what matters the most to limited partners?
DESCRIPTION
This is a piece of independent research done for my final year dissertation.TRANSCRIPT
UNIVERSITY OF EDINBURGH
What matters the most to Limited Partners?
by
Chung Ang Taing
Dissertation presented for Honours Degree in International Business
2013/2014
Dissertation Advisor:
Mehdi Safavi
Abstract
otivated by the disparity of private equity investments across developed and
emerging markets, this paper is interested in identifying the most important
country-specific and firm-specific determinants of capital allocation decisions.
Building on the existing literature, this abductive research differentiates its contribution by
directly surveying limited partners through questionnaires. This research is conducted at a global
scale with a diverse sample of 76 limited partners. A series of Wilcoxon Signed Rank tests is
employed to establish the rank positions of the tested determinants. This paper successfully
identifies the most important country-specific and firm-specific determinants.
At the country- level, while investors are attracted by the expected returns of private equity
investments in emerging markets, issues related to securing their claims such as investor
protection, bribing and corruption and regulation on repatriation of capital also rank highly
among investors. Investors also have strong concerns about local entrepreneurial management
quality and skills. Public funding and subsidies are not effective in attracting investments. Such
findings urge policymakers to re-evaluate their efforts, and more emphasis should be placed on
facilitating the enforcement of investors’ claims. At the firm-level, investors concur that the
integrity and transparency practices of general partners are the most important determinants.
Likewise, investors desire general partners who possess the right match of expertise and strategy.
Key findings suggest the possibility of firm-level corporate governance as an alternative
mechanism to compensate for the shortcomings of legal protection. Investors believe that general
partners could bring about significant improvements to compensate for the lack of local
entrepreneurial management quality and skills.
Keywords: Private Equity, Limited Partners, General Partners, Emerging Markets, Determinants.
M
Acknowledgement
I am obliged to my supervisor Mr. Mehdi Safavi for his advice, guidance and support during the
period I am writing this dissertation. I also would like to thank him for providing me with other
career development opportunities. I am sincerely thankful to Professor Jake Ansell and Professor
Jo Danbolt for spending their valuable time to provide feedbacks and conduct expert tests on the
questionnaire used for this research.
Without the supports from limited partner community, this dissertation would not be completed.
I would like to express my deepest gratitude to many investment and business executives for
participating in this research, further redistributing questionnaires and providing valuable
feedbacks. Many thanks go to two anonymous warriors who had allowed me to conducted phone
interviews with them. I am enchanted by the dedication to education within the limited partner
community.
I am grateful to a few very good friends of mine including Angela Mi, Marie Chia and Martin
Lam for their valuable comments and encouragements. Last but not least, special thanks are due
to Benjamin Lau for providing technical support and valuable feedback and for proofreading this
dissertation.
Table of Contents Chapter One: Introduction ...............................................................................................................1
Chapter Two: Literature Review .....................................................................................................3
2.1. Introduction ............................................................................................................................. 3
2.2. Country-specific determinants................................................................................................... 3
2.2.1. Capital market ................................................................................................................... 3
2.2.2. Economy ........................................................................................................................... 4
2.2.3. Investor protection and legal environment ........................................................................... 5
2.2.4. Human and social capital environment ................................................................................ 6
2.2.5. Taxation ............................................................................................................................ 8
2.2.6. Entrepreneurial activities .................................................................................................... 8
2.3. Firm-specific determinants........................................................................................................ 9
2.3.1. Individual capability .......................................................................................................... 9
2.3.2. Incentive structure............................................................................................................ 10
2.3.3. Firm-level corporate governance ....................................................................................... 11
2.3.4. Strategic focus ................................................................................................................. 12
2.4 Conclusion and gaps in the literature ........................................................................................ 13
Chapter Three: Research Setting ...................................................................................................15
3.1. Rationale and approach of identifying the target population ...................................................... 15
3.2 Description of census .............................................................................................................. 16
3.2.1 Fund origin....................................................................................................................... 16
3.2.2 Type of LPs...................................................................................................................... 16
3.2.3 Fund size .......................................................................................................................... 17
Chapter Four: Research Design .....................................................................................................18
4.1 Methodology .......................................................................................................................... 18
4.2 Methods ................................................................................................................................. 19
4.2.1 Structure of the questionnaire ............................................................................................ 19
4.2.2 Process of constructing the questionnaire............................................................................ 20
4.2.3 Sampling and treatment to the mailing list .......................................................................... 21
4.3 Analysis ................................................................................................................................. 22
Chapter Five: Data analysis ...........................................................................................................23
5.1 Description of collected data and identification of potential bias................................................. 23
5.1.1 Fund origin of the responding LPs ..................................................................................... 23
5.1.2 Type of responding LPs..................................................................................................... 24
5.1.3 Fund size and commitment to private equity investment of responding LPs .......................... 24
5.2 The most important country-specific determinants, and appreciation of key drivers of capital
allocation in EMs.......................................................................................................................... 26
5.3 The most important firm-specific determinants of capital allocation in EMs ................................ 29
5.4 The most important determinants – reconciling firm-specific factors with country-specific factors 31
5.5 Sample bias and reliability test ................................................................................................. 33
Chapter Six: Discussion.................................................................................................................35
6.1 The most important country-specific determinants..................................................................... 35
6.1.1 The expected return in PE investment in EMs ..................................................................... 35
6.1.2 Property right and investor protection................................................................................. 36
6.1.3 Bribing and corruption ...................................................................................................... 36
6.1.4 The regulation on repatriation of capital ............................................................................. 37
6.1.5 The entrepreneurial management quality and skills ............................................................. 37
6.1.6 Public funding and subsidiaries .......................................................................................... 37
6.2 The shortcomings of country-level endowments in emerging markets ......................................... 38
6.3 The most important firm-specific determinants ......................................................................... 38
6.3.1 The integrity of GPs .......................................................................................................... 38
6.3.2 The transparency practice of the GPs.................................................................................. 39
6.3.3 The matching between GPs’ expertise and strategy ............................................................. 39
6.3.4 Track record ..................................................................................................................... 40
6.3.5 Accessibility to deal flows ................................................................................................. 40
6.3.6 Size of cumulative AUM, popularity of the funds and co-investment programmes ................ 40
6.4 Reconciliation of firm-specific determinants with country-specific determinants ......................... 41
6.5 Research Implications ............................................................................................................. 42
6.5.1 Theoretical contribution .................................................................................................... 42
6.5.1 Implication to policy makers of EMs .................................................................................. 42
6.5.2 Implication to GPs ............................................................................................................ 43
6.6. Conclusion ............................................................................................................................ 43
Bibliography ..................................................................................................................................45
Appendices ....................................................................................................................................50
List of Tables
Table 1: Geographic distribution of fund origin .................................................................................. 16
Table 2: Demographic distribution of LPs type................................................................................... 17
Table 3: Description of fund size ....................................................................................................... 17
Table 4: Geographic distribution of the responding LPs ...................................................................... 24
Table 5: Distribution of responding LPs by type of investors ............................................................... 24
Table 6: Distribution of the responding LPs by size ............................................................................ 25
Table 7: Distribution of the responding LPs by commitment to PE investments .................................... 25
Table 8: Kruskal Wallis test on level of commitment into PE, grouped by fund size .............................. 26
Table 9: The most important country-specific determinants ................................................................. 28
Table 10: The most important firm-specific determinants .................................................................... 30
Table 11: Reconciling the most important firm-specific determinants with country-specific determinants
....................................................................................................................................................... 32
List of Figures
Figure 1: Overview of workflow ....................................................................................................... 18
Figure 2: Nominations of the importance of country-specific factors.................................................... 27
Figure 3: Appreciation (effectiveness) of the key drivers of country-specific factors ............................. 29
Figure 4: Nominations of the importance of firm-specific factors......................................................... 30
Figure 5: Nominations of the importance of (top-five) firm-specific and country-specific determinants.. 32
List of Acronym
Emerging Market [EM]
Private Equity [PE]
General Partner [GP]
Limited Partner [LP]
Initial Public Offering [IPO]
Asset Under Management [AUM]
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Chapter One: Introduction
According to The World Bank (2011), by 2025, more than half of global economic growth will
be accounted for by the six major emerging economies - China, Brazil, India, Indonesia, South
Korea, and Russia. It is also projected that emerging markets [EMs] will grow on average by 4.7%
per year (about twice the rate of developed economies) between 2011 and 2025. The urgent need
to finance capital in EMs is evident. In EMs where capital markets are less developed, private
equity [PE] should play a critical role in financing such growth. However, in 2012, investments
in EMs only accounted for 8.8% of global PE investments (Klownoski, 2013). The PE
penetration1 (0.14%) in EMs is also significantly lower than the U.S. (0.98%) and the U.K
(0.75%).
On the other hand, there is a strong consensus in the academic and professional literature that PE
investments bring about superior returns to investors. Financing at the individual-company level
also translates to significant economic development. It has been shown that PE involvement in
investee companies increases the efficiency and economic benefits of innovation efforts (Learner
et al., 2011). It enhances the level of productivity in individual companies as well as in the
economy as a whole (Ernst and Young, 2012). PE investments also foster stronger
competitiveness at the macroeconomic level (Samila and Sorenson, 2011).
Therefore, it is important to understand why does the supply of capital seem unable to match up
with the strong demand of capital in EMs? While some EMs such as China, Brazil and India
have increasingly received a tremendous influx of capital, the PE activity in other EMs is low.
Why is there such a significant difference across EMs? These prompt us to identify the most
important determinants of capital allocation decisions in PE investments in EMs – what matters
the most to LPs? Certainly, there are many aspects of consideration when LPs make capital
allocation decisions. But the two main fundamental decisions to be made are the choice of
countries/regions and the choice of a general partner [GP]. Two main bodies of literature explore
the determinants of PE investments. The first body of literature looks at the various factors that
might attract or hinder PE investments in a country. The second body of literature looks at firm-
specific factors as key determinants of capital allocation decision. However, these two main
bodies of literature mainly derive their findings through surveying GPs or running multivariate
analysis on secondary data. This research is an abductive research that aims to differentiate its
1 Private equity penetration refers to a ratio of private equity investment to gross domestic product.
2
contribution by addressing directly the source of capital, i.e. the international LPs who are
investing or interested in PE investments in EMs.
The remaining of this paper is structured as follows: First, the two main bodies of literature will
be reviewed. Gaps in the literature and research questions will also be identified at the end of the
section. Then, a description and rationale of the chosen research setting and design will be
provided. Next, comprehensive analysis will be performed to identify the most important
determinants. Finally, a discussion of research findings and implications will be provided, and
the entire paper will be concluded with suggestions of future research areas.
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Chapter Two: Literature Review
2.1. Introduction
Two main bodies of literature will be reviewed in this chapter. At the country level, the first
group of literature explores various institutional and environmental factors as key determinants
of capital allocation decisions in PE investment in EMs. These factors will be explored with
different themes, namely: capital market, economy, taxation, investor protection and legal
environment, social and human capital environment, and entrepreneurial activities. At the firm
level, the second group of literature explores various firm-specific determinants of allocation
decisions for a PE fund. These determinants will be grouped into four subcategories, namely:
GPs’ individual capability, incentive structure, firm-level corporate governance, and strategic
focus. The extensive literature encompasses different disciplines, including finance,
entrepreneurial finance, international business, economics, and law.
2.2. Country-specific determinants
2.2.1. Capital market
The various pieces of literature have a strongly harmonised view that financial markets are
important for the development of private equity markets. Black and Gilson (1998) point out the
important link between an active stock market and a strong PE market. The potential for exit
through an initial public offering [IPO] allows entrepreneurs and GPs to contract implicitly over
future control of the targeted company. Such exit potential is critical to the development of a
private equity market. Where the entrepreneur hold a call option on the firm and has strong
financial incentive to exit through IPO sales, 2 Jeng and Well (2000) find that the volume of IPOs
fosters strong demand for venture capital funds. On the supply side of capital, Jeng and Wells
(2000) quantitatively evaluated the determinants of private equity fundraising across 21 countries.
Echoing Black and Gilson (1999), both studies find the strength of IPO markets (measured by
the number of venture-back IPOs) is a key determinant of capital commitment to private equity
fundraising. 3 Wurgler (2000) concludes that developed financial markets appear to improve
2 A Venture Economics (1998) study found that the exits through IPO provide an average return of 195 per cent on initial investment, with an average 4.2 years holding period. Compared to the next best exit alternative through trade sales, yield a return of just 40 per cent over an average 3.7 years holding period. 3 However, as noted by Gompers and Lerner (2004), it is inconsistent with the experience of Singapore and Israel, whose private equity industries experienced dramatic growth without having strong domestic public equity market.
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efficiency in capital allocation. Kaplan and Schoar (2005) further confirmed the strong relation
between stock market cycles and PE fundraising activity.
PE investment is essentially illiquid (Sahlman 1990) (Lerner and Schoar 2004), which further
emphasizes the importance of liquidity and deal flows in private equity market. Balboa and Marti
(2003) empirically find that the market liquidity accessed by the amount of investment and
divestment of the previous year has a positive and significant impact on fundraising. One major
deficiency of this research is its data of the divestment volume, which is based on cost price. The
data provide no disclosure of the return obtained. In spite of this, its findings are highly
applicable to EMs where the information on returns are limited or unavailable. As a result, the
amount of investment becomes an important determinant for investors. However, Chemla (2005)
argues for the importance of the depth of the market (transaction size). Investment opportunities
in one particular region become attractive to investors, if only deal flows, transaction sizes, and
expected payoffs exceed certain hurdles that allow investors to cover their management fees and
expected premium.
The transaction size and availability of deal flows in one region could be related to the
accessibility of debt financing. Greene and Villanueva (1998) argue that the availability of debt
financing is crucial for start-ups in entering the market and further expanding their business.
However, Gompers and Lener (2004) find that the availability of debt financing is not a key
determinant of investing commitment for private equity firms. Together, the literature reveals an
interesting fact, that start-ups and private equity firms perceive the importance of debt financing
unequally.
The literature assesses the implications of various factors in a capital market on investing
commitment in the PE industry. However, there is little to no recognition of the degree of
acceptance of the PE market and the role of various agents and supporting institutions in their
work. This paper will also explore a linear relationship between the size of the economy and
private equity activity implied in their work.
2.2.2. Economy
Acs and Audretsch (1994) explored the influence of macroeconomic conditions on start-ups
through examining cross-sectional data of 117 industries over six different periods between 1976
and 1986. Their model demonstrates a positive relationship between the macroeconomic growth
rate and the number of new start-ups. Gompers and Lerner (1998) and Aylward (1998) provide
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supporting evidence for this relationship - an increase in growth rate of gross domestic product
[GDP] has a positive effect on the demand for private equity funding, and hence fundraising.
However, surprisingly, Jeng and Wells (2000) find that the GDP growth rate is not a significant
determinant of private equity investing. Likewise, Acs and Audretsch (1994) find that the
entrepreneurial activities of new start-ups are promoted by low cost of capital and a high
unemployment rate. Such relationships implicitly suggest a low interest rate environment is
associated with higher fundraising. However, Bygrave and Timmons (1985) and Gompers and
Lerner (1998) find no impact of interest rate on fundraising. In short, the impact of economic
activities on private equity investing and fundraising is unclear.
2.2.3. Investor protection and legal environment
Leeds and Sunderland (2003) emphasized that investor protection and the legal environment as
key determinants of performance and investment activities in EMs. They point out that the
underperformance of PE funds that entered EMs in the nineties was mainly due to shortcomings
in investor protection.
Desai et al. (2003) and Friedman et al. (2000) specifically studied the implications of investor
protection and the legal environment on the demand side of private equity, i.e. entrepreneurial
activities. Desai et al. (2003) find that greater fairness and greater protection of property rights
would increase the entry rate of enterprises into the market, enable a smooth transition and
reduce the exit rate. These effects are more profound in EMs and less so in more developed ones.
Friedman et al. (2000) quantitatively showed that start-up firms’ investment decision and
reinvestment of profit are affected by the perceived security of property rights. This coincides
with two different sets of cross-country tests conducted by Knack and Keefer (1995) and
Svensson (1998). They demonstrate that investor protection has a significant impact on private
investments and growth.
Cumming and Johan (2007), La Porta et al. (1997, 1998 & 2002) and Lener and Schoar (2005)
study the implication of investor protection and the legal environment on the supply side of
private equity, i.e., the investors’ financing incentives. Cumming and Johan (2007) emphasised
regulatory harmonization as a key determinant to increasing institutional investors’ allocation to
the asset class. La Porta et al. (1997 & 1998) found that the legal environment (measured by both
legal rules and their enforcement) would strongly determine the size (market valuation) and
breadth (scope of funding) of a country’s capital market and local enterprises’ ability to receive
external funding. Later reinforced by La Porta et al (2002) and Lerner and Schoar (2005), they
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empirically and independently test this finding. On one hand, La Porta et al. (2002) test the
concept using 539 large firms from 27 wealthy economies. The sample selection is biased as
only wealthy economies are included. Yet the problems of property rights and investor
protection are more profound in developing nations. The use of large firms also makes it more
difficult to assess the benefits of investor protection, since large firms have access to alternative
mechanisms (reputation-building, listing on international exchanges and foreign shareholdings)
for limiting the expropriation problem. On the other hand, Lerner and Schoar (2005) analyse 210
transactions from a wide variety of private equity groups primarily in developing countries.
Integrating both studies, a well-rounded and empirically tested conclusion provides confirmation
to La Porta et al. (1997). Both studies also show that deficiencies in the legal environment might
severely distort the contracting process by forcing PE firms to rely on large ownership to achieve
the desired level of control. Consequently, investors face constraints in diversifying their
portfolio and entrepreneurs have weaker incentives to perform since they are forced to give up
large cash flows and control rights early on.
Cumming et al. (2006 & 2010) also look at the implications of investor protection and the legal
environment on business operations of PE firms. They found that the quality of a country’s legal
environment has a very strong connection with facilitating private equity backed exits, even
stronger than the size of a country’s stock market (Cumming et al., 2006). They go one step
further and show that legal origin and accounting standards (as proxies for investor protection)
could significantly influence the quality of investment governance in the PE industry (Cumming
et al., 2010). They conclude that better laws and law enforcements facilitate deal origination,
deal screening, investors’ board representation and the use of desired types of securities.
2.2.4. Human and social capital environment
Within the human and social capital environment, various factors have been considered to be key
determinants in the private equity industry and the decision to allocate capital. In a simplified
manner, the extant literature on corruption and labour market rigidities will be reviewed.
Much of the literature studied the effects of corruption on investments and economic growth.
The inconsistent viewpoints have prompted a particularly fervent debate on this topic. Shleifer
and Vishny (1993) claim corruption makes investments and economic growth sluggish. As
pointed out in the case of foreign investment in the post-communist Russia, where foreign
investors preferred not to invest due to high cost associated with bribing and other corrupt
practice. Murphy et al. (1991) addressed this issue implicitly by looking at the general human
7
capital allocation of a country in relation to its entrepreneurial activities. They provide evidence
that countries where talented people are involved in rent-seeking activities more than innovating
and producing tend to grow slower. In contrast, Leff (1964) suggests that corruption might
actually be beneficial for investments through two mechanisms, i.e. to avoid bureaucratic
inefficiency and to provide personal incentive. Probably, the East Asian Puzzle 4 might lend
some supports to Leff (1994). In response to the controversial nature of this debate, Maoro (1995)
and Keefer and Knack (1995) find empirical evidence for the negative impact of corruption on
investments and economic growth. Stone et al. (1996) and Paul (1995) provide evidence of high
transactions costs accompanying corrupt practices.
Labour market rigidities might negatively affect the attractiveness of the PE industry. Bozkaya
(2009) suggests that labour market rigidities are likely to impact PE firms in two ways. First,
heavy dismissal costs might demotivate PE firms, (especially the early-stage venture capitalists)
that operate in high growth and rapidly restructuring sectors. Indeed, Jeng and Wells (2000) used
multivariate analyses and empirically found that strict employment regulations have a strong
negative impact on early-stage venture capital investments across countries but not later-stage
transactions. Second, labour market rigidities can pose a great restriction on PE firms’ ability to
reallocate resource across portfolio companies. It is essential for PE firms to aggressively
reallocate their resources from the underperforming businesses to winning ones. Strict
employment regulations increase the costs of such adjustments. The impact of labour market
rigidities could hurt entrepreneurial activities, which implicitly affects the demand for capital.
Black and Gilson (1999) believe that restrictions on layoffs impose costs on start-up businesses
and thus discourage their initial formation.5 For example, as in the case of Germany where there
is strong employment protection; or in Japan, where there are little formal employment
protections but the strong embedded culture of career for a lifetime have hindered employees to
create their own ventures.
Overall, the literature reveals that corruption has strong and negative implications on investments.
Labour market rigidities also have a strong and negative impact on the operation of PE firms and
4 Transparency International (1996) ranks China, Vietnam, and Thailand among the most corrupt countries and yet. These countries have continued to grow substantially, and more importantly, to attract considerable flow of private investment. The phenomenon is called the East Asian Puzzle by the academia. 5 Start-up businesses are generally subjected to volatile business risk, hence during the initial stage, they would involve extensive restructuring and searching for the right talents.
8
the demand for capital. Both factors are important to the capital allocation decision of PE
investments in EMs.
2.2.5. Taxation
Gompers and Lerner (1999) emphasised the role of capital gains tax on private equity activities.
Poterba (1989) explores the role of capital gains tax on both the demand and supply side of
private equity. Its findings indicate that a decrease in tax rate is associated with an increase in
capital commitment to private equity funds. This relationship is mainly driven by an increase in
demand of private equity, i.e. an increase in entrepreneurial activities, and not so much by an
increase in supply. In fact, Gompers and Lerner (1999) confirmed this demand-side effect
through their observations that a decrease in tax rate would increase the capital committed by
both tax-exempt and tax-sensitive investors. If this relationship is due to supply-side effect, they
should have observed a disproportionate increase of capital commitment by tax-sensitive
investors. Bruce (2002), Cullen and Gordon (2002) and Bruce and Gurley (2005) provide
evidence that taxes influence entrepreneurial activities, and hence the innovation activities in an
economy. The difference between personal income tax rate and corporate tax rate tends to
positively induce greater self-employment. Through a comprehensive study across 85 developed
and developing countries, Djankov et al. (2008) conclude that the corporate tax rate tends to
negatively affect entrepreneurial activities, aggregate investments and foreign direct investments.
Overall, taxes have a significant impact on private equity activities in one country, and it mainly
influence the demand-side of private equity.
2.2.6. Entrepreneurial activities
Gompers and Lerner (1998) examined both the demand-side and supply-side forces that affect
fundraising of independent private equity firms from 1972 through 1994. They found that
demand-side factors, i.e. those that affect entrepreneurial activities, are more important than
supply-side factors. Industrial and academic R&D expenditures are the demand-side factors that
appear to have a significant impact on fundraising. Subsequently, through a simple demand-and-
supply economic model, Gompers and Lerner (2002) suggested that an increase in demand in the
long run, measured by volume of funds invested, will lead to an increase in supply, measured by
volume of funds raised. Hence, the demand for the risk capital for funding entrepreneurial
activities will incentivize investors to supply capital. Supported by Schertler (2003), they
claimed that human capital endowment, as measured by number of employees in R&D fields and
number of patents, has a positive and significant impact on private equity activities. Interestingly,
9
Baughn and Neupert (2003) argued that national cultures shape institutional practices and
policies, which in turn will affect the development of entrepreneurial activities. It is also possible
to predict the environmental conditions that favour entrepreneurship in different nations through
the understanding of culture and economic conditions. Understanding the essence of such
cultures also allows LPs to assess the level of acceptance of PE activities in different nations. All
of the literature discussed suggested that entrepreneurial activity is an important determinant of
private equity activity in one market.
2.3. Firm-specific determinants
2.3.1. Individual capability
As discussed earlier, a wide range of literature explores the determinants of PE activities at a
country- level. Balboa and Marti (2000) mainly differentiate their contribution by looking at
variables that directly relate to the PE process at the firm-level, i.e. by focusing on the capability
of GPs. The findings are achieved from studying panel data of GPs who operate in European
Union countries, during the nineties (at that time, PE was still a developing industry). Within the
EMs context, Balboa and Marti (2000) found that the higher the amounts invested earlier by GPs,
the easier it was to raise new funds. Besides considering the amount divested and past
performance, investors are interested in the GP’s ability to access and close a satisfactory
number of deals.
Kaplan and Schoar (2005) found that GP’s ability to raise capital into new funds is positively
related to GP’s past performance. They also found that performance tends to improve with fund
size and GP’s experience. By using the profit sharing scheme as a reflection of performance, this
explanation is supported by Gomper and Lerner (1999). They found that the profit sharing
scheme for GPs is generally higher for older and larger GPs. In addition, those GPs tend to
perform well. Gomper and Lerner (1999) further argued that GPs should capitalize on their
experience and past performance to increase their compensation by raising more funds. However,
it is puzzling that there is a concave relationship between performance and funds raised. This
means that with the same proportionate increase in performance, the top performer grows
proportionally less than the average performer in terms of funds raised. Based on the LPs’ claims
that those top performers were always oversubscribed, Gomper and Lerner (1999) deduce that it
might be the GP’s choice to stay smaller. They suggest there must be an incentive for GPs to stay
oversubscribed to appear as top performers. Such attempts might be applicable in the context of
early funds in EMs, where GPs could leverage the popularity of existing oversubscribed funds to
10
attract investors to commit capital in their new EMs funds. The findings of this paper will
validate this phenomenon.
Gompers and Lerner (2004) claimed that better GPs would foster good corporate governance and
establish relationships with LPs who could provide more value-added activities. Hsu (2004)
argues that better GPs have the ability to access better deal terms than average GPs. He
empirically tested the benefit of GPs’ reputation as an economic good, and found that offers
made by GPs with high reputation are three times more likely to be accepted.
Overall, the literature depicts GPs’ capabilities as being important determinants of the capital
allocation decision. Such capabilities could be assessed by the amount of investment and
divestment, track records, GPs’ experience, accessibility to deal flows, and reputational capital.
Indeed, the empirical evidence produced by the literature suggests that GPs’ superior
performances are positively associated with these measures.
2.3.2. Incentive structure
As discussed, track record and reputation are important determinants of investors’ capital
commitment. However, in EMs where the private equity industry is at its earliest stage, local
GPs have no established track record and reputation to leverage from. Based on the predictions
in a signalling model of compensation, Gompers and Lerner (1999) suggested that inexperienced
GPs should signal their capabilities by having higher pay-for-performance sensitivities and lower
base compensation. Out of some of the venture capitalists being studied, the base compensation
in their contract might be even negative. Rationally, GPs with higher capabilities are more
willing to take risk than GPs with lower capabilities. Ironically, Gompers and Lerner (1999) find
no evidence of a relationship between incentive compensation and performance. It seems that
GPs’ incentives to perform are secondary in contributing to good performance of their
investments. Another effective way to signal to investors of GPs’ capabilities is through equity
participation. The industry standard of equity participation is from 1% to 2% of total fund size.
However, some prestigious private equity firms, who are willing to take more risk, might have
up to 5% of equity participation. Overall, regardless of the effectiveness of the proposed
incentive structure, investors consider it as a powerful signal of capabilities. Hence, the ince ntive
structure is a key determinant of capital allocation.
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2.3.3. Firm-level corporate governance
Legal rules and legal enforcements only provide basic protection when dispute occur. If a
country’s legal protection is insufficient, it is safe to assume that investors will have to rely on
firm-level corporate governance as alternative mechanisms to mitigate risk. 6 Love (2010)
mentioned that additional provisions or mechanisms include increasing transparency, selecting
self-governing and well- functioning boards of representatives, and imposing various disciplinary
mechanisms to prevent expropriation.
At the fund managers- investors level, agency risk is largely lessened through the use of unique
incentive structure, limited partnership structure and other strict contractual provisions. Despite
all these mechanisms, the ex-post danger of agency risk might still exit. Cumming and Walz
(2010) empirically find that PE funds have the tendency to overstate the value of their
investments in order to attract new investors into their subsequent funds. The problem is even
more severe in countries where the accounting rules are less stringent and the law enforcement is
relatively weak. As a result, investors rank the quality of disclosure by private equity funds as
one of the most important hurdles in PE investment (Cumming and Johan, 2009). At the fund
managers-portfolio company level, the agency problem remains a major concern to investors.
The discussion of the specific problems is beyond the scope of this paper.
The importance of corporate governance is further emphasized when exploring the relationship
between corporate governance and performance. A group of literature including Black (2001),
Black et al. (2006), Chong and Lopez-de-Silanes (2007), Bauer et al. (2003), Klapper and Love
(2004), Durnev and Kim (2005) and Epps and Cereola (2008) explore this relationship within
both the developed markets EMs contexts. Independently, they all find this relationship to be
fairly strong and positive. Some of the literature suggests that in countries where legal protection
is weak, firm-level corporate governance matters more for firm valuation.
However, another group of literature questions the positive relationship between corporate
governance and performance. For example, Pham et al. (2011) studied this relationship in
Australia and Firth et al. (2002) studied it in the case of China and both found it to be
insignificant. Surprisingly, Aman and Nguyen (2008) found a negative relationship in Japan,
suggesting poorly governed firms tend to significantly outperform better-governed firms in term
6 Easterbrook and Fischel (1991) and Black and Gilson (1998) address the flexibility in making adjustment to the country-level protections.
12
of market returns. While all these studies are statistically proven to be significant a nd robust,
each of it only provides a time-series analysis in one particular country.
The support of this paper is tending toward the positive relationship between firm-level
governance and performance, since the research for this position was conducted in a more
comprehensive manner using multivariate analysis across countries (spanning across both
developed and emerging markets) and over long period of time. Overall, the important takeaway
here is that investors rely on firm-level corporate governance to safeguard their capital,
especially in EMs where legal protection is insufficient. F irm-level corporate governance is an
important hurdle when considering capital allocation in EMs.
2.3.4. Strategic focus
Investment in private equity is highly illiquid and investors have little freedom to influence their
investments once the capital is committed. In some instances, especially during downturns,
investors might find the GPs’ management style and investment strategies very frustrating.
Hence, at ex-ante, investors would only entrust their capital with a fund manager if only they
share the same investment foresights; or investors find the investment strategies credible.
Gao (2011) claimed that GPs’ strategies to manage individual investments and portfolio
composition are likely to relate to their degree of involvement in the management of portfolio
companies and expertise. Elango et al. (1995) and Acharya et al. (2010) address these issues
separately. Elango et al. (1995) found that the level of involvement of private equity firms differ
with their stage of specialization. Acharya et al. (2010) found evidence that there are
combinations of strategies and expertise that correlate with abnormal return. GPs who are ex-
consultants and ex- industry managers tend to have expertise in the operation, and are associated
with outperforming deals focused on operational improvement. GPs who are ex-bankers and ex-
accountants tend to have expertise in finance, and are associated with outperforming deals
focused on mergers and acquisitions activities.
At the portfolio-composition level, Gao (2011) addresses three types of investment strategies,
namely, specialisation, diversification and complementary networks investments. Private equity
firms could be specialized in term of industry, stage of development and geography. Gupta and
Sapienza (1992) and De Clercq et al. (2001) illustrated that the advantages of specialisation are
associated with the reduction of information asymmetries and uncertainties, added expertise,
knowledge and know-how experience, and understanding complexities specifically embodied in
13
one particular industry or development stage. Gao (2011) and Cressy et al. (2007) found a
strong association between abnormal performance and industry specialization. However, Cressy
et al. (2007) find stage specialization might only help in spurring growth but not profitability.
Sharpe (1963) described the advantages of diversification in his portfolio theory. Interestingly,
while Knill (2009) found some benefits associated with stage or industry diversification, at the
same time, he also finds such strategies might cause a delay in exiting the portfolio company.
Gao (2011) also investigated if private equity firms follow a strategy in exploiting
complementarities and synergies among different portfolio companies. Gao (2011) looked at the
investments in information technology and communications classified through a method of
“software stack7”. He found that the diversified portfolio in this narrowly defined industry had
positive abnormal returns, suggesting the benefit of the complementary-network strategy.
At the individual- investment level, Barber and Goold (2007) emphasis the usefulness of the
basic strategy of value adding and transforming. Other strategies including value strategy,
aggressive debt strategy and merger and acquisition investments are also investigated. Value
strategy refers to the investment in underperformed businesses or units of businesses at a
substantially undervalued price. After introduced various structuring such as cash flow and
margin improvement, the investments is expected to exit at a higher multiple. Aggressive debt
strategy is used to capture the benefits of financing and tax shield.
Overall, GPs’ investment strategies are important determinants of capital commitments by
investors. The specialization strategy seems to generate better performance than diversification.
This is also consistent with Acharya et al (2010)’s findings, suggesting that fund managers could
better utilize their expertise in specialized industries or business areas. Complementarities could
be found in portfolio companies if they are located in the same narrowly define network.
2.4 Conclusion and gaps in the literature
This chapter presented two main bodies of literature, i.e. country-specific and firm-specific
determinants of capital allocation decision. However, each group only looked at a small selection
of named factors. In comparable term, the literature does not clearly distinguish which of the
determinants is the most important one (except Groh et al., 2008). To provide practicable and
7 This concept was introduced earlier by Gao (2006). This concept defines the software industry into different layers. The application of this concept is premised by the idea that each software firm could utilize services provided by other members in the network without knowing how these services were implemented.
14
meaningful conclusions to policy makers and GPs, there is a need to fill this gap. Two main
research questions emerge and they are set to be explored within the EMs context.
(1) What are the most important country-specific determinants of capital allocation decision in
PE investments in EMs.
(2) What are the most important firm-specific determinants of capital allocation decision in PE
investments in EMs.
Furthermore, while LPs consider both country-specific and firm-specific criteria when allocating
capital, none of the literature explores the interactions between these two groups of determinants.
The last research question is motivated by an interest in exploring such interactions.
(3) What are the firm-specific determinants that would sufficiently compensate for the
shortcomings of the country-specific disadvantages in EMs.
Building on the existing literature, this paper seeks to answer the established research questions
through conducting primary research with LPs. The fo llowing two chapters provide detailed
explanations of the research setting and research design on how this research will be carried out.
15
Chapter Three: Research Setting
In this chapter, the rationale and approach of identifying the target population for this research
will be discussed. Some geographic and demographic descriptions of the target population, such
as fund origin, fund size and type of LPs will also be provided. This chapter sets the foundation
for the representativeness check done later in the analysis section.
3.1. Rationale and approach of identifying the target population
The literature reviewed earlier only looked at a selection of regions or capital markets. The
majority of the studies run cross-sectional analysis on secondary data collected from various
agencies. Some of them attempted to conduct primary research through surveying GPs. This
research follows the rationale of Groh et al. (2008), arguing that ultimately it is LPs that make
capital allocation decision both at the country level and fund level. Hence, it is most appropriate
to formulate research findings based on LPs’ opinion on capital allocation decision. As
secondary data on such opinion is scarcely available, primary research is chosen to solicit
opinion from LPs through a questionnaire. This research is highly differentiated from others
studies in many ways. First, it directly assesses the source of capital, i.e. the LPs. Second, rather
than focusing the research population on several countries or regions, the research in this paper
attempts to solicit opinion of LPs at a world-wild scale.
This research aims to assess the opinion of LPs on capital allocation decisions into PE
investments in EMs. Hence, the target population is limited to the LPs (or potential LPs) who are
investing or interested in PE investments in EMs. However, due to the inseparability of
information of such LPs from those who are not interested in EMs, the objective is to cover as
many LPs as possible. While Groh et al. (2008) claim to cover the majority of LPs population by
sourcing 1,079 LPs from three different databases, in comparison, a list of 3,647 LPs8 from the
Dow Jones LP Source database was attained for this research. Certain efforts were employed to
deliberately enhance the size of the research audience, first, by manually sourcing contact details
from several sovereign wealth funds, pension funds and private equity association websites. This
attempt would pose little danger of selection bias or overrepresentation, since all the association
websites claim to contain companies that have diverse fund size, origin and investment activities
across different EMs. Second, a snowballing technique was used by asking the recipients of the
questionnaire to further forward it within their networks of LPs. The potential danger of 8 The number indicated here is a unique number of LP, but not the actual number of mailing address available.
16
capturing opinion from non-targeted research audience is mitigated by explicitly indicating in the
invitation, as well as in the cover page of the questionnaire, the description of target population.
3.2 Description of census
Since this is an abductive research, the objective is to cover LPs across a wide range of
demographic and geographical characteristic such as different fund size, origin, markets of
interest, level of private equity commitment and types of funds. However, due to limited access
to the Dow Jones LP Source database, neither the information of LPs’ private equity
commitment nor the information of emerging markets of their interest is attainable. Also due to
the incomplete records in this database, a number of mailing addresses does not match with the
number of LPs. However, for the best representation of the LP population, the description of the
entire 3,647 LPs in the Dow Jones LP Source database is provided here.
3.2.1 Fund origin
The majority of the LPs are originated from the U.S. and Canada followed by Europe, Asia and
the rest of the world. LPs from the U.S. and Canada accounted for more than half of the total
depository in the database. Together with Europe, they account for almo st 90% of the depository.
Table 1 provides a summary of the distribution.
Table 1: Geographic distribution of fund origin
3.2.2 Type of LPs
The Dow Jones LP source database provides detailed description of the type of LPs. They were
classified into 17 specific types of investors. For simplification, the closest types of investors
were combined together to a more manageable number of 14 groups as shown in Table 2. Such
details and specific descriptions of investor types make representative check feasible. Pension
Fund is the biggest group, accounting for one fifth of the database depository. One major
deficiency of this data is the unmentioned Fund of Funds group that could be classified in the
Private Investment Firm, Other and/or Unknown group.
17
Table 2: Demographic distribution of LPs type
3.2.3 Fund size
LPs are also classified into four different groups based on their fund size. The small to medium
(100 million to 999 million dollars) and medium to big (1 billion to 9 billion dollars) are the two
biggest groups in this database. Together they account for 27.31% of the depository.
Unfortunately, the unknown record of 60.49% is extremely high. Table 3 provide a summary of
fund size description.
Table 3: Description of fund size
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Chapter Four: Research Design
In this chapter, the rationale and merit of the chosen methodology, methods and analysis will be
provided. In the research methods section, more details on the questionnaire’s structure, the
process of constructing it and treatments to the mailing list will be provided. Figure 1 provides
an overview of workflow in carrying out this research.
Figure 1: Overview of workflow
4.1 Methodology
The literature has produced an overwhelming amount of findings related to the determinants of
PE activities in EMs. Each study tends to produce sensible and significant findings in their own
fashion, whether deductive or inductive. However, it is not clear which determinants are the most
significant criteria. This research is an abductive research that aims to build on the existing
literature, and verify, calibrate, and generate highly differentiated findings from it. The main
objective is to identify the most important country-specific and firm-specific determinants. These
findings will lead to exploring the interaction between the two groups of determinants when
investors making capital allocation decision.
To identify the most important determinants, a ranking procedure is required. Hence, it is clear
that a quantitative research is the most appropriate methodology since it provides the most
objective measure. Although this paper subscribes to a post-positivism view9 , a pragmatist
9 Balnaves and Caputi (2001), Post-positivism accepts the criticism presented by the subjectivists that we cannot observe the world in a total and absolute reality. However, post-positivists believe in the possibility of there being an objective reality. In this research, while the opinions of LPs are somewhat subjective to their own preference and experience, but collectively their opinions shape their own capital allocation decisions and hence the overall market condition.
19
approach10 to research is employed. To answer the research questions, many opinion-based
answers are required from LPs. It seems that qualitative research would provide better
explanatory power. However, existing studies already offer many good explanations of the
theories about relationships and causalities between certain determinants and investments. The
main task here is not to explore alternative explanations. Instead, for practical purposes, the
focus is on helping policymakers and practitioners to identify the most important determinants in
the current investment climate through using quantitative research. Hence, they can benefit from
academic literature in the most effective way. To ensure the explanatory power and depth of this
research, much effort was put into the design of the questionnaire, which shall be discussed in
the next section.
4.2 Methods
To comply with the requirements of the research setting outlined earlier, an electronic
questionnaire appears to be the best choice in attaining opinions from LPs at a worldwide scale.
Google Forms, a web-based software, was used to send questionnaires and collect responses.
The merit of an electronic questionnaire is judged based on its effectiveness in collecting
answers. In a practical sense, this method is quick and effective in distributing questionnaires
and collecting responses. It can obtain responses from LPs at a global scale, which might not be
possible if face-to-face or phone interview methods were chosen instead. In term of its
effectiveness in yielding answers, a questionnaire is sufficient to assess the level of importance
of each determinant. However, this method limits potential discussion that might lead to
unexpected results. To ensure that all the important issues are covered, other efforts are
employed within the process of constructing the questionnaire.
4.2.1 Structure of the questionnaire11
To answer the research questions, opinion-based answers of the LPs’ assessment on each
country-specific and firm-level factor are required. Factual information about the LPs such as
fund size, origin, level of commitment and preference of EMs are also required for further
analysis of patterns and findings. The questionnaire was structured around three main sections.
The first section is the cover page which explains the purpose and the aims of this study. This
10 Balnaves and Caputi (2001), Pragmatist approach simply suggests that each philosophy view or research approach should be best viewed in term of their practical uses and outcomes. The merit of a research approach is judged by its usefulness in answering the questions. 11 Due to space limitations, the actual questionnaire is not provided but available upon request.
20
section allows the research audience to have a brief idea of what is expected from them and what
kind of questions will be asked. It also contains a statement of their right of anonymity and
choice of participation. More importantly, this section serves as a filter to rule out those not
targeted. The second section contains all the factual questions. The third section contains all the
opinion-based questions which are further categorized into two main sub sections on country-
specific and firm-specific factors that affect the capital allocation decision into PE investments in
EMs. Following Groh et al. (2008), within the subsection on country-specific factors, six themes
of questions are included, namely economy, capital market, investor protection and legal
environment, taxation policies, social environment and entrepreneurial opportunities. In the
subsection on firm-specific factors, four themes of questions are covered, namely capabilities of
a general partner, incentive structure, firm- level corporate governance and general partner’s
strategic focus.
All of the opinion-based questions require metric responses. Participants were asked to indicate
their assessments of the level of importance of each factor on a six-point Likert scale. The
ordinal responses range from “not at all important” to “very important”. To ensure that all
important determinants are included, the respondents were asked to use key words to indicate
any missing factors.
4.2.2 Process of constructing the questionnaire
The first four steps in Figure 1 regard constructing the questionnaire. Please note that these four
steps are not entirely sequential, and refinements are made back and forth across different stages.
The majority of the literature only focuses on a few factors. The questionnaire-constructing
process is started off by consulting Groh et al. (2008), Jeng and Well (2000) and Balboa and
Marti (2003) which covered the most factors. In Groh et al. (2008)’s study alone, almost the
entire list of country-specific factors studied by the literature is surveyed. Jeng and Well (2000)’s
and Balboa and Marti (2003)’s regression analysis also contains an extensive list of variables. To
ensure the most important country-specific and firm-specific factors are covered, other studies
are also carefully reviewed in detail.
After the initial refinement steps, two informal phone interviews with practitioners in the private
equity industry were conducted. These interviews were not executed for the purpose of data
collection as part of any sorts of qualitative research, but merely for further exhausting the list of
factors in the questionnaire. Due to the interviewee’s right of anonymity, they would only be
21
identified in this paper by their initials. KB 12 and RM 13 provided significant contribution,
especially in identifying the firm-specific factors, where literature coverage is relatively much
scarcer than the country-specific factors.
To ensure the reliability and validity of the questionnaire as suggested by Easterby-Smith et al.
(1991), two professors at the University of Edinburgh were approached to help in conducting
expert tests. Reliability refers to the degree of stability of the questionnaire. Ideally, it should
yield the same result if it was administered to the same individuals at two different occasions.
While LPs’ opinions could have changed according to the changes in investment climate, the
questionnaire should yield temporal stability within a short timeframe. Validity refers to the
extent to which a test measures what it is supposed to measure. The two experts are Professor
Jake Ansell14 and Professor Jo Danbolt15. With help from these two experts, the validity and
reliability of the questionnaire was significantly improved. At least to a certain extent, construct
validity and content validity were enhanced. Construct validity refers to the degree of
appropriateness to which the questionnaire indeed measures the intended construct. Content
validity refers to the extent that the questionnaire covers a representative set of factors to be
measured. While it is difficult to measure the extent of reliability, the inclusion of explanations
and help text greatly improved it.
4.2.3 Sampling and treatment to the mailing list
As discussed earlier in section 3.1 on target population, the entire data from the Dow Jones LP
source database was used. While this census is far from a complete list of all LPs, at least, it
provides the best representation to the LP population. The following rules were used to sort the
entire mailing list in the Dow Jones LP Source database. First, all personal emails were identified.
Second, all corporate emails that addressed to different personnel were identified. Third, the
remaining corporate emails of non-repeated companies name were included. Following these
12 KB – a finance professor in one of the most prestige business school in the United States. His primary focus is on venture capital and private equity research. He also sits on the investment board of committee at the university’s endowment and other private equity firms. 13 RM – a principle at one of the most prominent international investment advisor firm. He is primarily responsible for fund of funds investment program of the European private equity and venture capital. He also focused on the coverage in emerging Europe, Russia and Africa. 14 Professor Jake Ansell – a professor of risk management and head of marketing research group at the University of Edinburgh. He is a consultant in statistics who has research interests in economic statistics and indices, expert systems, risk management and assessment, reliability and so on. 15 Professor Jo Danbolt – a member of the University of Edinburgh’s school research committee and research champion for finance. He taught a wide range of finance subjects and has research interest in shareholder wealth effects of mergers and acquisitions, capital structure determinants and corporate governance and firm value and so on.
22
rules, a unique list of 3,475 non-duplicated emails was attained. Unfortunately, the numbers of
corresponding LPs were reduced from the total of 3,647 in this census to only 2,437. With great
consideration of the risk of over representation from some companies, multiple recipients per
company are allowed. The argument for this decision is that multiple recipients are attributed to
different fund managers or business representatives who are managing different emerging
markets. Hence, their answers are formulated based on different background and experience.
4.3 Analysis
The IBM SPSS Statistics 20 was used to conduct the statistical analyses. To assess the level of
importance of each factor compared to other factors, a simple ranking based on the mean of
Likert scores of each factor is used. To confirm the ranking, I followed Groh et al. (2008)’s
method to perform several pair-wise Wilcoxon Signed Rank tests to determine if there is a
significant different between the ranked factors. This test does not assume the normality of
distribution of responses; hence it is non-parametric in nature. The Wilcoxon Signed Rank test
considers the means and standardizations of the tested pair, and detects if the difference of the
means are indeed statistically significant. Three rounds of ranking were performed. First, all the
individual countries-specific factors were ranked to establish the top five most important
determinants. Second, all the firm-specific factors were ranked to achieve the top five positions.
Third, the top-five determinants from each category were ranked together to directly answer the
main research question. In addition, other types of analysis such as Kruskal Wallis, Mann
Withney U test, frequencies table and reliability test were conducted. All of the non-parametric
tests that produce a p-value smaller than 0.05 are said to be significant.
23
Chapter Five: Data analysis
In this section, descriptions of the data collected and its status in comparison to the census will
be provided. An assessment of its representativeness and any potential bias is suggested. After
establishing an overall picture of the responding LPs, the three rounds of rankings as described
in the analysis section will be performed. To investigate the potential biases and ensure the
robustness of the findings, a series of comparison tests will be carried out. Finally, to check for
the internal consistency of the responses, a reliability test on the data collected will be done.
5.1 Description of collected data and identification of potential bias
From the 2,437 LPs addressed, 76 valuable responses were received. Considering this response
rate of 3.12% for an electronic questionnaire type of primary research, it is quite satisfying.
Compared to Groh (2008)’s response rate of 7% from 1,079 LPs, this repose rate seems much
less significant. However, in absolute term, the same number of responses is achieved.
5.1.1 Fund origin of the responding LPs
Geographic distribution of the respondents’ fund origins are: U.S. and Canada, Asia, Europe, and
the rest of the world. Table 4 is a frequencies table of the respondents’ fund origins. There is
only one missing datum from 76 responses. Due to the possibility that an LP fund’s origin could
belonging to more than one geographic group, the segmentation of respondents is not mutually
exclusive. According to the response rate of each reported geographic group, the LPs that have
fund origin in Europe (41.4%) dominate the data then followed by those in U.S. and Canada
(33.8%). Unfortunately, there is no way to find out the actual distribution of the entire LP
population. The comparison with the depository in the Dow Jones LP Source database offered
the best alternative to check for potential bias since it is the most complete database available.
Compared to the U.S. and Canada group (54.04%) in the depository, this group is significantly
underrepresented in the data collected. Unfortunately, it is not possible to make any adjustment
to the data. On the other hand, the Europe group is overrepresented compared to the same group
in the depository (34.77%). To address this bias, a series of Mann Withney U tests between the
Europe and non-Europe group was carried out to detect if there is a significant difference
between them. The test results will be presented in a subsequent section of this paper.
24
Table 4: Geographic distribution of the responding LPs
5.1.2 Type of responding LPs
The respondents are segmented into different types of investors as in Table 5. As expected, the
data is dominated by fund of fund (26.7%) and pension fund (16.2%) investors. The pension
funds investors are only slightly underrepresented (21.5% in the depository). This would not
meaningfully bias the findings. However, the fund of funds investors is unclassified in the Dow
Jones LP source database. To address any potential bias, a series of Mann Withney U tests on
fund of funds versus non fund of funds group will be carried out.
Table 5: Distribution of responding LPs by type of investors
5.1.3 Fund size and commitment to private equity investment of responding LPs
As reported in Table 6 and Table 7, the fund sizes of the responding LPs are relatively
heterogeneous, while the commitments to PE are not. Two distinct groups of investors are
highly-specialized investors who commit 80% of capital or more in PE investments (44.7%) and
diversified investors who commit less than 20% into the asset class (42.1%). This distribution is
similar to what Groh et al. (2008) find in their data set which further reinforces the
representativeness of this research. These kinds of distribution lead to an investigation of the
relationship between the level of commitment and fund size. It is suspected that the level of
commitment into PE investment decreases as the fund size increases. There is a possibility that
25
smaller-specialized funds are simply investment vehicles that received funding from larger-
diversified funds. Hence, a Kruskal Wallis test is performed to investigate whether the level of
commitment differs with fund size. The hypotheses H0: µi = µk suggests there is no significant
difference in term of level of commitment to PE across different fund size. The alternative
hypotheses H1: µi ≠ µk suggests there is a significant difference.
Table 6: Distribution of the responding LPs by size
Table 7: Distribution of the responding LPs by commitment to PE investments
The result of the Kruskal Wallis test with mean rank and test statistics are reported in Table 8.
The test statistic suggests that H0 has to be rejected. Hence, there is a significant difference in
levels of commitment across different groups of fund sizes, but not in the expected manner.
Surprisingly, the smallest and largest investors (have a mean rank of 33.94 and 29.23
respectively) have a smaller mean rank than the medium fund size investors (those fa ll in $100m
- $999m and $1000m - $9,999m, have a mean rank of 47.11 and 38.94 respectively). The
medium size investors are more specialized in PE investments. The proportion of variability in
the ranked level of commitment accounted by the fund size was 11.88%,16 indicating a fairly
strong relationship between fund size and level of commitment.
16 Eta square = Chi-square / (Number of observation – 1)
26
Table 8: Kruskal Wallis test on level of commitment into PE, grouped by fund size
Summarizing these statistics, it can be reported that a unique dataset of LPs who are investing (or
interested) in EMs’ PE asset class is achieved. This dataset covers a diverse sample of LPs in
term of type of investors, fund size, geographic distributions and level of commitment. A series
of Mann Withney U tests will also be carried out to detect the difference in responses between
large (larger than $1 billion) and small investors (smaller than $1 billion), and between
specialized investors (more than 80% of commitment in PE) and diversified investors (less than
80% of commitment).
5.2 The most important country-specific determinants, and appreciation of key drivers of
capital allocation in EMs
The questionnaire asked LPs to indicate the level of importance of various country-specific
factors as discussed in the literature review section. The individual factors are grouped into six
main drivers for private equity investments in emerging markets, i.e. economy, taxation policies,
capital market, investor protection and legal environment, social environment and
entrepreneurial opportunities. Figure 2 presents all the individual factors being considered and
their means. These factors are presented in their corresponding categories. The bars indicate the
range within 95% confident interval where the means are expected to fall in. 17 Figure 2 reveals
that, on average, the expected returns of PE investments in EMs, and property rights and investor
protection, are ranked the most important criteria. Figure 2 also clearly indicates that public
funding is ranked as the least important factor.
17 The 95% confident interval is used instead of an interval based on +/- standard deviation here, because it is a stricter measurement. It is not to say that the normality of distribution is assumed. A series of non-parametric test is used to determine the rankings.
27
Figure 2: Nominations of the importance of country-specific factors
Firgure.2. presents that, within a 95% confident interval, the sample means are quite close to
each other. Hence, it is not clear which factors dominate others as the most important
determinants in capital allocation decision. Therefore, a series of pair-wise Wilcoxon Signed
Rank tests are used to determine the rankings of the top five most important factors (based on
mean nominations). These are expected returns of PE investments in EMs (5.47), property rights
and investor protection (5.36), bribing and corruption (5.23), regulations on repatriation of
capital (5.19) and entrepreneurial management quality and skills (5.08). These Wilcoxon Signed
Ranks tests are non-parametric in nature with the hypothesis: H0: µi = µk and H1: µi ≠ µk to
determine a ranking. View Appendix 1 for the test statistics of all the tested pairs. The result is
shown in Table 9.
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Table 9: The most important country-specific determinants
At significance level of 0.05, Table 9 reveals that the definition of absolute ranks based on
investors’ ratings is impossible. The expected returns of private equity investments in emerging
markets and property rights and investor protection are ranked either at the first, second or third
position. Both factors are clearly ranked before the forth criterion, i.e. the regulation on
repatriation of capital. Next is bribing and corruption (ranking at 1, 2, 3, 4 or 5). Then, the
regulation on repatriation of capital, and entrepreneurial management quality and skill follow
closely (broth are ranking at 3 or 4 or 5). While the rankings are rather sticky, only the expected
returns of PE investments in EMs, property rights and investor protection, and bribing and
corruption could possibly ranked as first or second. These three factors are viewed as the most
important determinants for capital allocation decisions.
The respondents were also asked to rate their level of appreciation (perceived effectiveness) of
the key drivers of the country-specific factors on a six-point Likert scale. One being the least
effective and six being the most effective. Figure 3 reveals the level of appreciation in LPs’
opinion. These findings have to be interpreted with caution, since the investment environments
and challenges within each EM are different. The comparison of the findings in Figure 3 with the
results in Table 9 clearly point out two obvious problems that emerging markets face in
attracting PE investments. First, while investors rank highly importance of bribing and
corruption and entrepreneurial management quality and skills, they perceive the social
environment provided in the EMs to be weak. Second, even though investors perceive investor
protection and the legal environment in EMs to be of moderate strength, they still rank highly the
importance of property rights and investor protection and regulation on repatriation of capital.
This indicates that investor protection and the legal environment is still relatively unstable in
investors’ perception and they do not take it for granted.
29
Figure 3: Appreciation (effectiveness) of the key drivers of country-specific factors
5.3 The most important firm-specific determinants of capital allocation in EMs
The questionnaire asked LPs to indicate the level of importance of various firm-specific factors
as discussed in the literature review section. The individual factors are grouped into four main
drivers of a qualified GP, i.e. the capability of a GP, incentive structure, firm-level corporate
governance and GP’s strategic focus. Figure 4 reveals that, on average, investors highly concur
that integrity and transparency practices of GPs are the most important criteria, and then
followed by the match between GP’s expertise and investment strategy. Certainly, the majority
of investors are not impressed by the size of cumulative assets under management [AUM] and
the popularity of the fund (assessed by the actual fundraising amount in comparison with the
target amount), hence these factors are deemed to be the least important. The availability of co-
investment programmes to LPs is also ranked as one of the least significant factors.
30
Figure 4: Nominations of the importance of firm-specific factors
To confirm the rankings, a series of pair-wise Wilcoxon Signed Rank tests were carried out on
the top five most important factors (based on mean nominations), namely the integrity of GPs
(5.77), transparency practices of GPs (5.60), the match between GPs’ expertise and investment
strategy (5.53), track record (5.49) and accessibility of deal flows (5.31). The tests with the
hypothesis: H0: µi = µk and H1: µi ≠ µk are described in Appendix 2 and the result presented in
Table 10.
Table 10: The most important firm-specific determinants
31
Table 10 reveals that investors have a strong consensus that the integrity of GPs (ranking at 1)
and the transparency practices of GPs (ranking at 2, 3 or 4) are the most important determinants
of qualified GPs. Next is the match between GPs’ expertise and strategy focus (ranking at 2, 3 or
4), followed by the track record (ranking at 2, 3, 4 or 5) and accessibility of deal flows (4 or 5).
While the integrity of GPs is hard to assess, investors ranked it as the most important attribute.
This finding gives a direct corollary to the country-specific factors ranked as most important
such as property rights and investor protection and bribing. Investors appear to view firm-level
corporate governance as an alternative solution to poor investor protection and bribing issues in
the law in emerging markets. This statement is further investigated in the next section. The top
five of both country-specific and firm-specific factors are ranked together, to determine if indeed
some GPs’ attributes are viewed as effective compensations to the shortfalls of country-specific
factors by the LPs.
5.4 The most important determinants – reconciling firm-specific factors with country-specific factors
Figure 5 reveals that, on average, investors consider the integrity of GPs, the transparency
practices of GPs, the match between GPs’ expertise and investment strategy and track record to
be more important than other country-specific determinants. The ranges of the confident
intervals also suggest that investors have more consensuses on the level of importance of these
firm-specific determinants (i.e. smaller standard deviations) than the country-specific ones.
32
Figure 5: Nominations of the importance of (top-five) firm-specific and country-specific
determinants
To confirm the ranking, pair-wise Wilcoxon Signed Rank tests with the hypothesis: H0: µi = µk
and H1: µi ≠ µk were carried out. The test statistics is shown in Appendix 3 and the results is
shown in Table 11.
Table 11: Reconciling the most important firm-specific determinants with country-specific determinants
33
As expected, Table 11 reveals that only the integrity of GPs is ranked as the first. Hence,
investors think that the integrity of GPs is absolutely the most important factor. The absolute
ranks of other factors are impossible. This suggests that investors would consider all these
determinants to be closely important when making capital allocation decision.
5.5 Sample bias and reliability test
The heterogeneous set of LPs in the sample could be categorized into several homogenous sub-
samples. These sub-samples could be either European or not, fund of funds or not, large (larger
than $1 billion) or small (smaller than $1 billion) or highly specialized investors (more than 80%
of commitment to PE) or not. Mann Withney U tests are carried out to detect if there are any
differences between sub-samples regarding their key determinants of capital allocation decision.
First, based on the distribution of the origins of the responding LPs, European investors are
overrepresented compared to the depository. It is arguable that European investors might face
different challenges or follow a different approach to investing. Hence, they may perceive
different key determinants of their capital allocation decision compared to other LPs.
The European investors are distinguished from non-European investors. The Mann Withney U
tests with the hypothesis H0: µi = µk and H1: µi ≠ µk are performed. Only the top five of the
country-specific and firm-specific determinants are included in the tests. The results suggest
there is no significant difference between European and non-European investors regarding their
perception of key determinants of capital allocation decision. The test statistics are shown in
Appendix 4.
Second, the distribution of the fund of funds investors is not available in the depository, yet it is
the biggest group in the sample. To anticipate any potential bias, fund of funds are distinguished
from non-fund of funds investors, the Mann Withney U tests with the hypothesis H0: µi = µk and
H1: µi ≠ µk are performed. As before, the focus is on testing for different perceptions of the top
five most important determinants from both groups of factors. The test statistics in Appendix 5
show that fund of funds investors only differ in opinion from non-fund of funds investors
regarding the matching between GP’s expertise and investment strategy. The fund of funds
investors (mean rank of 44.41) have a marginally higher mean rank than non-fund of funds
investors (mean rank of 34.18) on this determinant. Hence, the overall high ranking of the
matching between GP’s expertise and investment strategy is driven by the opinion of fund of
funds investors. A possible explanation is that fund of funds act as agents for other types of
34
investors in allocating capital to PE firms, and hence the matching between GPs’ expertise and
investment strategy is naturally more important to them.
Third, the comparison by investors’ size is also impossible since such information for the
majority of LPs in the depository is unknown. The segmentations of investors by size in the
sample are rather heterogeneous. To address any potential bias, large investors are distinguished
from small investors. A series of Mann Whitney U tests with the hypothesis H0: µi = µk and H1:
µi ≠ µk are performed. The test statistics in Appendix 6 indicate that the two groups’ opinions on
property rights and investor protection, and regulation on repatriation of capital are different but
not very significant. Large investors have a marginally higher mean rank for both factors than
small investors. Since large investors generally have a higher exposure to investments than small
investors, it is natural for them to have a stronger concern about the return of their capital.
Consequently, large investors are more likely to rank these two factors more highly.
Last, the information on the level of commitment in PE is not available in the depository. It is
interesting to see whether there is any difference between specialized and diversified investors.
The Mann Withney U tests with the hypotheses H0: µi = µk and H1: µi ≠ µk are carried out. The
test statistics in Appendix 7 shows that there is no significant difference between the perceptions
of specialized and diversified investors on their key determinants of the capital allocation
decision.
A reliability test is conducted. This test calculates the Cronbach’s alpha, which is a measure to
assess the correlations among the test items. Hence, it is an internal consistency estimate of
reliability. Since the Cronbach’s alpha is not robust to missing data, list-wise deletion based on
all test items is ensured. Based on 88 test items, the reliability statistics in Appendix 8 indicate a
Cronbach’s alpha of 0.88. Following a general rule of thumb, a set of tests with Cronbach’s
alpha that is larger than 0.7 is considered to have good internal consistency.
Summarizing all these results, there are some minor differences in the capital allocation decis ion
of certain sub-samples. However, these differences are not significant to such an extent that will
meaningfully bias the general findings toward certain sub-groups of investors. The findings
generated from this research are also considered to have good reliability. In the next chapter,
these findings will be put into perspective and reconciled with the existing literature. From this
discussion, the important implications for policymakers and GPs will be explored.
35
Chapter Six: Discussion
This chapter will discuss the findings of the previous chapter, and their implications. There are
many ways to interpret these results that go beyond the scope of this paper. The discussion in
this chapter is focused on answering the research questions mentioned earlier. First this chapter
will discuss the country-specific and firm-specific determinants of capital allocation decisions in
PE investments in EMs that were identified to be the most important in the previous chapter.
Next, through abductive reasoning, these determinants of capital allocation were ranked together.
The findings enable two propositions that might then answer what, if any, are the firm-specific
determinants that would sufficiently compensate for the shortcomings of the country-specific
disadvantages. These propositions are:
Proposition (1) Integrity and transparency practices of the GPs act as effective mechanisms of
firm-level corporate governance that would sufficiently compensate for the shortcomings of
protection offered by legal and social environment in EMs.
Proposition (2) GPs’ with the right match of expertise and strategy would sufficiently
compensate for the lack of entrepreneurial skills and quality inherent in emerging markets.
6.1 The most important country-specific determinants
6.1.1 The expected return in PE investment in EMs
As shown in Table.9, investors identify the following country-specific factors as their key
determinants of capital allocation decision: expected returns of PE investments in EMs, property
rights and investor protection issues, bribing and corruption issues, regulation of repatriation of
capital, and entrepreneurial management quality and skills . Generally speaking, it is clear that
investors’ decisions to invest in EMs are driven by the expected returns of PE investments. PE
investments are extremely illiquid and risky, especially in EMs where the exit potential is
constrained by their underdeveloped capital markets. Once capital is committed, investors are
susceptible to investment losses and opportunity costs if the investments do not work as expected.
Hence, investors have to ensure that the expected returns justify the risks they are taking in the
first place. It is the most important prerequisite for investors to even consider allocating a portion
of their capital in EMs.
36
6.1.2 Property right and investor protection
Investors also rank the issues of property rights and investor protection as equally important
(both factors are ranked at 1, 2 or 3). Despite measuring a moderate increase in perceived
effectiveness of investor protection and the legal environment compared to a previous study by
Groh et al. (2008), investors do not take this issue for granted. Such cautious attitudes could be
attributed to the previous experiences of underperformance in the 1990s, which were caused by
poor investor protection in EMs (Leeds and Sunderland, 2003). The rationale for such a high
ranking is rather intuitive. Investors’ claims on private equity funds have to be secured. Similarly,
the private equity funds’ claims on portfolio companies also have to be secured as it would
directly affect investors’ payoffs. If investors are not confident of the protections offered by a
country’s legal environment, they are reluctant to invest in it. This high ranking of property
rights and investor protection is strongly supported by La Porta et al. (1997, 1998 and 2002). The
high ranking of these issues suggest that investors are greatly incentivized by the actual demand
of their capital. Quality of property rights and investor protection could fundamentally influence
the demand of risk capital, i.e. the entrepreneurial activities. This interpretation is supported by
Desai et al. (2003).
6.1.3 Bribing and corruption
Bribing and corruption issues (ranking at 1 or 2 or 3 or 4 or 5) were also ranked highly. This
further emphasises investor’s desire for securities and claims of their capital, as investors worry
of the additional unexpected transaction cost. In some severe cases, corruption could directly
disrupt the exercise of investors’ claims by influencing the possibility of the law being enforced.
Maoro (1995) and Paul (1995) lend strong support to such an explanation. However, within the
limited scope of the questionnaire, it is impossible to completely exclude the possibility that
investors rank this issue highly because of its perceived benefits as conceptualized by Leff
(1964). Despite such drawbacks, and not to ignore the benefits of bribing, the suggested
explanation is most likely to be the case. As supported by empirical studies (Stone et al., 1996
and Paul, 1995), investors are most likely to have strong concerns on this issue because of its
negative influence on their investments.
37
6.1.4 The regulation on repatriation of capital
Investors also rank regulation on repatriation of capital (ranking at 3 or 4 or 5) highly. While
investors are return driven, a combination of such high rankings on related issues on securing
their claims suggest that investors are more concerned with the return of their money than the
returns on their money. The nature of investing in the PE asset class is highly illiquid, possibly
spanning five to ten years. Within this period, the regulation on repatriation of capital and other
forms of capital controls could drastically change. At ex-ante, investors would decide to invest in
a country only if they find the regulations on capital controls in that particular country are
acceptable and expected to remain stable in the long run. Any delays of the repatriation of capital
would disrupt the redeployment of their capital. Investors might incur significant opportunity
cost if they are unable to supply their capital when it is most needed. This explanation is in line
with the findings of Dooley and Isard (1980) and Desai et al. (2006). As a reflection of this
disruption, Desai et al. (2006) find that investors in countries with strict capital controls tend to
face higher cost of capital. Investors also face significant costs associated with the actions to
avoid the impact of control on repatriation of capital. Hence, investors’ incentive to invest is
significantly reduced.
6.1.5 The entrepreneurial management quality and skills
LPs also place great emphasis on the entrepreneurial management quality and skills (ranking at 3
or 4 or 5). This suggests that LPs need to rely on talents to drive for abnormal returns. Despite
the expertise and business connections brought about by private equity funds, ultimately it is the
entrepreneurs who drive business growth. Hence, it makes sense that investors place significant
emphasis on entrepreneurial management quality and skills. This is also related to other issues
within the downstream chain of agents whom investors rely on to generate superior returns, such
as the integrity, incentive, capability and level of involvement of the agents.
6.1.6 Public funding and subsidiaries
It is worth highlighting that investors are not attracted by public funding and subsidiaries
provided by local governments. They rank this criterion as the least important factor with clear
absolute ranking. As Groh et al. (2008) said, “Private money does not follow public money.”
Investors are looking for a market with true growth potential and strong demand of their capital,
rather than an artificial capital risk market. To prove this view point, this research also indicates
that investors rank the economy growth rate and the entrepreneurial spirit and culture highly (test
38
results are not shown in this paper). Likewise, this finding is confirmed by Da Rin et al. (2005),
Armour and Cumming (2006) and tested by Groh (2008).
6.2 The shortcomings of country-level endowments in emerging markets
Within the current investment climate, as shown in Figure.3, the perceived strength of economic
activities and entrepreneurial opportunities offered by EMs is high among investors. While the
perceived strength of capital markets is moderate, the overall expectation of the return potential
coincides with investors’ opinions on the importance of this determinant. Unfortunately, while
bribing and corruption issues and entrepreneurial management quality and skills are ranked
highly, investors do not perceive the effectiveness of the human and social capital environment
in EMs to be high. Furthermore, despite the improvement in the perceived effectiveness of
investor protection and the legal environment, investors are still holding an extremely cautious
attitude toward this issue. This suggests investors still have fairly little confidence towards the
investor protections offered by EMs. Considering this at a country- level, these two problems
become the main obstacles that prevent investment in EMs. In the short term, these two problems
would not be resolved or assumed away by investors. The solutions might be found at the firm
level instead.
6.3 The most important firm-specific determinants
6.3.1 The integrity of GPs
As indicated in Table.10, investors identify the following firm-specific factors as key
determinants of capital allocation decision: the integrity of GPs, the transparency practices of
GPs, the match between GPs’ expertise and strategy, track record and the accessibility of deal
flows. Unsurprisingly, investors concur that the integrity of GPs is the most important
determinant with an absolute rank above other firm-specific criteria. The integrity of GPs is the
most powerful self-governing mechanism. This very quality would effectively resolve agency
problems at the fund manager-investor level and lessen its negative impact at the fund manager-
portfolio company level. The integrity of GPs is difficult or virtually impossible to assess, since
it has a very subjective measure. It is also built on a long-term relationship between LPs and GPs.
These present a significant challenge for LPs in assessing it, as well as for GPs to demonstrate
such quality to investors.
39
6.3.2 The transparency practice of the GPs
The integrity of GPs is immediately followed by the transparency practices of GPs (ranking at 2
or 3 or 4). The “transparency practice” determinant is ranked highly because investors are faced
with severe asymmetries of information both before and after they commit their capital.
Investors attempt to monitor and eliminate the moral hazard problem that might potentially
deteriorate their returns. In some cases, the GPs might have a strong incentive to generate their
payoffs through fees. In other instance, GPs might have a tendency to overstate the unrealized
returns of backed companies in order to facilitate raising capital for their new funds. This
explanation is supported by Cumming and Walz (2010), who echo the problem of disclosure in
the international private equity industry. Likewise, Cumming and Johan (2009) strongly suggest
that investors rank transparency practices as one of the most important hurdles in private equity
investments.
6.3.3 The matching between GPs’ expertise and strategy
Investors also rank highly the matching of GPs’ expertise and strategy (ranking at 2, 3 or 4). LPs
are fundamentally in the business of picking winning private equity funds. To achieve abnormal
returns, investors have to rely on GPs to make operational improvement in the portfolio
companies or bring about added value externally through merger and acquisition deals. Such
improvements require the right expertise and strategy. The reason for this high ranking is
investors are attempting to increase their chances of picking winning PE funds, by identifying
the right GPs who possess skills that matter the most to the proposed investment strategies. At
ex-ante, investors would not entrust their capital to GPs if they do not think highly of the GPs’
investment strategies. Likewise, they would not invest if the GPs do not possess the necessary
expertise in implementing those strategies. This explanation is supported by Zarutskie (2010),
where task-specific human capital factors seem to matter the most and is dependent on the type
of investment. Similarly, Acharya et al (2010) present evidence that there are combinations of
GPs’ strategies and backgrounds that correlate with abnormal performance at deal level.
Follow this line of discussion, with the right expertise and strategy, GPs could create value
through different ways. For example, by imposing high leverage and powerful incentives (Jensen,
1989, and Lichtenberg and Siegal, 1990), making operational improvements (Kaplan and Schoar,
2005), adding professional structure and rigor to start-ups (Hellmann and Puri, 2002), and
improving long term innovation (Sorensen and Stromberg, 2008).
40
6.3.4 Track record
Another key determinant is track record (ranking at 2 or 3 or 4 or 5). Even though past returns do
not guarantee future returns, it gives a good reference point to a GP’s capabilities. Investors
value track records greatly because they provide the most concrete and objective measure of a
GP’s skills and capability. With proper due diligence, by assessing an extended track record,
investors are able to determine if the outperformance of the private equity fund is due to the GP’s
proven strategies and capabilities or pure luck factors.
Evidence suggest that investors indeed rely on track record such as the amount invested and
divested earlier by GPs and past performance to make their capital allocation decision (Balboa
and Marti, 2000, and Kaplan and Schoar, 2005).
6.3.5 Accessibility to deal flows
Beyond the GPs’ capability and strategy, investors want to ensure that GPs have sufficient deal
pipelines. They place significant emphasis on GP’s access to deal flows (ranking at 4 or 5). If a
GP has no accessibility to good deal opportunities, any capital allocation to the funds is wasted.
Investors would like GPs to deploy their capital in the most efficient way. The longer the initial
period of capital deployment, the more opportunity cost investors bear. Insufficient deal flows
also suggest a longer investment lifecycle, which means investors end up paying more fees and
leaving themselves in a risky situation.
6.3.6 Size of cumulative AUM, popularity of the funds and co-investment programmes
Surprisingly, investors do not rank the size of cumulative AUM highly. There are two possible
explanations for this finding. First, the size of cumulative AUM is only an indication of the
amount of experience that GPs have, but it gives little information about their performance. In
other words, a private equity firm could be quite successful at raising funds, but less successful
at generating returns than its peers. Second, PE funds in EMs generally have a smaller size of
cumulated AUM, which should not be a discounting factor.
Nevertheless, investors are not attracted by the popularity of the funds and the availability of a
co-investment programme to them. Popularity of a fund is measured by the actual fundraising
amount relative to the target fundraising amount. Investors rank this factor as one of the least
important criteria. This proves that GPs’ efforts to stay oversubscribed as suspected by Gomper
and Lerner (1999) is useless.
41
The co-investment programmes allow LPs to bypass the limited partnership structure and enable
them to invest in specific deals. With certain specific deals that they are confident of, they could
deploy more capital into it. Such programmes are useful when investors are trying to influence
their investment life cycle. However, because of the lack of direct involvement in portfolio
companies in EMs, the risk of deploying equity directly is extremely high. Hence, investors are
not attracted by co-investment programmes at all.
6.4 Reconciliation of firm-specific determinants with country-specific determinants
Informed by the two major obstacles in EMs, the main objective is to find out what firm-specific
determinants would sufficiently compensate for the country- level disadvantages. The top-five
determinants from both groups of firm-specific and country-specific factors were ranked together.
With reference to Figure.5, it seems that the majority of investors concur that firm-specific
determinants are more important than country-specific determinants. Further, in attempt to
validate the two emerging propositions mention earlier, the ranking results in Table.11 are
closely investigated. Regarding proposition (1), the integrity of GPs is the only factor that has an
absolute rank above property rights and investor protection, bribing and corruption and
regulation on repatriation of capital. This finding suggests that investors consider the integrity of
GPs as the most powerful self-governing mechanism. It would sufficiently compensate for the
shortcoming of investor protection offered by legal and social environment in emerging markets.
However, as mentioned earlier, investors face difficulty in assessing the integrity of GPs. They
have to rely on a combination of other types of firm-level governance and incentive structures in
making adjustments for the insufficient country-level protection. For example, Love (2010)
suggests other provisions or mechanisms that could be used including well-defined transparency
practices, self-governing and well- functioning boards and other disciplinary mechanisms to
prevent expropriation. Unfortunately, the transparency practice of a GP does not have an
absolute rank above property right and investor protection, and bribing and corruption issue.
Regarding proposition (2), investors rank the matching between GPs’ expertise and strategy
above entrepreneurial management and skills. Only GPs with the right match of expertise and
strategy could bring about significant improvement by transferring skills, creating powerful
incentives, imposing professional structures at portfolio companies and so on. This finding
further reinforces the literature that GPs generate abnormal return through value creation in the
portfolio companies. Investors believe that GPs with the right match of expertise and strategy
42
alone is sufficient to compensate for the shortcomings of entrepreneurial management and skills
at local countries.
6.5 Research Implications
This paper is highly differentiated from other literature since it is conducted at a global scale
with a highly diverse sample of LPs. While the majority of other pieces of literature study the
investment process through proxies or surveying GPs, this research directly addresses the source
of capital, i.e. LPs. Even though certain group of investors are overrepresented, the comparison
tests across all subsamples suggest the findings produced in this paper are not meaningfully
biased toward any particular group of investors. The internal consistency of this research is also
proved to be reliable.
6.5.1 Theoretical contribution
The findings in this paper provide direct support to Cumming and Walz (2010), and Cumming
and Johan (2009) on transparency practices as an important hurdle in PE investments. This paper
further confirms the robustness of the following studies on investor protection as a key criterion
for investment decisions: Cumming and Johnson (2007), La Porta et al (1997, 1998 and 2002),
and Lener and Scholar (2005). In response to Easterbrook and Fischel (1991), and Black and
Gilson (1998) and Love (2010), this paper successfully identifies key firm-level governance as
adjustments to country-level protections. The major contribution of this paper is that it acts as an
out-of-sample test to Groh et al. (2008). The findings on country-specific determinants are
almost identical which further confirms the reliability of both studies.
6.5.1 Implication to policy makers of EMs
Public funding and subsidies provide little or no incentive for LPs to commit their capital into
EMs. Policymakers should re-evaluate their efforts to attract investments. Investors are looking
for an investment environment with a strong growth potential and high demand for their cap ital.
While international investors are attracted by economic activities (economic growth rate) and
entrepreneurial opportunities of EMs, poor investor protection and legal environment hinder
their investments. Bribing and corruption as well as strict capital controls would also negatively
influence the supply of capital.
In order to provide investors with the desired level of security, policymakers should focus on
strengthening the country’s legal framework and law enforcement as well as encouraging
corporate governance culture and practice. Corrupt practices must also be kept within control.
43
Policymakers should also ensure fair and stable capital controls. The regulations on repatriation
of capital that favour investors would reduce their cost of capital, and hence incentivize their
investment activities.
Ultimately, investors are relying on local entrepreneurs to drive the growth of their investments.
Policymakers should have a long-term commitment to education. Likewise, they must have some
short-term strategies to improve key managerial skills such as offering training programmes and
industrial placements overseas.
6.5.2 Implication to GPs
Investors are not attracted by the size of cumulative AUM and the popularity of the funds.
Similarly, when investing in EMs, investors do not appreciate the availability of co- investment
programmes. GPs should re-evaluate their marketing and fundraising strategies when raising an
EMs fund.
Track records and accessibility of deal flows are important prerequisites for capital commitment.
In EMs, where the capital markets are relatively inactive and supporting agents are scare, GPs
have to rely on local connections and other unconventional strategies in building up deal
pipelines.
Investors believe GPs could bring about value creation at investee companies. To strengthen
investors’ confidence, GPs should emphasize the right match between their expertise and
strategy.
To lessen the negative impact of weak country- level protection, GPs should ensure sufficient
corporate governance. While the integrity of GPs is what investors most desire, this presents a
major challenge for GPs to demonstrate it.
6.6. Conclusion
The abductive research is conducted at a worldwide scale with a diverse sample of LPs in term
of fund size, geographic distribution, type of investors, markets of interest and level of
commitment to PE investments. At the country- level, investors consider the following factors as
their key determinants of capital allocation in PE investments in EMs, i.e. the expected returns of
PE investments in EMs, property rights and investor protection, bribing and corruption,
regulations on repatriation of capital and entrepreneurial management qualities and skills.
Investors are not attracted by the public funding and subsidies. At the firm-level, the key
44
determinants are the integrity and transparency practice of the GPs, the matching between GPs’
expertise and strategy, track records and the accessibility of deal flows. Investors are not
impressed by the size of cumulative AUM and the popularity of the private equity fund. They are
also less attracted by the availability of co- investment programmes as investing in specific deals
in EMs is extremely risky.
Regarding proposition (1), the integrity of GPs is an effective mechanism that could sufficiently
compensate for the shortcomings of country-level protection. However, GPs face with great
challenges to demonstrate such attributes. Similarly, LPs find it impossible to assess this as well.
Transparency practices alone are not sufficient to eliminate investors’ concerns about
expropriation. Both GPs and LPs have to rely on a combination of other firm-level corporate
governance and incentive structures to achieve the desire level of protection. Regarding
proposition (2), investors believe that GPs with the right match of expertise and strategy would
sufficiently compensate for the lack of entrepreneurial management qualities and skills in EMs.
The comparison tests across many subsamples reinforce the generalization of the findings in this
paper. The internal consistency of the research is also proven to be reliable. However, the
explanatory power of the two emergent propositions is constrained. The two propositions were
only derived after analysing the responses. The investors were not asked to provide explanations
to these propositions. The interpretation could only be offered by using abductive reasoning and
referring to the existing literature. The findings in this paper set many potential arenas for future
studies. The two propositions certainly deserve further attention for testing and validation in
order to generate more meaningful implications. Future research could pay more attention to the
investors’ decision-making process, and hence find out how investors trade off the costs and
benefits between country-specific and firm-specific advantages/disadvantages. This paper only
explores the capital allocation decision process at two levels, i.e. at the firm level and country
level. There is a need for future study to explore key determinants at the global level, such as the
implication of globalization on private equity investments and capital allocation decisions.
45
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50
Appendices
Appendix 1: Wilcoxon Signed Rank test statistics of the top five country-specific factors
Descriptive Statistics
N Mean Std.
Deviation
Minimu
m
Maximu
m
Percentiles
25th 50th
(Median)
75th
Expected return_PE
in Emrg Mkt 75 5.47 .920 1 6 5.00 6.00 6.00
Property right/investor
protection 76 5.36 .919 1 6 5.00 6.00 6.00
Bribing and corruption 74 5.23 1.245 1 6 5.00 6.00 6.00
Regulation on
repatriation of capital 75 5.19 1.009 1 6 5.00 5.00 6.00
Entrepreneurial
management quality
and skills
75 5.08 1.075 1 6 5.00 5.00 6.00
Test Statisticsa : Expected return of private equity investment in emerging market vs other
criteria
Property
right/investor
protection -
Expected
return_PE in
Emrg Mkt
Bribing and
corruption -
Expected
return_PE in
Emrg Mkt
Regulation on
repatriation of
capital -
Expected
return_PE in
Emrg Mkt
Entrepreneurial
management
quality and skills
- Expected
return_PE in
Emrg Mkt
Z -1.005 -1.426 -2.255 -2.767
Asymp. Sig. (2-tailed) .315 .154 .024 .006
a. Wilcoxon Signed Ranks Test
Test Statisticsa : Property right and investor protection vs other criteria
Bribing and
corruption -
Property
right/investor
protection
Regulation on
repatriation of
capital -
Property
right/investor
protection
Entrepreneurial
management
quality and skills
- Property
right/investor
protection
Z -.970 -2.058 -2.401
Asymp. Sig. (2-tailed) .332 .040 .016
a. Wilcoxon Signed Ranks Test
51
Test Statisticsa : Bribing and corruption vs other criteria
Regulation on
repatriation of
capital - Bribing
and corruption
Entrepreneurial
management
quality and skills
- Bribing and
corruption
Z -.630 -1.135
Asymp. Sig. (2-tailed) .529 .256
a. Wilcoxon Signed Ranks Test
Test Statisticsa : Regulation on
repatriation of capital vs
Entrepreneurial management quality
and skills
Entrepreneurial
management
quality and
skills -
Regulation on
repatriation of
capital
Z -1.140
Asymp. Sig. (2-tailed) .254
a. Wilcoxon Signed Ranks Test
52
Appendix 2: Wilcoxon Signed Rank test statistics of the top five of firm-specific factors
Descriptive Statistics
N Mean Std.
Deviation
Minimu
m
Maximu
m
Percentiles
25th 50th
(Median)
75th
Integrity of GPs 75 5.77 .509 4 6 6.00 6.00 6.00
Transparency
practice of GPs 75 5.60 .678 3 6 5.00 6.00 6.00
Match btw GPs ’
expertise and
investment strategy
75 5.53 .684 3 6 5.00 6.00 6.00
Track records 76 5.49 .663 4 6 5.00 6.00 6.00
Accessibility of deal
flows 74 5.31 .757 3 6 5.00 5.00 6.00
Test Statisticsa : Integrity of GPs vs other criteria
Transparency
practice of GPs
- Integrity of
GPs
Match btw GPs’
expertise and
investment
strategy -
Integrity of GPs
Track records -
Integrity of GPs
Accessibility of
deal flows -
Integrity of GPs
Z -2.829b -3.084b -3.085b -4.495b
Asymp. Sig. (2-tailed) .005 .002 .002 .000
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
Test Statisticsa : Transparency practice of GPs vs other criteria
Match btw GPs ’
expertise and
investment
strategy -
Transparency
practice of GPs
Track records -
Transparency
practice of GPs
Accessibility of
deal flows -
Transparency
practice of GPs
Z -.779 -1.144 -3.014
Asymp. Sig. (2-tailed) .436 .253 .003
a. Wilcoxon Signed Ranks Test
53
Test Statisticsa : The match between GPs’ expertise and
investment strategy
Track records -
Match btw GPs ’
expertise and
investment
strategy
Accessibility of
deal flows -
Match btw GPs ’
expertise and
investment
strategy
Z -.284 -2.040
Asymp. Sig. (2-tailed) .776 .041
a. Wilcoxon Signed Ranks Test
Test Statisticsa : Track records vs
accessibility of deal flows
Accessibility of
deal flows -
Track records
Z -1.781
Asymp. Sig. (2-tailed) .075
a. Wilcoxon Signed Ranks Test
54
Appendix 3: Wilcoxon Signed Rank test statistics of the top five of country-specific and firm-specific determinants
Descriptive Statistics
N Mean Std. Deviation Minimum Maximum Percentiles
25th 50th
(Median)
75th
Integrity of GPs 75 5.77 .509 4 6 6.00 6.00 6.00
Transparency practice of GPs 75 5.60 .678 3 6 5.00 6.00 6.00
Match btw GPs’ expertise and
investment strategy 75 5.53 .684 3 6 5.00 6.00 6.00
Track records 76 5.49 .663 4 6 5.00 6.00 6.00
Expected return_PE in Emrg Mkt 75 5.47 .920 1 6 5.00 6.00 6.00
Property right/investor protection 76 5.36 .919 1 6 5.00 6.00 6.00
Accessibility of deal flow 74 5.31 .757 3 6 5.00 5.00 6.00
Bribing and corruption 74 5.23 1.245 1 6 5.00 6.00 6.00
Regulation on repatriation of
capital 75 5.19 1.009 1 6 5.00 5.00 6.00
Entrepreneurial management
quality and skills 75 5.08 1.075 1 6 5.00 5.00 6.00
55
Test Statisticsa : Integrity of GPs vs other criteria
Transparency
practice of GPs -
Integrity of GPs
Match btw GPs'
expertise and
investment
strategy -
Integrity of GPs
Track records
- Integrity of
GPs
Expected
return_PE in
Emrg Mkt -
Integrity of GPs
Property
right/investor
protection -
Integrity of GPs
Accessibility
of deal flow -
Integrity of
GPs
Bribing and
corruption -
Integrity of GPs
Regulation on
repatriation of
capital -
Integrity of
GPs
Entrepreneurial
management
quality and
skills - Integrity
of GPs
Z -2.829b -3.084b -3.085b -2.409b -3.373b -4.495b -3.022b -4.183b -5.069b
Asymp. Sig.
(2-tailed) .005 .002 .002 .016 .001 .000 .003 .000 .000
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
Test Statisticsa : Transparency practice of GPs vs other criteria
Match btw GPs’
expertise and
investment
strategy -
Transparency
practice of GPs
Track records -
Transparency
practice of GPs
Expected
return_PE in
Emrg Mkt -
Transparency
practice of GPs
Property
right/investor
protection -
Transparency
practice of GPs
Accessibility of
deal flow -
Transparency
practice of GPs
Bribing and
corruption -
Transparency
practice of GPs
Regulation on
repatriation of
capital -
Transparency
practice of GPs
Entrepreneurial
management
quality and skills
- Transparency
practice of GPs
Z -.779b -1.144b -.676b -1.858b -3.014b -2.089b -2.760b -4.271b
Asymp. Sig.
(2-tailed) .436 .253 .499 .063 .003 .037 .006 .000
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
56
Test Statisticsa : The match between GPs’ expertise and investment strategy vs other criteria
Track records -
Match btw GPs’
expertise and
investment
strategy
Expected
return_PE in
Emrg Mkt -
Match btw GPs’
expertise and
investment
strategy
Property
right/investor
protection -
Match btw GPs’
expertise and
investment
strategy
Accessibility of
deal flow -
Match btw GPs’
expertise and
investment
strategy
Bribing and
corruption -
Match btw GPs’
expertise and
investment
strategy
Regulation on
repatriation of
capital - Match
btw GPs’
expertise and
investment
strategy
Entrepreneurial
management
quality and skills -
Match btw GPs’
expertise and
investment
strategy
Z -.284b -.330b -1.535b -2.040b -1.532b -2.529b -3.442b
Asymp. Sig.
(2-tailed) .776 .741 .125 .041 .126c .011 .001
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
c. The test statistic here is insignificant. However, the standard deviation of Bribing and Corruption is too large. The removal of outlier suggest
different conclusion.
Test Statisticsa : Track records vs other criteria
Expected
return_PE in
Emrg Mkt -
Track records
Property
right/investor
protection -
Track records
Accessibility of
deal flow -
Track records
Bribing and
corruption -
Track records
Regulation on
repatriation of
capital -
Track records
Entrepreneurial
management quality
and skills - Track
records
Z -.016b -.862b -1.781b -1.211b -2.089b -2.907b
Asymp. Sig.
(2-tailed) .987 .389 .075 .226 .037 .004
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
57
Test Statisticsa : Expected return in private equity investment in emerging market vs other criteria
Property
right/investor
protection -
Expected
return_PE in
Emrg Mkt
Accessibility of
deal flow -
Expected
return_PE in
Emrg Mkt
Bribing and
corruption -
Expected
return_PE in
Emrg Mkt
Regulation on
repatriation of
capital -
Expected
return_PE in
Emrg Mkt
Entrepreneurial
management
quality and skills
- Expected
return_PE in
Emrg Mkt
Z -1.005b -1.660b -1.426b -2.255b -2.767b
Asymp. Sig.
(2-tailed) .315 .097 .154 .024 .006
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
Test Statisticsa : Property right and investor protection vs other criteria
Accessibility of
deal flow -
Property
right/investor
protection
Bribing and
corruption -
Property
right/investor
protection
Regulation on
repatriation of
capital -
Property
right/investor
protection
Entrepreneurial
management
quality and skills
- Property
right/investor
protection
Z -.481b -.970b -2.058b -2.401b
Asymp. Sig.
(2-tailed) .631 .332 .040 .016
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
Test Statisticsa : Accessibility of deal flow vs other criteria
Bribing and
corruption -
Accessibility of
deal flow
Regulation on
repatriation of
capital -
Accessibility of
deal flow
Entrepreneurial
management
quality and skills
- Accessibility of
deal flow
Z -.438b -.927b -1.682b
Asymp. Sig.
(2-tailed) .661 .354 .093
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
58
Test Statisticsa : Bribing and corruption vs other
criteria
Regulation on
repatriation of
capital - Bribing
and corruption
Entrepreneurial
management
quality and skills
- Bribing and
corruption
Z -.630b -1.135b
Asymp. Sig.
(2-tailed) .529 .256
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
Test Statisticsa : Regulation on
repatriation of capital vs
Entrepreneurial management
quality and skills
Entrepreneurial
management
quality and skills -
Regulation on
repatriation of
capital
Z -1.140b
Asymp. Sig.
(2-tailed) .254
a. Wilcoxon Signed Ranks Test
b. Based on positive ranks.
59
Appendix 4: Mann Withney U test statistics of the European vs non-European investors on the top five determinants from both groups of factors
Test Statisticsa : European vs non-European investors
Integrity of
GPs
Transparency
practice of GPs
Match btw
GPs ’
expertise
and
investment
strategy
Track
records
Expected
return_PE in
Emrg Mkt
Property
right/investor
protection
Accessibility
of deal flow
Bribing and
corruption
Regulation on
repatriation of
capital
Entrepreneurial
management
quality and skills
Mann-Whitney U 471.000 480.000 435.000 450.000 529.500 431.000 456.000 503.500 418.500 453.000
Wilcoxon W 1956.000 1965.000 1920.000 1990.000 2014.500 1971.000 1941.000 693.500 1958.500 663.000
Z -1.233 -.899 -1.500 -1.362 -.152 -1.588 -1.123 -.135 -1.390 -1.139
Asymp. Sig. (2-
tailed) .217 .369 .134 .173 .879 .112 .261 .893 .165 .255
a. Grouping Variable: Fund origins [Europe]
60
Appendix 5: Mann Withney U test statistics of the fund of funds vs non-fund of funds investors on the top five determinants from both groups of
factors
Test Statisticsa : Fund of funds vs non-fund of funds investors
Integrity
of GPs
Transparency
practice of GPs
Match btw
GPs’
expertise
and
investment
strategy
Track
records
Expected
return_PE in
Emrg Mkt
Property
right/investor
protection
Accessibility
of deal flow
Bribing and
corruption
Regulation on
repatriation of
capital
Entrepreneurial
management
quality and skills
Mann-Whitney U 541.000 647.500 478.500 601.000 521.500 610.000 587.500 534.000 574.000 598.000
Wilcoxon W 1669.000 1053.500 1606.500 1777.000 1697.500 1016.000 1715.500 912.000 1702.000 1726.000
Z -1.892 -.142 -2.298 -.871 -1.647 -.745 -.580 -1.280 -.995 -.705
Asymp. Sig. (2-
tailed) .058 .887 .022 .384 .100 .456 .562 .201 .320 .481
a. Grouping Variable: Investor type [Fund of funds]
Ranks
Investor type [Fund of funds] N Mean Rank Sum of Ranks
Match btw GPs’ expertise and investment strategy
No 47 34.18 1606.50
Yes 28 44.41 1243.50
Total 75
61
Appendix 6: Mann Withney U test statistics of big vs small investors on the top five determinants from both groups of factors
Test Statisticsa : Big vs Small investors
Integrity
of GPs
Transparency
practice of GPs
Match btw
GPs’
expertise
and
investment
strategy
Track
records
Expected
return_PE in
Emrg Mkt
Property
right/investor
protection
Accessibility
of deal flow
Bribing and
corruption
Regulation on
repatriation of
capital
Entrepreneurial
management
quality and skills
Mann-Whitney U 595.000 644.500 560.000 670.000 537.000 505.000 541.500 627.000 450.500 607.000
Wilcoxon W 1001.000 1050.500 966.000 1846.000 943.000 911.000 919.500 1005.000 856.500 1783.000
Z -1.019 -.183 -1.254 -.025 -1.563 -2.008 -1.147 -.096 -2.459 -.485
Asymp. Sig. (2-
tailed) .308 .855 .210 .980 .118 .045 .251 .924 .014 .628
a. Grouping Variable: Big vs Small
Ranks
Big vs Small N Mean Rank Sum of Ranks
Property right/investor protection
Big 48 41.98 2015.00
Small 28 32.54 911.00
Total 76
Regulation on repatriation of capital
Big 47 42.41 1993.50
Small 28 30.59 856.50
Total 75
62
Appendix 7: Mann Withney U test statistics of the specialized vs diversified investors on the top five determinants from both groups of factors
Test Statisticsa : Specialized vs Diversified investors
Integrity
of GPs
Transparency
practice of GPs
Match btw
GPs’
expertise
and
investment
strategy
Track
records
Expected
return_PE in
Emrg Mkt
Property
right/investor
protection
Accessibility
of deal flow
Bribing and
corruption
Regulation on
repatriation of
capital
Entrepreneurial
management
quality and skills
Mann-Whitney U 669.000 646.000 674.500 685.000 571.500 585.000 618.500 624.000 601.000 695.500
Wilcoxon W 1264.000 1207.000 1535.500 1588.000 1132.500 1180.000 1146.500 1185.000 1196.000 1556.500
Z -.440 -.620 -.280 -.345 -1.529 -1.505 -.641 -.648 -1.105 -.017
Asymp. Sig. (2-
tailed) .660 .535 .780 .730 .126 .132 .521 .517 .269 .986
a. Grouping Variable: Specialized vs Non-specialized investors
Appendix 8: Reliability test statistics
Case Processing Summary Reliability Statistics
N %
Cronbach's Alpha
N of Items
Cases Valid 39 51.3
.881 88 Excludeda 37 48.7
Total 76 100.0
a. Listwise deletion based on all variables in the procedure.