1 private equity returns and disclosure around the world douglas cumming and uwe walz hofstra...

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Private Equity Returns and Disclosure Around the World

Douglas CummingandUwe Walz

Hofstra Conference on Private EquityMay 2, 2007

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Motivation: Worldwide Policy Debate

2002 CALPERS disclosure lawsuit– Public pension funds must disclose venture capital and private equity

returns, even on unexited investments

Implications for understanding determinants of, and reporting of, returns

Do we need mandated disclosure standards for VC and PE funds?

Biggest issue for VC/PE markets since collapse of Internet bubble

Regulation of VC and PE funds one of the biggest issues in UK Financial Times last week

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Research Questions

1. What are the determinants of VC and private equity returns across countries?

2. Are unexited investment values over-reported to institutional investors?

3. Are biases in reporting unexited investments related to legal conditions?

4. Relative merits of alternative approaches to stimulating VC markets

4

Prior Research

VC / PE Returns– Cochrane (2005 Journal of Financial Economics)– Cumming and MacIntosh (2007 Cambridge Journal of Economics)– Hege, Palamino and Schwienbacher (2003 WP)– Lerner, Schoar and Wong (2006 Journal of Finance)– Ljungqvist and Richardson (2003 WP)

VC Exits– Cumming and MacIntosh (2003 Journal of Banking and Finance)– Cumming, Fleming and Schwienbacher (2006 Journal of Corporate Finance)

VC value-added– Cumming (2006 Journal of Business)– Gompers and Lerner (1999 MIT Press)

No prior paper on disclosures of unexited VC returns

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New Contributions

1. First look at project-specific returns to VC and private equity across countries

2. Innovative application of econometric selection methods to measure VC returns

3. First look at biases in unexited returns and relations to fundraising

4. Policy implications: Reporting Standards needed in VC?

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I. Theory and Hypotheses

II. Data

III. Econometric Tests

IV. Policy Implications

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Institutional andOther Investors

Venture Capital Funds

Entrepreneurial Firms

$ Returns

$ Returns (realized vs ‘expected’)

Venture Capital Cycle

E.g., CALPERSCalifornia PublicPension Fund

PensionPlanMembers(you and I)

Reporting bias ofunexited returnsin annual reports?

Why care?Distorted assetallocations,less overallfundraising

2-7 years beforeexit event (IPO,Acquisition, Write-off)

This PaperCumming &Johan (2007JBF)

CD Howe Institute,AEI Sciences Po,Brookings,PWC,EVCA, NVCA, etc.They all care a lot!

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1. Advice, Monitoring & Returns

Monitoring/advice activities of VC are responsible for return of VC

Main focus on VC characteristic

Model with asymmetric information Advice is not contractible

IRR must be sufficiently large to induce VC to undertake optimal level of advice/monitoring

The more productive the VC is, the higher the optimal advice/monitoring level

the lower the price of shares for the VC the higher the VC returns

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1. Advice, Monitoring & Returns (Continued)

Hypotheses:

The higher the intensity of monitoring and advice the higher the expected IRR of the VC

– Convertible securities, syndication higher expected rate of return– Co-investment: lower returns– Smaller portfolios (# investments) / manager lower returns

Better legal environment more efficient advice and less information asymmetries upon exit the higher expected returns

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2. Biases in Reporting Un-Exited Investments

Valuation take place against trade-off between Fundraising concerns (higher valuations potentially facilitate

fundraising in next round) Reputational concerns (overvaluation damages long-run

reputation)

Simple set-up: two projects, two VC types

Pooling equilibria may emerge (bad projects are overstated)

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2. Biases in Reporting Un-Exited Investments (Continued)

Hypotheses:

Expected Fundraising Benefit > Expected Reputation Cost– Inexperienced VCs: overstate– Earlier stage and high tech: overstate– Syndicated investment: less likely to overstate– Co-investment: more likely to overstate

Legal environment increases costs of overstatement– Less stringent accounting rules: overstate– Sarbanes Oxley: less likely to overstate

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II. Data



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CEPRES Dataset

221 venture capital and private equity funds 72 venture capital and private equity firms 5117 entrepreneurial firms (3826 venture

capital and 1214 private equity) 32 years (1971 – 2003) 39 countries (North and South America,

Europe and Asia)

Table 1 (see paper) defines the variables

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-100 -50 0 50 100 200 300 400 500 1000 5000

Unrealized IRRs

Partially Realized IRRs

Fully Realized IRRs

0

200

400

600

800

1000

1200

# Entrepreneurial Firms

IRR (%)

Figure 1. Histograms of Fully Realized, Partially Realized and Unrealized IRRs

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0

100

200

300

400

500

600

700

800

900

Number of Investments

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003Year

Figure 2. Number of Investments by Year

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Table 2. Summary Statistics and Difference Tests

Unrealized / Partially realized Ent

Firm InvestmentsFully Realized Ent Firm

Investments Difference Tests

PE Fund Characteristics# Ent Firms

Average IRR

Median IRR

# Ent Firms

Average IRR

Median IRR Means Medians

All Funds

All Funds in the Data 2619 63.23 0.00 2419 68.67 16.99 0.22 p <= 0.00***

Market and Legal Factors

MSCI Return > 3.5% 611 76.88 9.32 1908 58.07 20.21 -1.14 p <= 0.000***

MSCI Return < 3.5% 2010 59.07 0.00 511 108.24 -10.99 0.64 p <= 0.000***

Risk Free Return > 3.5% 2333 49.36 0.04 2021 79.59 17.41 1.36 p <= 0.000***

Risk Free Return < 3.5% 311 213.32 0.00 411 12.92 15.74 -1.32 p <= 0.000***

Legality Index > 20 1874 60.01 2.16 1631 47.23 19.26 -0.87 p <= 0.000***

Legality Index < 20 747 71.30 0.00 788 113.04 14.21 0.54 p <= 0.000***

Country Earnings Aggressiveness Index > -0.383 765 27.43 3.17 646 85.50 18.39 1.03 p <= 0.000***

Country Earnings Aggressiveness Index < -0.383 1858 77.92 0.00 1773 62.54 16.22 -0.54 p <= 0.000***

Country Disclosure Level Index > 76 621 18.80 5.64 595 91.96 19.05 1.20 p <= 0.000***

Country Disclosure Level Index < 76 2000 77.02 0.00 1824 61.07 15.68 -0.60 p <= 0.000***

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Table 2. Summary Statistics and Difference Tests (Continued)





Average IRR

Median IRR

# Ent Firms

Average IRR


Fund Characteristics

Fund Number in the PE Firm > 3 1603 69.37 0.00 781 88.72 1.51 0.34 p <= 0.000***

Fund Number in the PE Firm < 3 1018 53.55 10.30 1638 59.11 20.27 0.29 p <= 0.000***

Age of Specific PE Fund > 1795 days 1230 54.15 9.23 2233 57.48 18.73 0.19 p <= 0.000***

Age of Specific PE Fund < 1795 days 1391 71.25 0.00 186 202.96 -91.74 0.67 p <= 0.000***

Portfolio Size (# Investees) / # General Partners > 20 1035 59.58 0.00 988 21.29 12.34 -2.52** p <= 0.000***

Portfolio Size (# Investees) / # General Partners < 20 1586 65.61 1.70 1431 101.38 22.07 0.87 p <= 0.000***

Entrepreneurial Firm Characteristics

Seed Stage 146 8.88 0.00 71 520.37 -2.92 1.01 p <= 0.097*

Start-up Stage 56 126.72 18.97 34 48.58 -11.45 -1.65* p <= 0.127

Early Stage 672 39.55 0.00 424 -1.52 -29.14 -2.93*** p <= 0.000***

Expansion Stage 240 36.40 0.00 226 28.91 14.54 -0.56 p <= 0.000***

Unknown Seed, Early or Expansion Stage 838 91.80 5.09 1119 71.69 20.00 -0.36 p <= 0.000***

Late Stage 168 55.77 0.00 116 121.20 25.34 1.50 p <= 0.000***

MBO/MBI 309 43.79 8.53 266 33.33 28.27 -0.35 p <= 0.000***

LBO 30 27.43 13.55 17 32.73 44.72 0.37 p <= 0.052*

Other Type of Private Equity 153 144.32 17.14 132 69.11 25.52 -0.69 p <= 0.006***

Publicly Listed Firm 9 31.41 0.00 14 649.54 29.45 1.29 p <= 0.680

Industry Market / Book > 5 1448 101.95 0.00 816 80.27 6.08 -0.55 p <= 0.000***

Industry Market / Book < 5 1173 15.42 7.92 1603 62.76 20.28 2.01** p <= 0.000***

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Table 2. Summary Statistics and Difference Tests (Continued)





Average IRR

Median IRR

# Ent Firms

Average IRR


Investment Characteristics

Lead Investment 864 75.01 8.33 633 45.11 20.33 -1.21 p <= 0.000***

Syndicated Investment 729 68.11 0.00 449 151.27 15.88 1.01 p <= 0.000***

Co-Investment 526 44.51 0.00 313 48.02 13.27 0.13 p <= 0.000***

PE Board Seat(s) 743 42.84 0.00 447 112.40 0.26 0.84 p <= 0.000***

Convertible Security with Actual Periodic Cash Flows 967 123.03 12.77 1162 73.62 25.99 -0.95 p <= 0.000***

Standard Deviation of Cash Flows to Entrepreneur / Initial $ Invested 1203 130.12 0.00 1364 125.85 31.49 -0.04 p <= 0.000***

Standard Deviation of Cash Flows to Entrepreneur / Initial $ Invested 1418 6.47 2.92 1055 -5.26 0.33 -3.06*** p <= 0.216

Initial Amount Invested > $US 2,500,000 1310 34.62 5.04 1040 75.58 25.22 1.09 p <= 0.000***

Initial Amount Invested < $US 2,500,000 1311 91.80 0.00 1379 63.46 8.60 -0.75 p <= 0.000***

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Table 3. [Condensed] Correlation Matrix

(1)

(1) Log (1+IRR) 1.00

(2) Log (MSCI) 0.15

(3) Log (Interest) -0.06

(4) Log (Legality) 0.03

(5) Log (Committed Capital) -0.06

(6) Log (Fund Number) 0.04

(7) Log (Portfolio Size / Manager) 0.03

(8) Seed -0.10

(9) Early -0.03

(10) Expansion 0.03

(11) Late 0.03

(12) Log (Industry Market / Book) 0.01

(13) Lead Investor 0.07

(14) Syndicated Investment 0.06

(15) Co-Investment -0.06

(16) Board Seats 0.00

(17) Convertible Security 0.05

(18) Standard Deviation of Cash Flows 0.01

(19) Log (Initial Investment) -0.04

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II. Data


IV. Remarks

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“Realized Returns Econometrics”

Multi-step Heckman correction to measure the returns to VC and private equity investment

Heckman selection corrections for1. Unexited / Exited Investments

2. Partial / Full Exits

Statistical problems associated with OLS on a subsample of fully realized IRRs

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3-Step Heckman Correction

1. Probit: Exit / No Exit

2. Selection Corrected Probit: Full / Partial Exit, accounting for the selection effects associated with an actual exit (step 1)

3. Heckman Linear Regression IRR, accounting for both steps # 1 and 2

Contrast to Cochrane (2002): moves from step # 1 to step # 3Contrast to Ljungqvist and Richardson (2003): OLS on restricted sample of realized returns

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Table 4. Heckman Corrected IRR Regressions

Continued…

Panel A. Seed, Start-up, Early and Expansion Stage Investments

Predicted Sign for Realized Returns

Model (1) Model (2)

OLS on Subsample of Fully Realized IRRs

1st Step Heckman Regression: Bivariate Probit Model

2nd Step Heckman Regression (Realized IRRs)Step 1a: Determinants of

Exit

Step 1b: Determinants of Full Exit, conditioned on

step 1a regarding an actual exit

Dependent Variable = Log(1+IRR)

Dependent Variable=1 if Exit

Dependent Variable=1 if Full Exit


Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic

Constant -5.87 -1.5 -0.44*** -11.7 -1.80 -1.0 -20.27 -4.0***

Duration of VC Investment (in Days)

0.0006 24.4*** -0.00008 2.5**


Log (MSCI Return) + 0.77 1.0 1.15 2.1**

Log (Risk Free Rate) ? -13.32 -2.7*** -27.08 -4.6***

Log (Legality Index) + 4.25 4.0*** 0.52 0.8 3.64 2.5**

Log (Committed Capital Overall Market at Inv Date)

- -0.94 -6.5*** 1.31 5.4***


Log (Fund Number in the VC Firm)

+ -0.01 -0.1 -0.14 -1.1

Log (Portfolio Size (# Investees) / General Partner)

- -0.41 -2.5** -0.51 -3.2***

Industry Dummy Variables? Yes No Yes Yes

Country Dummy Variables? Yes No Yes Yes

Exit Year Dummies? Yes No Yes Yes

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Table 4. Heckman Corrected IRR Regressions (continued)

Prior work: explains 1% (Cochrane, 2001) to 12% (Ljungqvist and Rihardson, 2003) of variation in VC returns

Predicted Sign for Realized Returns

Model (1) Model (2)

OLS on Subsample of Fully Realized IRRs

1st Step Heckman Regression: Bivariate Probit Model

2nd Step Heckman Regression (Realized IRRs)Step 1a: Determinants of

Exit

Step 1b: Determinants of Full Exit, conditioned on

step 1a regarding an actual exit


Dependent Variable=1 if Exit

Dependent Variable=1 if Full Exit




Lead Investment ? 0.18 0.6 0.19 0.7

Syndicated Investment + 0.34 1.3 -0.42 -3.8*** 0.51 1.7*

Co-Investment - -0.30 -1.2 -0.40 -1.7*

VC Board Seat(s) + -0.46 -1.2 -0.70 -2.2**

Convertible Security with Actual Periodic Cash Flows

+ 2.43 13.6*** 1.97 9.9***

Standard Deviation of Cash Flows to Entrepreneur

? 1.200E-02 2.0** 0.01 2.8***

Log (Amount Invested) ? 9.052E-02 1.5 0.11 1.9*

Heckman Lambda A - -2.18 -2.3**

Heckman Lambda B - -7.22 -11.3***

Model Diagnostics

Number of Observations 1358 3213 1358

Adjusted R2 0.29 0.35

F Statistic 15.74*** 19.65***

Loglikelihood Function -3456.74 -2756.44 -3373.45

Akaike Information Statistic 5.15 5.03

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Unexited Reported IRRs (2000 – 2003)versus Predicted IRRs

Contrast reported unexited IRRs (as reported to the institutional investors) with predicted IRRs for unexited investments

Log(1+IRR Reported)-Log(1+IRR Expected)= Log((1+Reported IRR)/(1+Predicted IRR) = 143%

Regression evidence: quite remarkably(!) consistent with the proposition that more informational asymmetry is associated with more ‘lying’!

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Table 6. Unexited Reported IRRs versus Predicted IRRs

Dep Var = Unexited IRR – Predicted IRR from Respective Model #

Continued…


Predicted Sign

Model (1a) Model (1b) Model (2a) Model (2b)

Dependent Variable:Unrealized Log(1+IRR) -

Fitted Values from Predicted Log (1+IRR) in Model (1) of

Table IV Panel A



Table IV Panel A


Fitted Values from Predicted Log (1+IRR) in

Model (2) of Table IV Panel A



Table IV Panel A


Constant 35.61 8.8*** 11.08 13.9*** 20.77 3.6*** 22.18 5.4***


Log (MSCI Return) - -1.21 -6.4*** -3.11 -9.1***

Log (Risk Free Rate) ? 36.57 16.2*** -14.17 -3.8***

Country Earnings Aggressiveness Index

+ 42.46 5.9*** 32.38 9.1*** 37.95 3.5*** 28.95 4.7***

Country Disclosure Level Index

- -6.59 -6.8*** -0.05 -5.4*** -5.29 -3.8*** -3.18 -3.3***

Sarbanes Oxley - -0.56 -6.2*** -0.34 -5.8*** -1.07 -8.1*** -1.38 -15.3***


Log (Age of VC Fund within the VC Firm)

- -0.42 -6.7*** -1.75 -13.5***


+ 0.49 10.9*** 0.82 11.1***

Industry Dummy Variables? Yes Yes Yes Yes

Country Dummy Variables? Yes Yes Yes Yes

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Predicted Sign

Model (1a) Model (1b) Model (2a) Model (2b)



Table IV Panel A



Table IV Panel A


Fitted Values from Predicted Log (1+IRR) in

Model (2) of Table IV Panel A



Table IV Panel A



Lead Investment ? -0.05 -0.7 0.14 1.3

Syndicated Investment - -0.310 -3.2*** -0.28 -4.2*** -0.76 -5.5*** -0.75 -8.2***

Co-Investment + 0.23 3.8*** 0.17 1.9*

VC Board Seat(s) ? 0.51 5.7*** 0.68 5.5***


- -2.46 -19.5*** -2.64 -10.5***


? -0.01 -9.7*** -0.01 -2.4**

Log (Amount Invested) ? -0.11 -6.5*** -0.05 -1.5

Model Diagnostics

Number of Observations 1122 1122 1122 1122

Adjusted R2 0.36 0.74 0.25 0.70

F Statistic 37.50*** 102.20*** 28.10*** 91.66***

Loglikelihood Function -1830.18 -1307.71 -2262.49 -1740.97

Akaike Information Statistic 3.29 2.39 4.06 3.16

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Subsample of 80 observations (investee firms) from 11 countries for which both the realized and unrealized reported IRR are known (Canada, Finland, France, Germany, Israel, Norway, Spain, Sweden, the Netherlands, the UK, and the US)

The correlation between out-of-sample average realized IRRs and our predicted IRRs is 0.45

Appendix: Compare Actual IRR to Prior Reported Unexited IRR(This is possible now in 2006!)

Average Median

Duration Report Exit 2.6 years 2.6 years

Unrealized reported IRR 219.71% 2.56%

Subsequently Realized Reported IRR

98.46% 8.70%

Predicted IRR (Based on Table IV Model)

15.22% 7.75%

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Table VIII. Determinants of the Difference between Reported Unrealized IRRs Disclosed to Institutional Investors and Subsequently Realized IRRs

Predicted

Sign

Model (A1) Model (A2) Model (A3) Model (A4)

Dependent Variable: Dependent Variable: Dependent Variable: Dependent Variable:

Unrealized Reported Log(1+IRR) - Fitted Values from Predicted Log (1+IRR)

in Model (1) of Table IV Panel B

Unrealized Reported Log(1+IRR) - Subsequently

Realized Log (1+IRR)






Constant 52.581 3.035*** 106.795 1.517 7.729 0.907 17.299 2.784***


Log (MSCI Return Reporting Time)

- -0.884 -0.801

Log (MSCI Return Reporting Time) - Log (MSCI Return Exit Time)

? 0.566 0.124 -1.925 -0.434 -0.168 -0.054

Duration from Reporting to Realization

? 0.362 0.987

Country Earnings Aggressiveness Index

+ 53.544 1.166 361.277 1.711* 387.377 2.530** 375.457 2.453**

Country Disclosure Level Index

- -9.577 -2.629*** -21.229 -1.420


Log (Age of PE Fund within the PE Firm)

- -0.441 -1.529 -0.351 -0.320 0.045 0.043


+ 0.070 0.309 -0.085 -0.049 1.058 0.595

Continued…

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Predicted Sign

Model (A1) Model (A2) Model (A3) Model (A4)

Dependent Variable: Dependent Variable: Dependent Variable: Dependent Variable:

Unrealized Reported Log(1+IRR) - Fitted Values from Predicted Log (1+IRR)

in Model (1) of Table IV Panel B








Entrepreneurial Firm Characteristics

Log (Industry Market / Book)

+ 0.673 2.620*** 0.162 0.147 -0.189 -0.168 0.051 0.042

Industry Dummy Variables?

Yes Yes Yes Yes

Country Dummy Variables?

No No Yes Yes


Syndicated Investment - -0.639 -2.600*** 0.691 0.518 0.657 0.511


- -2.703 -10.880*** -3.201 -3.145*** -3.215 -3.317*** -3.129 -3.437***


? 0.081 1.102 0.005 0.032

Log (Amount Invested) ? -0.112 -1.035 0.341 0.775 0.372 1.071

Model Diagnostics

Number of Observations 80 80 80 80

Adjusted R2 0.766 0.130 0.131 0.159

F Statistic 20.97*** 1.90** 1.74* 2.35**

Loglikelihood Function -105.336 -211.641 -209.713 -211.481

Akaike Information Statistic 2.983 5.641 5.668 5.587

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Not possible to assess causality

but there is evidence of positive correlations between overstatement of unexited reported IRRs and fundraising

Overstatement of Unexited IRRs and Fundraising

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Correlations: Overstatement of Unexited IRRs and Fundraising

ActualDifference(Reported -

Predicted IRR)

Fitted ValueFrom

DifferenceRegression

Actual Difference 1.00 0.23

Fitted Values from Difference Regression

0.23 1.00

Fund Size 0.18 0.27

VC Firm Age 0.24 0.39

Capital Under Management 0.21 0.33

Capital Under Management to Date of Fundraising

0.26 0.37

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II. Data



34

Measuring VC Returns

Heckman selection effects are crucial Misspecification of model without selection effects Like Cochrane (2002), unlike Ljungqvist & Richardson (2003), unlike

Brander et al. (2002) Multidimensional selection effects are a useful new component

introduced in this paper

VC value-added is crucial E.g., portfolio size / manager Enables us to explain up to 36% of the variation in returns Cochrane explains at most 1% using market variables only; Ljungqvist &

Richardson explain up to 13% with some fund variables, but no proxies for value-added

• Legality is crucial for cross-country differences

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Unexited IRRs Reported to Institutional Investors

Our findings are quite remarkably(!) consistent with the proposition that more informational asymmetry is associated with more ‘lying’! for smaller ENTs, tech companies, higher earnings

aggressiveness index, lower disclosure index

Positive correlation between fundraising and lying

1 private equity returns and disclosure around the world douglas cumming and uwe walz hofstra...

Documents

vc markets

determinants of vc

private equity returns

disclosures of unexited

bias of unexited returns

vc characteristic model

vc convertible securities

projectspecific returns