Editor’s Letter

The Spring 2019 issue of The Journal of Private Equity arrives at a time as US merger & acquisition (M&A) activity during the first quarter recorded its strongest start with the announcement of $490 billion in new deals since 2000 and up by over 9% from a year ago. This growth in M&A value was primarily a result of an increase in larger deal size. The active US market is in contrast to the sharp slowdown in the M&A market outside of the US related primarily to continued Brexit uncertainty, the slowdown in the Chinese economy, and the relatively week international trade growth adversely impacting other developing economies throughout the World. Notably, among the major more advanced developing economies only India continues to experience strong growth, projected at 7.4% this year, while China’s GDP growth has fallen to near 6%.

The economic outlook for the US looks favorable this year to increased private equity activity. The recent temporary softening in economic growth in the US may help to weaken the high valuation premium on US acquisition targets. The Federal Reserve Bank has indicated it will take a break from pushing interest rates upward, thus helping leveraged buyouts. Rising wage rates may help to improve productivity increases and will help sustain consumer spending levels, while recent consumer price increases will help provide support for sustained corporate profitability and expansion investments. Furthermore, while the government’s tax cut for 2018 has provided little benefit to the average consumer, it has helped to sustain corporate profitability, which could further contribute to expansion investment.

Remaining uncertainties are the US government’s immigration and tariff negotiation policies. A slowdown in the inflow of legal immigrants could increase prices for lower-skilled, labor-intensive jobs, thus affecting basic services, agriculture, and construction costs for consumers. An important reason inflation has been kept low in the US is the result of low-cost imports of basic consumer goods from China in particular, in recent years. Prospects appear that at least the tariff issue with China could be resolved this year, which could restore some confidence to financial markets and the expanding retirement consumer community. However, in the interim, almost every country’s currency has depreciated against the US dollar; they have gained a competitive exchange rate advantage for increasing their exports to the US market, while the US competitive advantage to sell abroad has deteriorated. The corresponding appreciation of the dollar will impose an increased expense on US private equity companies investing overseas, further favoring their expanded activity in the domestic market.

We begin the Summer 2019 issue of The Journal of Private Equity with an article by Julia Corelli analyzing “Fund Fees and Expenses—A Tale of Four Surveys: Trends 2014–2018.” In 2018, 2016, and 2014, PFM published surveys—sponsored by Pepper Hamilton LLP, PEF Services, and WithumSmith + Brown—in which fund managers shared how they deal with fees and expenses. Also, in 2015, Pepper Hamilton and MergerMarket partnered to take a close look at the co-investment environment. These surveys offer unique insight into the granular approach that CFOs and CCOs must take to ensure the ordinary and extraordinary fees and expenses that occur in the life of a private equity fund will be allocated appropriately to investors, co-investors, and managers. In fund design, ongoing investor relations, and regulatory review and enforcement, the fees and expenses are borne by investment funds, and co-investment vehicles are receiving more intense focus each year. The Institutional Limited Partners Association (ILPA) has adopted a comprehensive reporting procedure for fees and expenses. Based on the PFM surveys and anecdotal information from audience polls at conferences, adoption of the ILPA form has been slow, but it is growing among middle-market funds (sub-$1B) and has found a more favorable platform in larger funds. This article examines certain questions around the treatment of fees and expenses, what guidance the surveys offer, and how to address unanswered questions when industry guidance is lacking. The author takes a hard look at costs associated with consummated deals, broken deal costs, co-investment relationships, regulatory costs, operating costs, and investor-driven costs. How does Corelli’s analysis compare with what you expected?

In the next article, we switch from private equity to venture capital as Mark Cannice examines “Confidence among Silicon Valley Venture Capitalists Q3 2017–Q3 2018: Trends, Insights, and Tells.” Confidence in the future (or the lack of it) impacts our decisions and actions in the present. Thus, our confidence in the future will help determine the future—for better or worse. Venture capitalists, financiers of innovation and new venture creation, have a longer-term time horizon than most other investment executives and so their confidence about the future will tend to impact the nature of the economy that affects all of us.

Silicon Valley venture capitalists making investment decisions in the global heart of innovation have demonstrated their influence on the evolution of business, and so their outlook may be a significant factor in determining the future. Tracking Silicon Valley Venture Capitalists’ confidence about the future entrepreneurial environment with a quarterly survey and report of about 30 VCs since Q1 2004, the author develops a quantitative index and qualitative commentary of trends and insights of their confidence. Cannice reviews Silicon Valley VCs’ indications of confidence over the last five quarters in the context of other current economic indicators. In the recent survey period, increasing VC sentiment tends to be based on improving exit opportunities and new technology disruptions that create new markets, while decreasing VC sentiment is linked to high valuations, rising costs of business, rising competition for talent, and uncertainty in the macro environment. VC confidence also appears to correspond to CEO confidence, perhaps due to the operational focus of VCs. As VCs’ confidence in the future entrepreneurial environment tends to impact their business decisions today (e.g., investments in new ventures), tracking VC confidence and the factors that drive their confidence may provide unique and valuable insights to private and public market participants.

Simon Raftopoulos and Jacob MacAdam provide their perspective on “Private Equity Trends to Look Out for in 2019.” Despite growing global geopolitical uncertainty, private equity continues to deliver strong returns aided in no small part by the prevailing climate of low interest rates. Asset prices have consistently risen as large pools of yield-hungry private equity-backed cash have sought out limited quality assets. The private equity model remains attractive to investors, resulting in significant quantities of dry powder going into 2019.

Increasing fund size facilitates ever larger M&A deals with private equity backing. Within this environment, the authors focus on development within a growth trend. With deals valued at over $60 billion in the first half of 2018 alone and Cayman Islands companies being the target of 421 transactions, the Cayman Islands, by deal volume, ranks as the number one offshore jurisdiction for M&A transactions. The deal structure typically includes a statutory merger, a scheme of arrangement, and a tender offer. Ever-increasing interest in the sector by private equity is resulting in aggressive consolidation in the fiduciary space—for example, the disposal by TMF Group, a global provider of compliance and administration services, to CBC partners for total consideration of $1.75 billion, and Apex Group Ltd. and Genstar Capital acquiring the Deutsche Bank Alternative Fund Services business. Fiduciary assets are attractive to private equity given the strong recurring cash flows derived from annuity-like revenues and the opportunity to apply rigorous management methods. These deals are almost exclusively cross-border, highlighting the importance of careful structuring.

Peng Wang and Steven Peterson, in their article on “Long-Run Management of Private Equity Investment,” present a stochastic simulation model that projects cash flows (capital calls and distributions) as well as unfunded commitment levels for private equity allocation through time. The contribution of the analysis links the underlying dynamics in the targeted private equity allocations to movements in the underlying portfolio while managing both liquidity and rebalancing risks. Importantly, the model allows investors to assess the impact of changing the annual commitment pace and of varying assumptions regarding capital calls, distributions, and underlying returns. The study also offers insights into more-efficient approaches to building allocations to private equity strategies over time.

The next article examines native country cultural difference in private equity as Josephine Gemson, Mark Creighton, and Sriram Radhakrishnan explore the question, “Do Investor Origins Affect Private Equity Investment Syndicates? A Case from India.” The private equity industry has become a growing international phenomenon in recent years. As capital providers, private equity firms are often seen to form collaborative relationships with one another during the investment process. These alliances can be pure syndicates—with similarly residing private equity investors (domestic/foreign) or co-investments—when domestic and foreign private equity investors jointly have stakes in the deal. In this study, the authors examine the composition of syndicates and their effect on investment patterns in India, a country that is a rather late entrant into the private equity market but has witnessed dramatic increases in private equity investment in the last two decades. Using data from 1998 to 2014, the authors compare pure syndicates against those that have co-investment. The study also analyzes if different syndicate types affect specific deal characteristics like industry sector and investment size. Finally, they explore the effects of investor origins and co-investment on investment size. The results of the analysis indicate significant variations between industry sectors and deal characteristics, implying differing investor preferences. How do these results relate to your fund manager decisions?

As India has emerged as the most rapidly growing advanced developing country that is among the least dependent on exports for domestic growth, the Khudsiya Zeeshan, Syed Azhar, and S. Sreenivasa Murthy study of “Profitability Analysis of Select Private Equity Funds in India” is uniquely relevant for foreign investors in India. The private equity firms studied include Sequoia Capital India, Chrys Capital, Everstone Capital Advisors Pvt, ICICI Venture, and WestBridge. Solvency has been explained by the debt-to-equity ratio, interest coverage ratio, and proprietary ratio. To measure profitability, they use ratios such as return on total assets, return on investment, and earnings per share. The results show that there is a significant difference in terms of current ratio, debt-to-equity ratio, proprietary ratio, and return on total assets ratio of select private equity funds in India. The results suggest that at least one of the means of a sample is different. The test results also indicate that there is no significant difference in terms of return on shareholders’ funds, return on investment, and earnings per share. Hence, ratio analysis is a useful management tool that improves the understanding of financial results and trends over time and provides a key indicator of organizational performance.

Market analysts and news media are prone to ranking which is best in anything they evaluate. How does this influence our perspective as well as the decision making of those ranked? Ravi Kashyap, in his study “For Whom the Bell (Curve) Tolls: A to F, Trade Your Grade Based on the Net Present Value of Friendships with Financial Incentives,” examines this issue. Kashyap explores a possible solution to an unintended consequence of having grades, certificates, rankings, and other diversions in the act of transferring knowledge, and zooms in specifically on the topic of having grades, on a curve. He conducts a thought experiment, taking a chapter from the financial markets (the trading of pollution), to create a marketplace, where grades can be traded, similar in structure to the interest-rate swap. The author connects this to broader problems that are creeping up, unintentionally, due to artificial labels we are attaching to ourselves. The policy and philosophical implications of the author’s arguments suggest that all trophies that we collect (e.g., including certificates, grades, medals) should be viewed as personal equity or private equity (borrowing another widely used term in finance). We should not use them to determine the outcomes in any selection criteria, except to have a cutoff point, either for jobs, higher studies, or financial scholarships, other than for entertainment or spectator sports.

One empirical regularity is that the takeover premium is lower in private acquisitions compared to public acquisitions. Ding Du and Mason Gerety focus on “Is the Corporate Control Market Segmented?” Other researchers, such as Gorbenko and Malenko (2014), have proposed a segmented-market perspective. Du and Gerety extend the literature by directly testing if a segmented-market perspective helps explain the premium difference between private and public acquisitions. Empirically, the authors follow Fidrmuc et al. (2012) and use a matched sample design. They find that private acquirers do not pay less compared to public acquirers when controlling for the selling mechanism (which characterizes different corporate control markets) as well as the effects of outliers. Their results suggest that premium differences between private and public acquisitions may be more consistent with a segmented-market perspective as opposed to the agency explanation of Bargeron et al. (2008).

A new and fascinating exploration is “Initial Coin Offering to Finance Venture Capital: A Behavioral Perspective” by Jinghan Cai and Ahmed Gomaa. Initial Coin Offering (ICO) is the procedure whereby ventures raise capital by selling tokens to investors. Compared with traditional financing methods, ICOs are new and less understood by both the industry and academia. For example, the literature is not clear about which factors determine the success rate or the funds raised in an ICO. Existing literature (Fisch 2019) shows that the signals of the private information of an ICO’s high quality determine the amount of funding in the ICO. This article is the first in the literature that provides evidence that investor sentiment and investor awareness are determinants of the funds raised in an ICO. Also, it provides evidence confirming the signaling hypothesis. Specifically, ICOs with a pre-ICO and with a higher rating tend to be more likely to raise larger funds. Cai and Gomaa believe that their analysis is the only study in the literature using the entire market, with 4,367 ICO’s to confirm their findings. The results extend the understanding of the dynamics of an ICO to the behavioral field and enable investors and practitioners to comprehend better the crucial determinants of both the ICO success rate and the amount raised.

A wave of the future is how to communicate increasing large amounts of data information more quickly or simply and more clearly by using “visuals” to explain increasingly complex information. Jimmy Solis is here to help us solve this issue in “Data Visualization Is King.” Over the past decade, there has been explosive growth in the amount of financial and operational data portfolio companies generate every day. The growing mass of data makes it difficult for private equity firms to derive the actionable insight necessary to impact a fund’s performance positively. In response to this challenge, private equity groups have turned to technology for help. Data visualization has emerged as a popular and impactful tool for analyzing large amounts of data. Visualization tools can help isolate financial performance issues, accelerate communication, and uncover performance improvement opportunities across a fund’s portfolio. When leveraged correctly, even the process of gathering data for use in visualizations generates performance-enhancing opportunities. However, converting these opportunities into meaningful performance improvement requires an understanding of what data visualization can do for your business and how to leverage it effectively across a portfolio. As my students say—this is really cool; now I understand and get the picture!

F. John Mathis

Editor

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