-disclosure 18 . Thus, since action and reaction patterns are not known between the parties a typical prisoner’s dilemma situation is established, which is logically counterproductive in terms of improved transparency and information disclosure within the industry. The fact that in this industry we have to deal with inefficient asymmetric information worsens the situation, since asymmetric information allows supernormal returns to be attained as a function of the possession of asymmetric information (in respect to both quality and quantity). 18 For instance, entrepreneurs may decide to invest in a new machine (i.e. they make use of the funds in a way which benefits them). The entrepreneurs do not know the reaction of the Venture Capitalist. The Venture Capitalist may object or become more concerned and therefore could require more monitoring actions or refuse additional capital. But if the Venture Capitalist does not know the entrepreneurs’ reaction to this decision, the entrepreneurs may become less motivated or may change their strategy (which thus ceases to be optimal from their point of view). Similar action/reaction may also apply between the Venture Capitalist and the LP and between the LP and the investor. 14
  15. 15. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 2.2 The (Double) Agency Problem and Asymmetric Information 2.2.1 Transaction Cost Individual investors have only a relatively restricted amount of funds available and therefore can undertake only a restricted number of investments. This leads to an inability t diversify risks. Financial intermediaries evolved over time in order to o reduce transaction cost. In the case of Fund-of-Funds investments there are two intermediaries: The VC as GP and the Fund-of-Funds as LP. Both exist, since their intermediation leads firstly to economies of scale and secondly to improved decision- making on the part of the investor. The former reduces transaction costs, since both LP and GP bundle the funds of many investors, so that they can take advantage of economies of scale. Without the intermediaries, each individual investor would need to invest a (relatively small) sum in each company. Since transacting in PE brings with it even higher transaction costs (since there is no such thing as a standardized contract as there is in the stock exchange), the necessity to bundle transactions becomes even stronger than it is for mutual funds. The latter arises from informational asymmetries. Financial intermediaries in the form of Venture Capitalists exist additionally because they are able to specialise and thus develop expertise. In PE above all this holds true. Lerner (2000b) argues that other potential financial intermediaries (e.g. banks) lack the necessary skills to evaluate and monitor this kind of projects. Additionally, the individual competition which is known in this kind of intermediaries is inadequate for monitoring since individual compensations are not linked to the funds’ returns. Thirdly, intermediaries from other areas have to obey regulations and cannot freely invest in PE. Lastly, the nature of the business makes it impossible for banks to grant orthodox means of financing, such as loans, since the risk associated with the project makes it impossible to use debt for financing, the level of risk associated with the investments would lead to interest rates which were out of touch with reality and unsuitable VC investments. The existence of transaction costs only partly explains why intermediaries - that is, Venture Capitalists and Fund-of-Funds - exist (Mishkin 1995). In order to 15
  16. 16. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective attain a comprehensive understanding, the factor information needs to be considered in more detail. Asymmetric information exists when one party has insufficient knowledge about the other party involved in a transaction to make accurate decisions (Mishkin 1995). Thus, asymmetric information is information concerning a transaction which is unequally shared between the two parties to the transaction. The most famous application of the problems which asymmetric information can create has been Akerlof's discussion of the second-hand car market. Other important applications relate to the principal-agent problem and moral hazard (www.xrefer.com, 10.07.2002). 2.2.2 Adverse Selection Akerlof (1970) showed with the so-called “lemon problem” that the result of information asymmetry is adverse selection, i.e. that in the venture capital market bad investments force good ones out of the market, since investors cannot distinguish high from low quality investments. Consequently, both kinds of investment must be being offered at the same price (for equity capital) which reflects the average price for the project on offer. As a consequence, first, bad projects might tend to be overvalued which would result in lower returns than demanded by the investor for undertaking a highly risky investment. Second, the price for which the entrepreneur sells the equity stake for superior projects might be too low and the entrepreneur would not be willing to commence a highly risky project if the potential reward were not high enough to compensate for this. Thus, due to the lack of incentives, superior projects might be forced out by inferior projects and information asymmetry. Thus the adverse selection phenomenon applies directly to the PE market (Milhaupt 1998) and reduces the efficient allocation of funds within this industry. Investor therefore claim high hurdle rates to compensate for the informational risk involved within the asset class (Smith and Smith 2000, 399). Since PE investments are in competition with all other asset 16
  17. 17. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective classes, it is obvious that this characteristic has an adverse effect on the asset class so as to attract funds at reasonable cost19 . 2.2.3 Moral Hazard Moral Hazard arises after transactions are completed (Mishkin 1995). The investor runs the risk that the entrepreneur will engages in activities which are undesirable from the investor’s point of view. For instance, the entrepreneur might misuse the funds of the investor. One interviewee for instance told a story in which the Venture Capitalist did not partic ipate in the payback of an invention since the patents were held in a different company; however, a certain portion of his funds was used in the development of the product since the company which the VC fund was invested in had incurred a significant portion of the development costs. Akerlof (1970), Mishkin (1995) and Gompers and Lerner (2002) show that if the information asymmetries could be eliminated, financing constraints would disappear. Thus improved transparency by improved disclosure and monitoring can alleviate the information deficiency problem. Although it might address the adverse selection in the initiation phase of an investment, monitoring might reduce information asymmetries at a later stage. Normally PE investments, in particular in venture capital, are not undertaken in one major investment but divided into various financing rounds where the committed capital of the investor is drawn down. Thus the investor has the chance of reducing the risk of adverse selection since the time between the financing rounds may produce further information. If a sustainable monitoring system is in place this can be used to reduce informational gaps to allow an investment appraisal. It is apparent that for PE to become mature, current monitoring procedures and practices need to be improved to overcome the deficiencies of this asset class. Sensible standards for the interchange of both monitoring and investment data will be one fundamental element for fostering PE without ignoring the idiosyncrasy of this asset 19 This inhibits to some extent the development of this asset class and can be seen as one of the reason why – in particular in continental Europe – the percentage of investments in relation to GDP is rather low. Please refer to Appendix Figure 5. 17
  18. 18. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective class. It is the objective of this research to shed some light on this barely considered issue. The literature review and theoretical framework together provide a sound theoretical basis for extending the research into practice. Summarizing, it is now clear why the PE industry is so opaque, what its features characteristics are and what characterises the relationship between LP and GP 20 . Given the theoretical framework and its impact, I want now to discuss the empirical findings. 20 Further information may be found in the Appendix about different guidelines in the industry and the potential impact of standards. 18
  19. 19. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 3 Assumptions, Research Method and Research Evaluation 3.1 Assumptions The views studied are not meant to be truth in the sense of quantitative and statistically backed research. Rather the suggested observations and conclusions are offered more modestly as tendencies or crude generalizations for which they might be many exceptions. However, I believe to formulate inductive conclusions in form of finding communalities from various interviews is beneficial to our understanding of the hardly researched PE area. Information deficiency problem of Fund of Funds Double sided principal agent Double sided principal agent with informational asymmetries with informational asymmetries and potential adverse selection / moral hazard and potential adverse selection / moral hazard Fund of Venture Capitalist Funds Investee (General Partner) (Limited Partner) Interest Reporting of capital commitments Company Performance Usage of funds for investment Fund Performance Fund Performance Not willing to disclose information Portfolio Reporting Portfolio Reporting Stock Distribution Risk exposure Capital Account Risk exposure Specific Industry knowledge Information avail on actual Degree of Reporting Specific management knowledge company state influence Funding Representation on board Visits Personnel decisions Determinants Strategic decisions Funding Content: What? Emphasis of the research Granularity: How detailed? (including influence of VC ? Investee relationship on LP ? GP relationship) Frequency / Timing: How often / When? Delay of disclosure: Lack of disclosure on time Diagram 1: The Information Deficiency Problem of Fund-of-Funds Secondly, as can be seen in Diagram 1, the research was conducted from the Fund-of- Funds perspective. The research sought to improve the understanding of LP and GP relationship in order to improve monitoring of Fund-of-Funds investments. 19
  20. 20. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 3.2 Research Method 3.2.1 Research Design The research conducted in this thesis is based on an approach which combines the descriptive, exploratory, explanatory and prescriptive. It is the aim of this thesis to contribute to knowledge in the area of PE since academics so far have paid little attention to it. The reason for this is the relative unavailability of data and the need to use intricate methods such as interviews for data collection. The aim which is highlighted in this research therefore is to: 1. Describe and highlight the nature of the information deficiency problem in this asset class 2. Present the current status quo of monitoring and reporting approaches in this asset class, using examples from several Fund-of-Funds organisations in Europe 3. Determine the requirements and needs for an improved risk and monitoring system for a Fund-of-Funds organisation and suggest potential improvements Question Research Design Conceptual Source of Data Framework 21 1 Combination of descriptive, Qualitative Secondary data, literature explorative and explanatory review approach 2 Combination of descriptive Qualitative Primary (interviews with and explanatory approach questionnaire) and secondary data 3 Explorative and prescriptive Qualitative Primary (interviews with approach questionnaire) and secondary data Table 1: Research Design In the literature review and in the status quo section of the empirical findings the characteristics of PE are presented using a descriptive approach, where the major known theoretical frameworks of information problems are presented. The explanatory 21 It is assumed that the amount of data and the scope of the project makes it impossible to retrieve statistically significant propositions 20
  21. 21. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective and explorative approach is used to show the causal relationship of the theories in PE and to hint at further research directions. For the second aim, the same approach is used in order to derive generalisations about specific informational requirements for the monitoring of various participants in the industry. For the third aim, a combined explorative and prescriptive approach is used in order to forecast the future development of in PE monitoring management. These methods are used since the goal is not drawn from any statistical conclusions derived from the empirical findings. 3.2.2 Conceptual Framework: Qualitative Method and Semi-Structured Interviews In a qualitative approach the researcher aims to understand or find a specific pattern within the investigated area. In this approach information is collected and then analysed and interpreted within the aim of answering questions without converting the data into numbers and statistical inference. Thus in a qualitative approach the researcher’s conception or interpretation of real world phenomena is critical. The method used in this research is of a qualitative nature and drawn from semi- structured interviews. According to White (2000), interviews have advantages because their face-to-face nature can reduce misunderstandings for instance by re-wording or re- ordering questions. Semi-structured interviews are particularly advantageous if a complex stock of knowledge about the topic under study need to be extracted from interviewees who can answer questions spontaneously (Flick 2002). The interviewer guides the discussion by asking specific question. The questionnaire used during the interview ensures that the content and development of the interview reaches a minimum standard to serve as a basis for later analysis. In this way, the advantages of an open interview leading to a sound structure for the analysis can be secured. Since the Research Design is of a descriptive, explanatory, explorative and predictive nature, I believe the semi-structured interview is the most appropriate method to collect qualitative data which will show up specific patterns in the PE industry. 21
  22. 22. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 3.2.3 Data Collection and Studied Interviewees The study is based on primary data which was collected by means of 14 semi- structured interviews in the period July to August 2002. Most of the interviews were conducted in person in order to maintain the explanatory, explorative and prescriptive approach best. I found that the conduct of an interview was easy and effective, since I was able to get immediate, though indirect, feedback from the interviewee. Potential interviewees were identified by means of the EVCA membership directory. Since the research focuses on fund-of-funds, only LPs which were classified as Fund- of-Funds in the EVCA directory were contacted, except for two GPs. The reason for this exception was my speculation that, in order to understand the LP-GP relationship, views from GPs might give additional valuable insights. Another source was the Internet, where I could identify potential interviewees from quotations in the press. In this way, for instance, I found the PE consultancy, which turned out to give some valuable insights, since the consultancy is completely detached from the actual business. In addition, I was able to talk to several PE houses. I made contact with them directly by telephone and potential interviewees were asked if they would participate in the research. At this point, I soon found out that it was much more difficult than I had expected to persuade potential interviewees to take part. I learned that many of the investment managers I contacted were quite reluctant to support such research, which might shed some light on this opaque asset class. It is also possible that some of the interview candidates might have not believed that the intention of this interview was merely academic research and might have supposed it a ruse by a competitor. All in all, this seems to confirm that the industry has to some degree the tendency not to move towards transparency, due to the adverse effects on established LPs or GPs, as described in the literature review; hence, this confirms to some extent the theoretical framework. This was also the reason for shifting the research from methodological to technical aspects, which immediately improved the willingness of potential interviewees to participate in the research. 22
  23. 23. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 3.3 Research Evaluation In order to minimize possible errors which might impair the empirical findings, every research evaluation must discuss its own validity and reliability. Validity addresses the issue of whether the research measures what it should measure, i.e. does the research design fully address the research questions and aims thought to be achieved? (White 2000). Reliability considers the quality of the measurement, i.e. to what extent findings can be replicated by another researcher using the same research design (Flick 2002). This does not, however, imply that the new interpretation and conclusions will be the same (White 2000). Type In Person Telephone EVCA Abbreviation22 PE Conglomerate / 2 1 18 A Independents Captive Bank / 2 - 6 B Mutual Fund Captive Insurance 2 - 1 C Professional Institutional 1 - 7 D Association - 1 - E GP 1 - - F Consultancy 1 - 5 G Academic 1 - - H Software Vendors - 2 - I Table 2 As can be seen from Table 2, the interviewed institutions represent a fairly diverse body 23 . Therefore the cluster sampling method should be adequate. I used the classification of Temple (1999) to delimit the sub-classes from each other. Although admittedly the interviews were not determined by exact representation of the market place but by mere availability, I still believe that it provided a representative selection for determining tendencies and attitudes by qualitative means. Clearly, the data has an inevitable bias towards institutions which were willing to participate in the interview, which is undoubtedly one of the limitations of the research. Furthermore, it must be 22 Used for the quotations in the data analysis part of this research. 23 Please note that the interviewees are located in London (5), Munich (3), Birmingham (2), Frankfurt (2), Brussels (1), and Paris (1). One might consider the country-specific differences within the sample as a limitation of the study. 23
  24. 24. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective acknowledged that the outcome of the research very much depended on each interview, all of which were very different from one another. It should not be forgotten that while some interviews, even though they were kind enough to participate, may have not made their true opinions apparent at all times during the interview. In the EVCA directory, 37 Fund-of-Funds companies are listed, which supposedly represent the majority of European fund-of- funds. Of the 7 Fund-of-Funds interviewed, 4 are EVCA members or associates. When the 37 EVCA Fund-of-Funds members are compared with the sample, one can see that there is a slight under-representation of conglomerates, consultants and professional investors and an over-representation of captive investors. Additionally, one should note that the classification was made according to my judgement of the companies’ internet pages which I viewed. It does not imply that the companies would have classified themselves in the same way and this should be seen as an additional limitation. The main concern of this study was to obtain a sample which would allow the research problem to be fully addressed rather than establishing a statistical acceptable level of inference. The sample does not only include investment professionals but also people from related professions, academics and software vendors, since these might potentially contribute by giving their own specialised views in the area of methodology and technical aspects. 24
  25. 25. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective 4 Empirical Findings / Data Analysis 4.1 Status Quo 4.1.1 Monitoring Policies and Process Concerning the status quo of monitoring policies one has to recognize that there is no single common standard. This is a major problem for LPs, since they receive the information in different formats, predominately paper-based, and this complicates monitoring management. Additionally there is no consistency in reporting i.e. the way in which information is reported or financial reports are presented, how valuations are made and how much informatio n on the underlying portfolio companies is made available. This incoherence must also have an impact on the LP’s monitoring policies and processes. Monitoring approaches of the different players Many of the interviewees made clear that their company has a quite unique approach and that this unique approach is considered to be a source of competitive advantage. “I haven’t come across a GP or LP with really efficient and effective seamless monitoring policies and processes which everybody followed” (G) Obviously, the initiation of a deal attracts most attention since the characteristic of this asset class makes it difficult to revoke an investment once made. However the concomitant monitoring should not be underestimated since the early identification of trends allows the LP to potentially influence its investment to move in a desirable direction and thus can significantly reduce sudden surprises. With respect to content, most of the respondents agreed that the EVCA are reflecting what is most commonly used in PE for monitoring management. However one could sense that the opinions on the EVCA guidelines were quite diverse. A small majority stated that the EVCA guidelines are a good approach, facilitating monitoring management. Companies 25
  26. 26. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective interviewed in the UK unanimously preferred the BVCA guidelines. But criticism of the proposed guidelines could be clearly be observed: “All guidelines proposed by associations are so opaque that they are almost valueless.” (C) Contrariwise one interviewee bewailed the inflexibility of the EVCA reporting guidelines. What can be concluded from this is that the views on reporting guidelines are inconsistent and subjective. Thus the industry seems to be far from a consensus in this area. It is acknowledged on the association level that the guidelines are not used in a coherent way. However in terms of content, most of the GPs strive to provide the information proposed in the EVCA guidelines, although some methodology issues in this industry remain a sore point, such as the IRR calculation. Additionally during the interviews it was often noted that different reporting frameworks (including different formats, terms and reporting principles) make it sometimes cumbersome to find the information needed by monitoring management from PE fund reports which are not in line with the EVCA guidelines. However, the tendency is that whereas for larger, more professional funds the introduction of the EVCA guidelines did not lead to a noticeable improvement in the reporting quality, smaller funds, in contrast were forced to improve their overall reporting and disclosure quality, which lead to less difference in reporting quality in line with the size of the PE organisation. Reporting Frequency Regarding reporting frequency, there was almost a unanimous vote on quarterly reporting. It is important to note that some of the interviewees emphasised the fact that in PE it is more important to identify a clear trend than a point-of-time snapshot of the fund investments which is more relevant in pub lic equity investments. Therefore monthly reporting was considered not to provide any additional benefit, i.e. it was merely considered to impose “additional noise”. The majority of the interviewed LPs remarked that the mainstream of its GPs provides quarterly reporting, though some European GPs still struggle to maintain this interval. 26
  27. 27. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Monitoring Procedures Monitoring procedures were quite different in detail, but some major tendencies can be determined: whereas captive and profession investors tend to make a clear distinction between investment management tasks and back-office tasks, independent PE houses tend to see these two functions as not distinctly separated. Thus the typical monitoring process for the former consists of a dual process approach, which separates formal from informal reporting24 . Generalizing, one can say that there is a tendency for larger players to differentiate between obtaining qualitative data by direct interaction of the investment managers and quantitative data represented by internal systems provided by a back-office functionality. For smaller PE conglomerates in particular, the lack of a distinct back-office implies that there is no separation of the financial data gathering and information obtained by specifically informal means. If the monitoring processes on the LP side are considered, the interviews revealed that there are differences between PE captives and conglomerates/independents. Whereas captives tend to have a more formalized and stringent monitoring process due to regulatory requirements25 , for conglomerates the monitoring information is more driven by potential return and cash- flow (draw-downs) deliberations than by the regulatory and risk aspect26 . Conversely, a typical process in a conglomerate is completely driven by the investment manager’s perception of how to monitor the investments for which he or she is responsible. This implies that the monitoring processes, too, need to be structured differently. For captives, the process is very much formalized and seems to 24 Formal reporting by the means of quarterly reports is often supported from the back-office by providing the GP’s fund information within the internal system, whereas informal reporting and analysis are normally carried out by the investment teams using both informal information which is gathered by means of personal interaction and financial information provided by the back-office. 25 for instance in Germany the „Mindestanforderungen an das Kreditgeschäft der Kreditinstitute“ (MaK) and the Basle II Accord. 26 For instance one interviewee of a captive depicted an internal process which included the appraisal of funds according to some objective criteria. Additionally, some standardised qualitative data are used to build an overall assessment of the investment into this fund. Furthermore an independent second rating takes place which results in an assessment. Both assessments need to be in line, otherwise the investment will evaluated further. Another example from an insurance company shows that for the internal group, risk reporting of certain assessments and evaluations must be carried out, such as the impact of currency deviations on the investment. 27
  28. 28. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective be closer to a risk management approach for loans with quite narrow rating criteria. The emphasis of conglomerates, however, is more informal with emphasis on future oriented information. 27 Data Availability Asked about the how they treated the difficulty of obtaining data most respondents made clear that the contractual obligation of information disclosure is in most participation agreements defined in a very fuzzy and loose way and thus it is difficult to derive a formal entitlement of specific reporting information from it. Therefore the vast majority of respondents agreed that the most valuable information is acquired by nurturing personal contacts between LP and GP, which was also considered to be the only really feasible way of overcoming data ava ilability. Accounting Standards To the question whether accounting standards are an issue in PE monitoring management, a clear majority replied that differences in accounting standards are not an impediment. GPs are expected to represent its portfolio irrespective of the accounts and give an objective view of the situation of the investment within the portfolio, i.e. it is expected that differences in accounting standards will be eliminated in the GP reporting. However, one significant shortcoming in reporting was considered by most interviewees in the valuation methodologies. Current difficulties concerning reporting and monitoring were considered mainly in ambiguous valuations i.e. the valuation methodology/guidelines and not the disclosure of the information i.e. the reporting methodology/guidelines per se. 27 For instance the process for a conglomerate Fund-of-Funds often includes a deviation analysis and a personal feedback-loop. The qualitative feed-back is then used to enrich official reported information with the intuitive impression and derive an own specific assessment of the investments; for captives, however, there is the tendency for assessments to be based on a more objectified basis (i.e. quantifiable information and formal scoring models). 28
  29. 29. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective “If you cannot compare what is happening in relation to other funds you have a big problem.” (E). 4.1.2 Monitoring Factors Measures Concerning monitoring factors, there were quite different views on the current methodology. Most of the interviews clearly preferred multiples 28 to IRRs 29 , since the IRR methodology is an imperfect measure for comparisons. “I don’t care what the internal rate of return is. I care about multiples.”(C) Surprisingly, most of the interviewees were not much concerned about the methodology issues which discuss the deficiency in the PE area in measuring performance. Currently the emphasis is clearly on the valuation and provisioning of the funds, although one has to ackno wledge that this issue has an impact on the calculation of returns. While in the technical literature the issue is at present extensively discussed (“LP become more concerned with how returns are getting reported”, Bhaktavatsalam (2002)), the practitioners interviewed seemed not to urge strongly for changes. It seems that investment managers are aware of the shortcoming of the lack of a standardised methodology and accept the limitation associated with it. One reason for this might be the fact that the actual performance can in any case only be determined objectively when the fund has been closed. 28 The most common multiples mentioned were Distribution to Paid-in, Residual Value to Paid-in, Total Value to Paid-in 29 The most common IRR factors mentioned were Average IRR, Capital Weighted IRR, Pooled IRR and its statistical indicators Median IRR, Standard Deviation, Maximum and Minimum IRR, Upper and Lower Quartile, Median IRR 29
  30. 30. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Portfolio View vs. Individual Investment View As already indicated, some interviewees again made clear that it is more important to identify the trend than to have a snapshot of the portfolio. One explanation might be that larger PE Fund-of-Funds due to their size alone have a more portfolio management view of their investments and are therefore less interested in specific information. This is due to the improved diversification effects of larger portfolios. 4.1.3 Interaction between LP and GP and Standards Relationship LP <=> GP The emphasis on personal relationships in this industry is a predicament for large PE players, since with the increase of the number of engagements, risk and monitoring management becomes more and more difficult to handle in the absence of an advanced information management system The relationship between LP and GP was characterised in varying ways, i.e. a common opinion on the relationship between LP and GP cannot be found in the interviews. Most of the interviewees considered the relationship to be a combination between reactive and passive, i.e. most of the GPs send out their quarterly or annual reports on a continuous basis and respond to ad hoc queries reactively. There is a consensus that it very much depends on the individual relationship and the professional advancement of the PE organisation and the sub- industry classification. Standards in the Industry Concerning standards, the vast majority of interviews paradoxically recognized the problem area and welcomed the idea of improved standards, but nobody actively supported such development. 30
  31. 31. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective “The real big problem is a missing standard around the world; sometimes you don’t get the information in a feasible way.” (B) “There is a real issue of information management in PE. And this between Portfolio Company and GP but also between GP and LP. Because there are no standards you get ad hoc requests. If you standardise, the number of ad hoc requests fall. In terms of efficiency this has be more efficient” (G) Many of the interviewees pointed out that the possibility of generalising is limited by the fact that each LP and GP relationship is unique. In particular PE Fund-of-Funds seem to emphasise this and take advantage by requiring additional information according to their specific informational needs30 . Thus one can observe the tendency that many of investment managers interviewed considered the establishment of a standard to be insufficient to fulfil their individual information requirements. It is believed that the most value adding information to portfolio management can in any case be acquired only informally. Secondly, some of the interviewees argued that before an industry-wide standard can be achieved, an additional maturing of the industry - in particular in Europe - is necessary. Currently the level of sophistication in reporting is very variable. Many interviewees therefore thought that once a higher level of sophistication is achieved throughout the industry, the introduction of improved common standards might become possible. On the association level the establishment of an electronic standard for data exchange is considered to be premature. The greatest challenge is currently considered to be in the area of valuation and related problems 31 . Generally speaking, the major current problem in reporting is that the content of the report is normally defined by the GP and 30 The research shows that additional qualitative information is often retrieved in an informal way, which allows the Fund-of-Funds to gain a fuller overall picture of the investments, in particular where forward monitoring information is concerned. Some PE conglomerates interviewed use a kind of balanced scorecard which determines the additional information in a systematic way. 31 Especially on the association level it is believed that until these issues are resolved, standardisation by the means of electronic data exchange will not be not feasible. Since valuation is at the midpoint of all the efforts to improve, EVCA is convinced that it is not at present feasible to consider a subcommittee. 31
  32. 32. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective the contractual obligation of reporting normally does not specify the quality of reporting, i.e. the reporting clauses are normally quite vague. The availability of information was mostly considered to be determined by the relative bargaining power between the parties and the extent of personal relationships. “The reason why there is no standard is primarily most of the power is at the GP not the LP. Every organisation has different needs. The GPs play on this by saying ‘That is just how we report’. Nobody else asked for it and thus you don’t get an answer. And thus they stick to their own methodology and thus there is a lot of inertia there” (B) 4.2 Requirements 4.2.1 Reporting The EVCA reporting guidelines have been derived by the best practice in the market- place and represent the most common information used for monitoring management in the PE industry. The questionnaire divided the requirements into content, volume, granularity, frequency, speed of response, data quality, access and presentation. Concerning content, most of the interviewees considered the EVCA guidelines to be sufficient in general32 . “The EVCA guidelines represent a good framework how to structure a report. Most of the report might have different layouts, but the respective information can normally be extracted from the reports.” (A) However when asked for risk management information, most of the interviewees remarked that for this area, the EVCA reporting guidelines are quite vague and the information disclosure depends very much on the GP’s willingness to disclose this 32 i.e. the informational partition in capital commitments, fund performance, portfolio reporting, stock distribution and capital account covers the aspects which are necessary to monitor the respective investments. 32
  33. 33. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective information in its reporting framework 33 . Concerning the volume and frequency, there is a firm consensus that reporting should be on a quarterly basis from the GP, with quarterly data 34 . An increase in reporting frequency was not considered to be beneficial but counterproductive, firstly due to the nature of the asset class (illiquidity) and secondly because it would not help to identify long term trends. The real issue, however, was considered to be the granularity of the information given. “What is missing is transparency. Some information is hidden in some aggregated figures” (C). This was in particular the case when fees were considered 35 . In addition, many interviewees wanted an improved breakdown on the portfolio company level36 . For Fund-of-Funds which are engaged in VC, cash figures were considered as being in particular important, which complemented the information supplied by ratios 37 . However since the accounting data is merely a snapshot of the company rather than a change in time, it is not astonishing that interviewees who required additional information by means of higher granularity made clear also that the most interesting information is the deviation (i.e. the dynamic of change). “It is more important to identify trend than the point in time and why. It is about am I going where I intended to go rather then where I want to be today” (A) 33 One investment manager remarked that there is a dilemma for GPs: On the one hand they are obliged to disclose information so that the LP is able to get an idea about the risk exposure, but on the other hand further information on risk may potentially reduce the chance for the LP to engage in future undertakings. Thus there is a tendency for risk exposure disclosures to be quite vague and bland. In additional to the disclosure problem itself, it is difficult to present each specific investment case objectively in the absence of a common risk framework. 34 The input of the quarterly reporting data (e.g. for the calculation of IRR) was required to be based on monthly data however. 35 One investment manager complained that the management fee breakdown is so different from fund to fund that one cannot really obtain a clear picture of how the overall costs are incurred. Therefore it was considered beneficial to have common standards with an exact classification of the different costs, which would in turn improve transparency and comparability. 36 In particular information on sales, profit and margins, overheads, and interest were most commonly required as performance indicators. Moreover, information from the balance sheet such as overdraft, cash, stock, debtors, creditors, net assets and total borrowings were found necessary to comprehend the capital structure of the portfolio company. 37 such as liquidity, gearing, interest coverage, stock turnover and debtor/creditors coverage 33
  34. 34. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Therefore the amount of information does not in itself improve the understanding of the investment in the absence of actual, budget and previous period information. Given this the current situation can be appraised and the longer term trend can be determined. What was pointed out by several interviewees was the need to have the underlying assumptions available for any disclosure 38 . Concerning speed of response, one has to differentiate between on-going reporting and ad hoc queries. For on-going timely reporting, it was considered to be very important for Fund-of-Funds since Fund-of-Funds need time to consolidate the investments and then report to their investors. Most investment managers said that they allow the GPs 60 to 90 days for quarterly reporting. For ad hoc queries, most of the interviewees said they needed the information instantly or within 24h at the latest. Regarding access and presentation most interviewees voted for an integrated solution which stores all the necessary information centrally. This however should be flexible enough for ad hoc queries and customized report generation. Additionally, some wanted to download certain information in a spreadsheet forma t for additional analysis. 4.2.2 Monitoring Factors Differences in the Monitoring Factor Requirement This section asked the interviewees where they see potential improvements for improved monitoring factors. First of all it is important to note that a major difference can be seen between larger Fund-of-Funds captive institutions and Fund-of-Funds conglomerates. Whereas the former seem to have a more portfolio management point of view, the latter rather emphasise individual interaction. The emphasis on each 38 Information is only meaningful if the underlying assumptions are known. One issue concerns the definition information, i.e. how it was retrieved. For instance, there are various ways to define “gearing”. An appropriate appraisal without the exact or even using changing definitions is not feasible. Other types can be explained by the bounded rationality theory of human beings: only if the entire circumstances of the appraised portfolio company are known can the optimum decision making be achieved. For instance the closure of a company’s plant might be misinterpreted as worsened sales and profit margin if the entire picture is not provided. However, it should be made clear that fund of funds are not supposed to interfere in the GP’s decision making in the interests of increased transparency. 34
  35. 35. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective individual investment leads to a closer review of the actual investments which the GP undertook, i.e. the portfolio companies. It is not surprising that this difference in the management of the investments in PE funds has also a direct impact on the information required. Thus monitoring factors for large captive Fund-of-Funds are more similar to the one in public market portfolios with an emphasis on diversification factors such as industry, currency and style 39 exposure, vintage year and performance measures. However, monitoring factors for smaller Fund-of-Funds tend to be more qualitative and often require this information in order to prepare a SWOT analysis for the investments undertaken 40 . Furthermore, smaller Fund-of-Funds tend to require more quantitative information of the portfolio companies, as mentioned earlier. The major problem was considered to be identifying investments which are “on or off the track” rather then a snapshot. “All you need to know for us is whether the data is used consistent and what is the trend” (B) Nonetheless, by merely looking to the individual companies, it is difficult to derive an overall view of the different investments. As one investment manager pointed out, he needs somehow an aggregate view of the portfolio i order to infer the state of the n investments. “What is interesting me is the condition of the portfolio. How can I measure this?” (A) The comparison of actual, planned and previous budget measures stated by the individual portfolio company, however, does not give an overall picture of the portfolio. Therefore some interviewees proposed to develop new measures which would describe the overall condition of the portfolio. The idea brought up was to develop certain ratios 39 For instance Early/Seed Stage, Balanced Venture, Later Stage Venture, Venture, Buyouts, Mezzanine. 40 It is important to note that the interviewees who advocated the SWOT analysis also make clear that the important monitoring factors result from comparing previous SWOT analysis with current ones in order to identify major deviations. 35
  36. 36. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective for the entire portfolio similar to already common used pooled IRR41 , which would then constitute an indicator for the entire portfolio 42 . Information on Future Developments In addition to this some interviewees would have liked to have more information about future potential developments, since this formation is normally extracted on an informal basis. It is obvious that this requirement is difficult to standardise. The use of a balanced scorecard approach, however, might be an option to represent both qualitative and quantitative aspects. One interviewee considered this approach as being the right one to improve monitoring: “Essentially, I think the monitoring factors will be around some kind of balanced scorecard” (G) Some interviewees, however, considered monitoring and risk management as being a job which is carried out by the investment managers themselves through their personal and informal relationships with the GPs. In their opinion, risk management cannot be supported by improved reporting standards or additional figures. “[Risk Management] I don’t think you can do anything with standards. That’s my job as an investment manager. I know my portfolio, I know where my risk is and I know where I am - ought to be. The real value added is to talk to the GPs personally on how the companies are doing. This is where my value added is coming in.” (C) Both statements are quite representative of the divergent opinions in the entire interview body. The difficulty of measuring risk in PE consequently makes it difficult to apply objective measures. Balanced scorecard approaches try to reconcile both 41 The pooled method is a measure which attempts to capture investment timing and scale. The pooled return is calculated by treating all funds as a single "fund" by summing their monthly cash flows together. This cash flow series is then used to calculate a rate of return (NVCA Methodology) 42 For instance for a start-up fund, a “pooled burn rate” might give an indication how far the fund is exposed to the liquidity risk of invested companies in comparison with the market average. 36
  37. 37. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective qualitative and quantitative measures by means of defined dimensions which represent the success factors of the investment. Since the actual advantageousness of a PE investment can only be derived after the closure of the fund, many interviewees considered the attempt to improve entropy by including additional qualitative information to be futile. “You end up with a series of exceptions which makes the underlying systemic approach more difficult” (B) The majority however agreed that there is the potential to standardise formal, quantitative information i.e. quantifiable accounting information. 4.2.3 Interaction between LP and GP and Standards Concerning interaction between LP and GP, the interviewees generally agreed that most importantly standardisation and automation in the reporting should lead to two major advances: improved information management should reduce the necessity for ad hoc queries, i.e. more relevant and better information would be available for investment appraisal which would reduce the number of further inquiries for routine monitoring and risk management tasks. As a consequence, however, the overall interaction between LP and GP is not thought likely to be reduced, but it should allow the investment managers to make better use of their time with more value adding tasks in the investment process43 . Secondly, cost advantages are sought. Currently most LPs receive reports in a paper-based format with no uniform definition of content or clearly defined semantic. Many LPs convert this information into their internal view, which includes the tedium of working out how the presented figures and information have been derived. This is very time consuming, error-prone and resource-intens ive and thus very costly. It also retards the reporting to the investor, which in some cases has to be content with information which depicts the situation of an investment six months ago. 43For instance the time could be used for more informal meetings which would allow the investment manager to improve monitoring management by including more informal, future orientated information in their investment appraisals. 37
  38. 38. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Most of the interviewees agreed that easier transfer of standardised information could lead to major productivity gains not only in information provision but also in the analysis of the data. “Most LP would like to see improved reporting and ideally direct electronic feeds from GP to LP to eliminate manual data entry. The technology exists to make this flow possible, but the missing link is a set of standards for data content and format to make it work” (I). Furthermore there is organisational inefficiency in the PE due to the failure to use appropriate technology. “It is very clear in the PE market the same piece of information is aggregated in different ways (....) it is unbelievably inefficient due to the proliferation of spreadsheets” (G) Thus it is obvious that the augmented use of Information Technology, together with precise standards for reporting, performance measurement and data exchange, has a potentially huge prospect of improving the efficiency and transparency of this asset class. “The transparency that a standardized process provides definitely takes away impediments for potential investors to invest in the PE class and increase their exposure to this type of investments. It is a key part of the end investor’s and the limited partner’s ability to see how well the portfolio is diversified and to what extent there is a specific vulnerability to industry groups or geographic areas” (de Klerk, 2002) Thus, in particular for large institutions with more than 100 funds to manage, the administrative complexity of monitoring investments without the support of an integrated system becomes increasingly difficult. Proponents of standardizing PE are 38
  39. 39. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective the LPs of institutional and large conglomerates whose call for timely and consistent investment information can no longer be ignored. 4.3 Improvements 4.3.1 Monitoring Policies and Process Automation and Software caveats A significant number of interviewees (30%) doubted that the changes which can be observed in many PE houses towards the introduction of business process orientated PE software and the integration of information management within the company, will extend to intra-company integrations. The reasons for this are multifaceted. Firstly, many established players consider their informal relationship as a competitive advantage. “Obviously the good relationship to the GPs is our competitive advantage“ (A) Since they have good informal relationship with their GPs, they are able to gather the information they need as things stand. Every additional piece of relevant information which is included into a standard would diminish their ability to judge the market in a superior way, which consequently implies that their relative advantage to a novice entrant into PE would be reduced. “It is difficult to find a systematic way to deal with these fundamentals in a standardized way. And in a way I am pleased that it is that way. There is always the requirement to create more efficiency. If you start doing this then the returns would fall and then there would be no difference to public markets” (B) Secondly, a major drawback was envisaged if the analysis process were delivered electronically. Some interviewees said that the fact that the reporting is done in a non- 39
  40. 40. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective standardized way is not necessarily a disadvantage in the analysis of the information provided by the GP. Since the information presented is so diverse, the analyst has to work through the details and make the information comparable. This tedious work however is a learning process, which improves the overall understanding of each investment. If the information w presented in a standardised format within its own as system, there is the fear that it would be analysed superficially. Clearly, this might reduce the overall in-depth understanding of each investment. Thirdly, the question of the cost remains, since improved processes imply that both the GP and LP would need to agree on a cost sharing arrangement. Electronic Data Interchange (EDI) and Sought Improvements There is no clear trend of opinion that the objective and the outcome of further automation would be improved efficiency in processing or an improved effectiveness in data management. When questioned on the expectations of the electronic data interchange and improved standards the interviewees expressed quite divergent views. The question asked whether the interviewee would expect improvements in information and data management (effectiveness) or improvements in cost reductions (efficiency) as being the primary benefit. The majority expected efficiency gains as the primary improvement, but around 40% were in favour of effective gains by means of the provision of higher quality, more detailed and more timely information for decision making44 . Integrated Platform as a Prerequisite The majority of interviewees agreed that an integrated electronic platform is a prerequisite for an electronic data interchange. Whereas most of the captive organisations interviewed already had integrated systems which reflect to some degree the entire PE investment process, some smaller conglomerates are still in a scattered 44 One interviewee said he expected the improvement in two steps: The first automation will lead to improved efficiency. In a second step, when improvements on the methodology of reporting can be implemented, the improvements will lead to an increase of effectiveness. In the short run, however, in particular in the absence of a clear agreement on methodological issues and industry wide agreed standards, the efficiency benefits are expected to prevail. 40
  41. 41. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective Excel world, which either is in process of being replaced or will soon be replaced by an integrated software solution. The tendency is that larger organizations have homemade IT systems which were developed in previous years, whereas smaller institutions tend to buy ready made PE packages which are now available and have an acceptable degree of sophistication. Nevertheless although an integrated system is in place, the problem of linking LP and GP remains. “The issue of course is the platform and compatibility” (B). Excel spreadsheets are easy to use and are considered to have some advantages when it comes to a specific analysis; their major drawback, however, is that they do not support the investment process in a coherent way. The reason for this is that spreadsheet computing was designed for individual data processing. But if Excel is used to represent workgroup and process-related tasks, the limitations regarding group wide information management, security issues and the integration of information become obvious. When it comes to inter-organisational automated data exchange, in particular, the advantageous flexible structure turns out to be counterproductive for standardised and process orientated data processing. However it is important to concede that the maturity of the asset class does not nearly reach the level of other asset classes. This clearly has a major impact on how far technology can be used effectively since the effective use of EDI requires an equally advanced use of technology for the entire industry. Additionally one interviewee maintained that accounting information and reporting information are different in nature and therefore should also be separated technically, i.e. in a different data base with different data models. “You have to differentiate between systems which are an integral part of your business process and systems which capture data.” (G) The reason for separation is due to the different tasks of the OLTP and OLAP. Whereas the former should make sure that information flows are integrated and 41
  42. 42. The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective coherent, the latter should allow the flexibility to query information according to the informational needs, without any limitation imposed by the system45 . 4.3.2 Monitoring Factors and Particularities of the PE industry When asked about the particularity of the PE industry, most of the interviewees confirmed that many people who are not engaged in PE do not recognize sufficiently the differences between PE and public equity investments. In particular the long term orientation of this asset class and the uniqueness of each investment make it necessary to have different ways of evaluating investments. “The nature of PE is not systematic, it is not systemic investment. What you do in public markets is take everything away which is actually driving the company. This then leads just to a statistical exercise and methodology. In PE you have not got a market, everybody is looking to fundamentals.” (B) What drives a company is, however, multi-dimensional and therefore difficult to grasp and represent systematically, i.e. each company has its own unique success factors. “The real characteristic which impedes standardisation is the idea the every company is different, which is true but it doesn’t mean that standardisation is a bad idea in some way”. (G) This implies that standards and systems need to provide a high degree of flexibility in monitoring management in order to accommodate different characteristics. 45 Typical relational databases are designed for on-line transactional processing (OLTP) and do not meet the requirements for effective on-line analytical processing (OLAP). As a result, data warehouses are designed differently from traditional relational databases. Warehouses are Time Referenced, Subject- Oriented, Non-volatile (read only) and Integrated. OLTP databases are designed to maintain atomicity, consistency and integrity. Since a data warehouse is not updated, these constraints are relaxed. (Source: Oracle http://www.orafaq.com/faqwh.htm#WHvsMART). 42

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