Private equity funds and hedge funds: a primer

Private equity funds and hedge funds are both alternative asset classes that are continuously growing in importance. Although they have different focuses, they share some characteristics. First of all, both have or allegedly have a significant impact on the economy as well as the financial system they operate in. Therefore, the question of a potential regulation of both asset classes arises. Due to the lack of sophisticated knowledge about the differences of these asset classes, market players fear that attempts to regulate hedge funds will adversely affect private equity funds. Besides the regulatory issue, there are several other links between these two asset classes that have to be looked at. The relationship between those two asset classes is therefore of general importance. Last months' developments in the hedge fund industry (e.g. rumors about turbulences as well as hedge funds forcing the dismissal of the CEO of Deutsche Börse) have now even led to a broad public debate about private equity and hedge funds. At least in Germany the debate has been partly fueled by the fact that both types of funds are highly funded by institutional investors from abroad. Due to this the debate widened and included criticism on Anglo-Saxon style capitalism as well. In the light of the last German elections, hedge funds and private equity funds have even been compared to locusts, notorious for exhausting whole countries. However, the distinction between hedge funds and private equity funds remains very vague in this discussion, so that deep mistrust is spread among the public opinion against these new, mostly unknown and misunderstood types of investors. For this reason it is important to * discuss the arguments for or against regulation, * look at the major links between the two asset classes, * look at the major differences that exist between the asset classes, and * conceive a set of criteria to clearly distinguish between both types of funds. The purpose of this paper is to comment on possible solutions to the above mentioned tasks. It outlines preliminary thoughts and findings. Further, it comments on the steps that we think should be taken to further enhance perception of private equity funds as opposed to hedge funds from a public as well as a regulatory perspective. --Private Equity Funds,Hedge Funds

Private equity entities and conglomerates: what are the differences?

We compare the characteristics of conglomerates and private equity entities. This is done by examining the differences among their business models. We analyze the relations of the two entity types to their investors on the one hand and to their investments on the other hand. The distinguishing characteristic of private equity entities is that they pursue a stand-alone-perspective with their investment policies, meaning that they treat each investment separately. Therefore, various linkages that exist in conglomerates do not occur in private equity entities. We describe these linkages in detail. We further argue that because of the lack of these linkages in private equity entities the shareholders and debtholders of a private equity entity and its portfolio companies are not faced with the following risks that are specific for a conglomerate: the asset shifting risk, the intra-group profit risk and the capital structure risk. Finally, we define crucial evaluation criteria for identifying a private equity entity and develop a way how regulators and other persons concerned with such a task could do so. --private equity,conglomerates,investment companies

Angels or demons? Evidence on the impact of private equity firms on employment

The impact of private equity firms on employment in their portfolio companies is a controversial topic widely discussed in academia and in practice in recent years. A large body of research has resulted from this debate. The studies are focused on different aspects of employment and are based on a variety of methodologies as well as samples representing e.g. different types of buyouts and geographies. The aim of this paper is to provide access to and enhance the understanding of the highly fragmented literature by way of a systematic review and to discuss areas for future research. We review evidence on employment growth, financial and non-financial indicators of employment in a total of 49 studies. The analysis of similarities and differences of the studies revealed manifold consequences of private equity on employment. Our review reveals that the impact varies across different employment indicators and between geographies. We therefore conclude that it is not possible to label private equity firms either positively or negatively as 'angels or demons' as this would not take account of their complex and heterogeneous effects on employees post-buyout. --private equity,employment,industrial relations,entrepreneurial companies,systematic review

What you get is what you need? The role of venture capitalists in managing growth of new ventures

The resource-based view is suggested as a useful concept to shed light on the particular challenges of high potential companies on their way to building a thriving and growing company. In order to be able to apply the theoretical constructs of the resource-based view in the present context, a categorization of resources is elaborated that fits particularly well to high potential companies. Existing literature provides evidence that these companies in general only dispose of a small resource base and that they are characterized by strong resource needs in all relevant resource categories. The role of venture capitalists is assumed to provide high potential companies with financial and non-financial resources that help to create core and non-core competencies. Ultimately, this bundle of core and non-core competencies would allow high potential companies to achieve a sustained competitive advantage. The empirical results of this paper are based on insights from three in-depth case studies on German start-ups, each representing a different investor-investee dyad. It comprises investees from different industries such as software, biotech, and energy as well as investors with an established track record, first fund investors, and semi-government-dependent investors. The cases show that venture capitalists provide a number of resources to their portfolio companies that allow building a competitive advantage. The role of the venture capitalists is thus to help high potential companies to complement existing resources and competences in order to develop their full economic potential. However, there is great variation between the resource provisions of the analyzed venture capital firms. --Entrepreneurship,Venture Capital,Resource-based View

Structure and determinants of financial covenants in leveraged buyouts - evidence from an economy with strong creditor rights

We apply control rights theory to explain the structure and determinants of financial covenants in private equity backed leveraged buyouts. We analyze 130 German transactions from 2000 to 2008, covering about 40 percent of the LBO market during this period. We consider Germany to be a superior institutional context as creditors have substantial rights in case of borrower default and contracts are negotiated more rigorously. Regarding structure we find that the financial covenant structure, in terms of number and types, is standardized and appears to be much more conservative than in the United States. Additionally, our results suggest that financial covenants are designed in a hierarchical manner, with the Debt to EBITDA covenant being the first to breach in early years. Regarding determinants we are the first, to our knowledge, to apply a direct measure of financial covenant restrictiveness, which is the real negotiated item between lead arrangers and sponsors. Our results show that financial covenant restrictiveness is significantly negatively related to the size of the private equity group, which serves as a proxy for reputation. Further we show that target-related factors, like growth and profitability, have a strong impact on financial covenant restrictiveness. With regard to transaction-based factors, increasing financial risk leads to more restrictive financial covenants. --financial covenants,leveraged buyouts,financing structure,control rights

Quantitative valuation of platform technology based intangibles companies

In the course of raising external equity, e.g. from venture capitalists, a quantitative valuation is usually required for entrepreneurial ventures. This paper examines the challenges of quantitatively valuing platform technology based entrepreneurial ventures. The distinct characteristics of such companies pose specific requirements on the applicability of quantitative valuation methods. The entrepreneur can choose from a wide range of potential commercialization strategies to pursue in the course of company development which is difficult to take account of in a quantitative valuation. By developing and applying a systematic map of valuation requirements in this context, we analyze whether the cost, market or income approach is suitable for platform technology based entrepreneurial ventures. We argue that all three valuation methods have drawbacks. Yet, the income approach fulfills most of the requirements and, therefore, is considered to be more suitable for the entrepreneur as well as external equity providers than other quantitative valuation methods. --entrepreneurial venture,platform technology,young venture valuation,quantitative company valuation,intangible assets,intellectual property,commercialization strategies,value extraction

Do corporate governance motives drive hedge funds and private equity activities?

We address the question of whether hedge fund and private equity investments in public firms are motivated by corporate governance improvements. As opposed to traditional financial investors both HF and PE are likely to have the incentives to alleviate agency conflicts. However, against the background of differences in their business models and organizational set ups, it remains an empirical question of whether they address the same or different agency conflicts. Studying HF and PE activities in a typical Continental European market like Germany promises to offer interesting insights about how HF and PE activities relate to the prevalence of family ownership, concentrated ownership structures and conflicts among majority and minority owners. We document empirical evidence that both HF and PE investments are driven by corporate governance improvements, but seem to address different types of agency conflicts. Whereas HF focus on firms with a lack of a controlling shareholder, in particular family shareholders, PE invest in firms which exhibit the potential to align manager-shareholder interests due to low managerial ownership. Both appear to address free cash flow problems differently. Aiming at dividend increases, HF tend use commitment devices that can be implemented over a short horizon. In contrast, PE are inclined to target firms which are particularly well-suited for a leverage increase because of low expected financial distress costs. This strategy requires a sufficiently long investment horizon. --private equity,hedge funds,corporate governance

Influence of internal factors on the use of equity- and mezzanine-based financing in family firms

The paper analyzes internal factors which influence the use of equity - and mezzanine-based financing instruments in German privately held family firms. Based on a sample of 195 surveys of family firms, we investigate the impact of family specific goals and corporate governance structures on the use of financial instruments such as retained earnings, private equity and silent partnerships. We find that family goals have a complex impact on the decision to use or not to use these instruments and parallel existing goals can result in diverging financing preferences. Furthermore, we find that the impact of corporate governance structures on financing decisions is mainly driven by the existence of an advisory board and the involvement of external managers in the management board. Our findings contribute to a better understanding of financing decisions in family firms and demonstrate the necessity to include family firm specific characteristics such as family goals and corporate governance structures in the analysis of financing decisions. --entrepreneurial finance,family firms,equity,mezzanine,retained earnings,private equity,silent partnership

The capital gains tax: A curse but also a blessing for venture capital investment

This article documents a statistical association between the number and success of venture capital investments and the capital gains tax rate. To do this, we analyze investment data and taxes of 32 countries from 2000 to 2010. In our data, higher capital gains tax rates are associated with fewer firms financed and a lower probability for ventures receiving follow-up funding. However, if the first investment is received when taxes are high, the probability of a firm eventually going public or being acquired increases. We conclude that high tax rates are associated with fewer, but on average more successful companies. --capital gains tax,venture capital,investment

Managing investment risks of institutional private equity investors: The challenge of illiquidity

Since private equity investments are not publicly traded, a key issue in measuring investment risks of institutional private equity investors arises from a careful measurement of investment returns in the first place. Prices of private equity investments are typically observed at low frequency and are determined by transactions under low liquidity. This contribution highlights useful approaches to the problem of return measurement under conditions of illiquidity. Then, specific risk management issues, including asset allocation issues, are discussed. --private equity,risk/return measurement,net asset values,cash flows,illiquidity,stale pricing,risk management,asset allocation