1. Viewpoint
Improving Transparency in the Private Equity Market
BY OSMAN GHANI, CFA reports, the investors would be better positioned to ascer-
tain how the portfolio company performed in terms of
P
rivate equity funds have undergone significant operating activities, evaluate any management discussions
changes in recent years. Whereas private equity and key areas identified in the management discussion
funds historically focused primarily on leveraged and analysis (MD&A), and examine the corresponding
buyouts and private stakes in public companies, notes to the accounts. Plenty of existing academic evi-
the past decade has seen private equity firms diversify into dence shows that investing in a private equity fund based
other areas, investing in real estate, distressed securities, on prior performance does not imply similar future per-
and infrastructure funds and even setting up their own formance (such as L. Phalippou [2010] and J. Chung
hedge funds. This shift is, in part, a response to the [2010]); nonetheless, investors should be in a better posi-
increased funds flowing into the private equity firms and tion, on the whole, to make a more informed decision if
reduced investment opportunities in the leveraged-buyout they are presented with more information rather than less.
(LBO) markets. Disclosure would also help other stakeholders. Many
Accompanying the private equity model is a lack of stakeholders believe that private equity firms create value
publicly available information concerning a portfolio com- by taking on excessive debt in order to reduce the com-
pany once it is taken over. There are two main reasons for pany’s tax burden and also by restructuring the company
this. First, the country where the portfolio company is and reducing its operating costs (namely, employee costs).
based may not require financial accounts to be audited or A private equity firm can improve transparency by pro-
publicly disclosed. Second, the company may believe it ducing annual reports that disclose what value has been
would lose its competitive advantage by disclosing infor- added by the management in terms of operating activities
mation that may help its competitors. But a strong argu- and whether the company is in a better position as a result
ment can be made that private equity firms should be of the acquisition.
more transparent about their portfolio companies and that An example of how private equity firms can disclose
such transparency should either be adopted voluntarily or information concerning their portfolio companies is pro-
become a compulsory requirement overseen by the local vided by the United Kingdom. U.K. private companies file
financial regulator. full accounts, most of which have been subject to statu-
Improving the level of transparency will help existing tory audit. (For 2010, U.K. companies are exempt from
and potential investors. With access to a set of accounts or producing an audited set of accounts if they meet certain
other such pertinent information, an existing investor can criteria.) The accounts are then available to the general
judge the performance of the private equity fund manager public via Companies House (the foundation for company
and determine how the manager actually adds value to the information exchange in the United Kingdom). Investors,
portfolio company. Disclosure about the performance of potential investors, and the general public can look at an
existing portfolio companies will allow potential investors individual portfolio company and examine its performance
to better judge the ability of the fund to deliver the desired from sales growth to the “bottom line figure.”
results. Such disclosure is beneficial for all the parties To conclude, the private equity industry as a whole
involved — reducing monitoring costs for existing investors likely would benefit from improved transparency and a
and reducing time and resources that potential investors reduction in information asymmetry. This issue has
would spend in choosing a private equity manager. These become more important in recent years due to the steps
two effects should result in a lower financing cost for the taken by some private equity funds to invest in asset
private equity fund by reducing the resources needed for classes not historically considered a core segment of the
its fund-raising activities. Several studies of public compa- private equity market, such as investments in real estate,
nies have found improved disclosure to be associated infrastructure projects, distressed securities, and hedge
with lower capital costs (for example, R. Lambert, C. Leuz, funds. This has created the potential for information
and R. Verrecchia [2006] and M. Barth, Y. Konchitchki, asymmetries to increase over time, which likely increases
and W. Landsman [2010]) Currently, existing and poten- investors’ required rates of return.
tial investors rely mostly on information that private
equity firms provide them, for example, related to data Osman Ghani, CFA, is a doctoral student in finance at the War-
concerning the portfolio company prior to acquisition, the wick Business School in the United Kingdom. He has previ-
exit price and the resulting internal rate of return (IRR), ously worked in audit and corporate finance, primarily focus-
and any other information available in the public domain. ing on private equity and venture capital portfolio companies.
If, however, the private equity firm provided annual
10 CFA MAGA ZI N E / MAY–J U N E 2011
![Viewpoint
Improving Transparency in the Private Equity Market
BY OSMAN GHANI, CFA reports, the investors would be better positioned to ascer-
tain how the portfolio company performed in terms of
P
rivate equity funds have undergone significant operating activities, evaluate any management discussions
changes in recent years. Whereas private equity and key areas identified in the management discussion
funds historically focused primarily on leveraged and analysis (MD&A), and examine the corresponding
buyouts and private stakes in public companies, notes to the accounts. Plenty of existing academic evi-
the past decade has seen private equity firms diversify into dence shows that investing in a private equity fund based
other areas, investing in real estate, distressed securities, on prior performance does not imply similar future per-
and infrastructure funds and even setting up their own formance (such as L. Phalippou [2010] and J. Chung
hedge funds. This shift is, in part, a response to the [2010]); nonetheless, investors should be in a better posi-
increased funds flowing into the private equity firms and tion, on the whole, to make a more informed decision if
reduced investment opportunities in the leveraged-buyout they are presented with more information rather than less.
(LBO) markets. Disclosure would also help other stakeholders. Many
Accompanying the private equity model is a lack of stakeholders believe that private equity firms create value
publicly available information concerning a portfolio com- by taking on excessive debt in order to reduce the com-
pany once it is taken over. There are two main reasons for pany’s tax burden and also by restructuring the company
this. First, the country where the portfolio company is and reducing its operating costs (namely, employee costs).
based may not require financial accounts to be audited or A private equity firm can improve transparency by pro-
publicly disclosed. Second, the company may believe it ducing annual reports that disclose what value has been
would lose its competitive advantage by disclosing infor- added by the management in terms of operating activities
mation that may help its competitors. But a strong argu- and whether the company is in a better position as a result
ment can be made that private equity firms should be of the acquisition.
more transparent about their portfolio companies and that An example of how private equity firms can disclose
such transparency should either be adopted voluntarily or information concerning their portfolio companies is pro-
become a compulsory requirement overseen by the local vided by the United Kingdom. U.K. private companies file
financial regulator. full accounts, most of which have been subject to statu-
Improving the level of transparency will help existing tory audit. (For 2010, U.K. companies are exempt from
and potential investors. With access to a set of accounts or producing an audited set of accounts if they meet certain
other such pertinent information, an existing investor can criteria.) The accounts are then available to the general
judge the performance of the private equity fund manager public via Companies House (the foundation for company
and determine how the manager actually adds value to the information exchange in the United Kingdom). Investors,
portfolio company. Disclosure about the performance of potential investors, and the general public can look at an
existing portfolio companies will allow potential investors individual portfolio company and examine its performance
to better judge the ability of the fund to deliver the desired from sales growth to the “bottom line figure.”
results. Such disclosure is beneficial for all the parties To conclude, the private equity industry as a whole
involved — reducing monitoring costs for existing investors likely would benefit from improved transparency and a
and reducing time and resources that potential investors reduction in information asymmetry. This issue has
would spend in choosing a private equity manager. These become more important in recent years due to the steps
two effects should result in a lower financing cost for the taken by some private equity funds to invest in asset
private equity fund by reducing the resources needed for classes not historically considered a core segment of the
its fund-raising activities. Several studies of public compa- private equity market, such as investments in real estate,
nies have found improved disclosure to be associated infrastructure projects, distressed securities, and hedge
with lower capital costs (for example, R. Lambert, C. Leuz, funds. This has created the potential for information
and R. Verrecchia [2006] and M. Barth, Y. Konchitchki, asymmetries to increase over time, which likely increases
and W. Landsman [2010]) Currently, existing and poten- investors’ required rates of return.
tial investors rely mostly on information that private
equity firms provide them, for example, related to data Osman Ghani, CFA, is a doctoral student in finance at the War-
concerning the portfolio company prior to acquisition, the wick Business School in the United Kingdom. He has previ-
exit price and the resulting internal rate of return (IRR), ously worked in audit and corporate finance, primarily focus-
and any other information available in the public domain. ing on private equity and venture capital portfolio companies.
If, however, the private equity firm provided annual
10 CFA MAGA ZI N E / MAY–J U N E 2011](https://image.slidesharecdn.com/cfm2ev222en32e2-13050591117021-phpapp01-110510152603-phpapp01/85/Transparency-in-the-Private-Equity-Market-1-320.jpg)
