A Peek Behind the Curtain

Image: UNC Kenan-Flagler Business School

Historically, research into private equity topics runs into one major barrier: access to data.

Finance professor Greg Brown, an expert in private equity, is familiar with the challenges of finding and analyzing data sets, which by their nature are private.
 
Big, institutional, multibillion-dollar investors don’t like to disclose this information,” Brown said. “If you’re lucky, you get a large limited partner to share their portfolio with you, which would give you data on hundreds of funds.”

There was no large, authoritative data source for private equity – until now. UNC Kenan-Flagler recently announced a collaboration with the Burgiss Group, a software and analytics company that provides data, management and analysis tools for investors in private equity funds. Now Brown has access to data on thousands of funds.

Brown has been developing a relationship with Burgiss over the past few years, and he has conducted one study and supervised another by a doctoral student, tapping into the Burgiss data sets for both. “The Next Generation: Global Private Investing” conference at UNC in December was the third such meeting he orchestrated to bring together high-end practitioners at the portfolio manager research level with academics researching private equity topics of buyout, venture, distressed and debt investing.

The conferences have been “research dating,” getting-to-know-you opportunities between academics and practitioners, Brown said. Limited partners are very interested in academic research, but they don’t want to share their data with everyone. The conferences have built trust between the people sharing the data and the people wanting to use the data for high-quality empirical research.

“Burgiss would share a little data, and academics would show some results,” Brown said. “They’d share a little more; we’d generate more results.”

UNC Kenan-Flagler gathered a consortium that includes the University of Virginia Darden School of Business, the University of Chicago Booth School of Business, and Saïd Business School, University of Oxford. UNC Kenan-Flagler, as the lead partner in the group, will play the gatekeeper role and coordinate the consortium.

A paper by Brown’s doctoral student Serdar Aldatmaz, “Private Equity in the Global Economy: Evidence on Industry Spillovers,” is the most recent to come out of the collaboration with Burgiss. Aldatmaz wanted to find out whether there was any empirical evidence to back up the anecdotes about vulture capitalists buying a company, firing everyone and shipping the jobs overseas.

The Burgiss data set allows Aldatmaz to study specific investments from private equity funds in 19 industries in 48 countries broken down by year. They show actual dollar amounts that have gone out of private equity funds into a particular industry in a particular country in a particular year. Aldatmaz used a statistical technique to examine the relationship between those investments and what happens to publicly traded companies in each country. He noted how the investments affected employment, profitability and productivity.

His results revealed an overall positive effect when private equity investments were made. In the industry as a whole, employment, productivity and profit margin all increased.

“When private equity firms come in, they light a fire under other companies that are then forced to improve because the competition has gone up,” Brown said. “They’ll have to reform their business operations, make sure their finances conform with best practices, do what private equity firms demand of the companies they’re backing. In economics, these are called spillover effects.”

Private equity firms are in a sense forcing companies to become more productive and more profitable. Moreover, growing employment will lead to overall greater wealth in the economy. Governments have no need to nervously put up barriers to outside investment, Brown said.

Private equity investments have a relatively minor impact on the stock market, Aldatmaz’s research showed. The effect depends on whether the investment is a buyout or an investment by venture capitalists. A buyout firm tends to have a negative effect on other industry returns, whereas the stock market reacts positively to venture capitalists.

Because venture capitalists usually make early-stage R&D investments, their interest in a company is akin to validating that the industry is worth investing in. It increases the likelihood that another venture capitalist will invest in a similar company in the same industry in the same country.
In contrast, a buyout expert will look for a mature company with steady cash flows that is not making the most of its situation. The buyer will restructure the company, change how it is operated, break it up into pieces, recapitalize it and take on more debt, remaking it into a more efficient company. Rival companies may increase their expenditures and debt level to keep up with this now-stronger competitor taking some of their profits, and it may take time for them to regain their place in the market.

“While a buyout is good for the broader economy,” Brown said, “it’s not necessarily good for shareholders of other public companies.”

Brown used the Burgiss data sets for an entirely different line of study. He investigated whether private equity funds were gaming returns.

Private equity fund managers raise capital from investors, then invest that pool of capital in a set of companies and determine an exit strategy. The lifecycle of such a fund might be seven to 12 years. Before that fund matures, the fund managers will begin raising capital to create another fund. Capital investors are in a position of having to decide whether to invest in a second fund before they know whether the first fund was successful. They know only which companies the fund invested in and estimates of the net asset value of those investments.

Because the companies are privately held, there is no public market for these securities, giving fund managers considerable discretion in the value they put on the companies in their books. Fund managers have plenty of leeway to value the companies so that the fund looks more promising than it might actually be.

“This is a hot issue now,” Brown said, “because the Securities and Exchange Commission is investigating some funds to see whether they’re gaming the performance numbers while they’re fundraising.”

With access to the Burgiss data sets, Brown analyzed returns of the existing fund before and after the second fund was raised.

“What we’ve found so far is that, if gaming took place, it doesn’t look like investors were fooled,” he said.

Looking at the fund managers who were successful in raising a second fund, Brown found that their existing funds showed either good performance both before and after the second fund was raised, or the performance numbers of the existing funds were high before the second fund was raised but leveled off after.

To check for gaming, Brown focused on fund managers who were unsuccessful in raising a second fund. The performance pattern of those existing funds ramped up as the effort to raise a second fund accelerated, but when the funds were cashed out, the actual realized returns were lower than the numbers forecast during the attempt to raise an additional fund.

“It looks like they’re juicing returns as a last-ditch effort to raise the next fund,” Brown said. “But they were unsuccessful. That’s how we know investors were not fooled.”

Because the data sets do not show individual companies in the portfolio, Brown can’t say specifically what investors paid attention to that might have warned them away from a second fund. As the investors were sophisticated institutions, Brown surmised they scrutinized the fundamental performance of the individual companies.

Brown’s analysis also showed some evidence of what he called “peer-group chasing.” Fund managers keep track of the performance of funds their competitors began in the same year as theirs. When their competitors have a good quarter, fund managers may adjust upward the value of their own funds. If their peers had a bad quarter, fund managers adjust their value down the next quarter.

“This may not signal anything nefarious,” Brown said. “It could be people just don’t have a good feel for what their portfolios are worth, and they don’t want to look too different from everybody else. Or it may be a sign of the wisdom of crowds.”
With access to the Burgiss Group data sets, Brown might be able to figure it out.

Greg Brown is the Sarah Graham Kenan Distinguished Scholar and professor of finance at UNC Kenan-Flagler.

[This article has been reproduced with permission from research from the UNC Kenan-Flagler Business School: http://www.kenan-flagler.unc.edu/]