Editor’s Letter

The U.S. economy has demonstrated persistent and relatively stable real growth this year. Even so, private equity activity has grown only cautiously in 2016, while corporate merger and acquisition activity has risen with larger deals underway. Although immediate risks to global financial stability have calmed, medium-term risks of financial instability have risen as per the IMF October 2016 “Global Financial Stability Report.” The concern for developed countries—particularly the United States—is about a low-growth and low-rate era, as the delay in normalizing monetary policy continues, and a weakening of financial institutions’ healthier balance sheets, which occurred despite the evolving regulatory environment. Increased cyclical and structural challenges could result in global financial instability, and these problems in advanced economies could further impact already weakened economic and financial conditions in many emerging markets.

Slower growth in developed countries will adversely affect growth in emerging markets and, together with already lowered commodity and energy prices, could delay the process of deleveraging corporate and government debt. In addition, aging populations and the insolvency risks of life insurance and pension funds would further aggravate global financial instability. As the traditional financial markets in developed and emerging market economies weaken and liquidity becomes less readily available, companies will be looking for new sources of funds to sustain themselves. This raises a question of how the private equity market will be impacted and how it will adapt.

In this last issue of 2016, The Journal of Private Equity is unique in that it contains several articles that represent new and thoughtful studies of different techniques to conduct venture capital and private equity activities. There is a variety of insightful and innovative articles discussing possible new trend subjects that have begun to emerge during the past year or so.

For example, the first article by Mario D’Ambrosio and Gianfranco Gianfrate is “Crowdfunding and Venture Capital: Substitutes or Complements?” The authors study the geographical and time series dynamics of crowdfunding and the degree to which it substitutes for or enhances venture capital (VC). Their findings support the argument that crowdfunding is a substitute for traditional VC for seed capital but a complement to VC activity in subsequent rounds of financing. Consistently, they also find that crowdfunding activity clusters in the same main centers as venture capital financing.

Eva Davis, Sara Cieniewski, and Josh Birenbaum explore “The Smart Money: When a Private Equity Minority Investment Can Be Better Than a Bank Loan (and What about a Family Office?).” Private equity has received plenty of criticism, but it may be the best source of capital to power your company’s growth. Just in the past year, companies such as Drybar, Fresh Direct, Hip Chick Farms, Jones Natural Chews, Pacific Catch, Snap Kitchen, Velvet Taco, and Viking Cruises have gone to private equity—rather than a bank—for additional capital to fuel their expansion. This article addresses the circumstances under which a private equity fund minority investment can be the best financing for a business, the investigation a company should undertake to select the right investor, the key investment terms that a company should expect from a private equity fund, and the circumstances under which a family office may be an even better long-term partner.

Jeffrey Hooke and Ken Yook analyze “The Relative Performances of Large Buyout Fund Groups.” Investors tend to concentrate their buyout fund commitments in the large fund groups. These groups, or families, manage multiple individual buyout funds. Many investors consider the large fund families to be the “winners” in the buyout industry, owing to their size and their number of funds. As a group, however, since 1990, they have not been outstanding performers, and their median performance results were only slightly above average. Over the last ten years (i.e., 2005 vintage), their quartile performance has been only average. The authors’ findings pose several questions as to why investors favor large fund families over smaller fund groups.

This article by Bob Damon identifies and examines “Three Rookie Mistakes Experienced CEOs Make in Managing a Private Equity–Backed Company.” It provides a top-line analysis of mistakes that new CEOs, with deep Fortune 1000 company experience, make in running a private equity–backed company. The three mistakes are: 1) CEOs do not understand the meaning of constant communication with the board of directors; 2) the CEO does not have a strong bias toward action; and 3) the CEO must drive results before infrastructure.

In the next article, Rohan Chinchwadkar and Vidhu Shekhar consider the “Evolution of Private Equity Regulations in Emerging Markets: A Case of India.” Since India’s economic liberalization in 1991, the private equity (PE) industry has played a significant role in India’s growth story, contributing more than $100 billion of stable long-term capital in the last 15 years. Owing to its fast emergence, the PE industry went from having an ad hoc regulation to a formal regulatory framework. This evolution presents a good case study to understand financial policy making as it happens in emerging markets. The article is also a comprehensive guide for PE investors who want to understand the history and landscape of PE regulations in India.

The authors track the evolution of the regulatory environment for the PE industry in India, from the SEBI (Venture Capital Funds) Regulations 1996 to the SEBI (Alternative Investment Funds) (Amendment) Regulations 2013, which govern the industry today. This historical study shows that while regulators in emerging markets are usually reactive rather than proactive, it also emphasizes the importance of effective regulation in boosting an important industry such as private equity. The article highlights the fact that a regulator should not create regulations in isolation; rather, it is critical to incorporate input from different stakeholders in order to develop effective regulations.

In addition, in this issue, we are including a small selection of articles from other Institutional Investor Journals’ publications. The central themes of private equity and the assets involved cross industry boundaries, and there is ample room for interdisciplinary research and practice. There are, not surprisingly, divergences of views between the buy side and the sell side. In the case of private equity, there is additional complexity and an even greater need to explain, educate, and frame the value proposition in ways that translate well to the spectrum of investors seeking information about the industry and its prospects today and in the future.

So with that in mind, we offer the following selections in the current issue of JPE, and we will continue to reach out across our brands to provide the best and broadest coverage possible to shed light on issues that will affect you and yours.

In “Forced Liquidations, Fire Sales, and the Cost of Illiquidity,” taken from The Journal of Portfolio Management, Richard Lindsey and Andrew Weisman of Janus Capital examine the downsides of illiquidity and decision making under duress. Their research serves as a counterpoint to the views that are held by some private equity firms, which clearly look at distress in a different light. Lindsey is also a fellow at the Courant Institute of NYU, and the authors strike a balanced tone between theory and practice.

One topic that weighs heavily on the mind these days is the issue of interest rates, with leverage being a closely related subject. In “DebtRank and the Network of Leverage,” Stefano Battiston, Marco D’Errico of the University of Zurich, and Stefano Gurciullo of the University College London observe that interconnectedness and leverage are now commonly viewed as key factors contributing to the presence of systemic risk. In this article, they explore what they call “networks of leverage” and develop a methodology for creating debt rankings that highlights certain vulnerabilities in terms of leverage across both external and interbank segments. For those who depend on others for access to capital, their analysis should stimulate further conversation and study. This article originally appeared in The Journal of Alternative Investments.

Finally, we offer a view from the far side of the table. In the long and persistent low interest rate environment, the quest for yield has risen and expanded across asset classes. This means that investors completely new to alternative areas, including venture capital and private equity, are taking an interest and asking questions. There is a visible lack of appreciation for the investment process and industry dynamics in some cases, and the heightened pressure on fees reflects the current level of dialogue. In the 40th Anniversary Issue of The Journal of Portfolio Management, Christopher Geczy of the Jacob Levy Equity Management Center for Quantitative Financial Research and the Wharton Wealth Management Initiative at the University of Pennsylvania offers one viewpoint in “The New Diversification: Open Your Eyes to Alternatives.” Referencing the well-known Yale model of making substantial investments in alternatives, he builds the case for their consideration. Geczy also notes the advent of liquid alts and describes some of the implications that such a “democratization” of the alt category holds for the industry and its newest investors.

We hope that you will enjoy these special offerings in this issue of The Journal of Private Equity, and as always, we welcome your feedback.

F. John Mathis

Editor

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