Private Equity Fund Investments

New Insights on Alignment of Interests, Governance, Returns and Forecasting

Cyril Demaria

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137400390
• Topic: Betriebswirtschaft
• Subtopic: Finanzdienstleistungen

This book presents new, advanced, evidence-based guidance on investing in private equity funds: first by assessing the investor's environment and motivations, then by looking into the risks, returns and overall performance of funds and finally, by offering practical solutions to the illiquidity conundrum.

1

Suboptimal Risk–Return Profiles in Private Equity: The Case of Minority Business Enterprises Investing¹

Socially responsible investing² results have fallen short of expectations [Amenc and Le Sourd, 2008]. The influence of SRI criteria on listed companies is still rather limited, as the investment methods used by SRI fund managers rely essentially on stock filtering. The next possible target for SRI guidelines could be small and medium-size businesses through PE investing. Investors could ideally use SRI criteria on small businesses thanks to superior corporate governance and shareholder involvement. Direct PE³ has been identified as a superior investment tool [BVCA, 2008; Gottschalg, Talmor and Vasvari, 2010], by promoting the alignment of interests between investors and managers thanks to efficient governance standards (at the portfolio company level [Chemmanur, Krishnan and Nandy, 2008; Katz, 2008]) and high level of shareholder involvement [Acharya, Hahn and Kehoe, 2010; Meerkatt et al. 2008; Quiry and Le Fur, 2010]).

However, applying techniques which have been developed, in theory, for large companies has proven difficult: for example, the ‘best-in-class investments’ approach (passive investing) is only relevant for stock picking in listed markets. An alternative method, which consists of implementing environmental and social investment (ESG) criteria (active investing), is often too complex to handle for small and medium-size businesses. Indeed, PE investments are vulnerable to bureaucratic and administrative burdens once the investment is done (post-investment monitoring process): the extra costs associated with the check-lists and additional reporting to ESG/SRI guidelines cannot realistically be taken on by small and medium-size businesses which have scarce human and financial resources.

To circumvent this hurdle, PE investors have applied part or all of the ESG criteria as filtering factors for their investment opportunities (in the pre-investment screening process). Hence, PE and SRI investing intersect in three main areas: venture philanthropy, social PE and minority-related investments. The third area of minority-related investments will be the focus of this chapter.

Venture philanthropy⁴ aims to regularly produce social returns. It is structured to use venture capital investment methods to finance emerging businesses for which social returns take precedence over financial returns, hence differentiating itself from typical venture capital investments.

Social PE investing aims at producing essentially social return (and possibly financial returns) with existing businesses. The focus of social PE is on creating value for society (as opposed to appropriating value); it seeks to address public sector and market failure by challenging or disrupting existing rules and institutions and applying market-based solutions in innovative ways [Maretich and Bolton, 2010].

Minority-related PE investing focuses on the due diligence and evaluation of investments. In that respect, it targets financial returns as well as correcting certain social imbalances.⁵

Despite its promising endeavor, minority-related investing is still not part of mainstream PE (that is, it does not qualify in a PE allocation as an investment segment such as venture capital, growth capital, LBO, distressed debt, turn-around capital, mezzanine financing ... ). This is likely due to the fact that it is largely unknown by potential LPs [Alphonse, Hellmann and Wei, 1999], though this would not hold back the most sophisticated LPs (such as US endowments) from investing, as they are looking for novel ways to invest. We hypothesize that the main reason is that the risk–return profile of minority-business enterprise (MBE) PE is suboptimal.

Defining minority-related PE is a difficult task. Indeed, the National Association of Investment Companies (NAIC) avoids any mention of minorities when defining the scope of investment of its members. Instead, it refers to ‘ethnically diverse businesses.’⁶ In fact, the NAIC’s main references for its members’ field of investments⁷ are ‘underserved markets’ and ‘emerging domestic markets’ (EDM). This definition echoes the concept of ‘inner cities investing’ developed by Michael Porter [1995]. Porter stresses the fact that social initiatives did not solve the economic distress of inner cities in the USA. A lack of connection with the surrounding economy, businesses of sub-scale dimension and the failure to exploit competitive advantages have, according to Porter, ruined past efforts.

The definition of minority-related PE is a moving target, for at least two reasons:

1.the target of investing in minority-related businesses is to generate returns, unlike in venture philanthropy or social PE. The NAIC, which gathers PE funds investing in minority-related businesses,⁸ states that its ‘member companies invest in privately-held businesses that have a high probability of growth and the ability to generate significant returns for investors and shareholders’⁹ [NAIC]. The definition of ‘significant returns’ is not provided by the NAIC, but we can infer that is not symbolic (venture philanthropy), nor negligible (social PE).

2.investing in minority-owned or minority-related businesses is an additional criteria to filter out the investment universe, as stated by the NAIC. The way the ethnicity (or gender) criteria is actually used is open to debate. In fact, it could be measured essentially through:

i)

the actual ownership of the companies financed. This would limit the intervention of PE funds to the role of minority shareholders. The superior governance of PE investors is related to the level of ownership and the alignment of interests between investors and managers. By giving up the ability to actually own the majority of businesses, PE investors would lose one of their major governance levers. Even if promoting minorities to the status of business owners can be a political and social target, it is unlikely that for-profit investing considers this target as a legitimate one (that is, as mandatory to achieving high returns).

ii)

the actual leadership of the companies financed. This criterion is probably more in line with the usual PE investing guidelines (that is, aligning the interests of investors and managers, notably through incentives). However, it is more difficult to assess over time. Even if a business is fully managed by minorities at the time of investment, it is possible that through management changes this situation evolves. It can be suboptimal to choose managers not on their skills, but on the basis of their gender or ethnicity.

Even though there is no mention of the ethnic or gender background of the entrepreneurs of inner cities in his paper, Porter implicitly refers to the ethnic background of its inhabitants. Reference is made when Porter states that entrepreneurs and managers from inner cities can better target local market demands. According to him, inner cities entrepreneurs and managers understand local customers as they share the same specific ‘characters’¹⁰ [Porter, 1995].

Based on this competitive advantage, and also because they are ‘trend setters,’¹¹ local entrepreneurs and managers can: capitalize on a strategic location to serve adjacent markets and even ‘other similar communities’ nationally and internationally; congregate in clusters of companies to create economies of scale; integrate in a regional cluster as providers; and capitalize on specific human resources (community-knowledgeable and at a moderate cost). He therefore recommends hiring locally, tailoring products and services to local needs, and training the staff and increasing loyalty, as well as giving incentives to equity providers through specific tax breaks (deemed to be more effective than direct financing by public authorities).

1.1 Research question

Minority business enterprises (MBEs) have less access to capital than similarly situated white-owned firms [Bates and Bradford, 2008]. The conclusion of Bates and Bradford is that ‘if MBEs indeed experience such restricted access to capital, then this market segment is being underserved and attractive returns may be available to funds choosing to specialize in financing this client group’ [Bates and Bradford, 2008, p. 490]. The study refers to investor short-sightedness. We tend to disagree.

The strong increase in capital available for PE would have indeed addressed the investment opportunities that these companies represent should they present the same risk profile as other opportunities. According to Preqin (2010) and Pitchbook (2009) the volume of funds available to be invested by PE investors is estimated at USD 400–500 bn. These PE investors permanently look for the best opportunities in a given market. It is unlikely that they would ignore opportunities on the ground despite the cultural, ethnic, gender or social background of the management. If PE investors are targeting mid-market LBOs or even non-high-tech venture capital opportunities, they will do so regardless of the ethnicity, gender or social origin of the management.

Porter’s mention of the necessity of a specific incentive for equity providers through tax breaks means that he implicitly assumes that there is either:

i)	a lower return for a certain level of risk associated to minority-related investing (that is, investing in local businesses managed by local people who have and thus leverage a local specific ‘character’); or
ii)	a real or perceived risk associated with inner-city investing which is not compensated by additional returns. Hence, the return of inner cities PE investors may not be up to the level of typical PE investors.

The ignorance of ‘emerging domestic markets’ by PE fund managers may be due to the unusual risk–return profile of the investments in MBEs. PE fund managers have typical expectations: either in a mature market, an average net return of 12.2 percent [JP Morgan, 2007; and Figure 35, Crédit Suisse, 2010], or in an emerging market, a high...

Table of contents

• Cover
• Title
• 0 Introduction
• 1 Suboptimal Risk–Return Profiles in Private Equity: The Case of Minority Business Enterprises Investing
• 2 Fee Levels, Performance and Alignment of Interests in Private Equity
• 3 The Predictive Power of the J-Curve
• 4 General Conclusion
• References and Bibliography
• Index