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RESEARCH PAPERS | ALTERNATIVE INVESTMENTS

Hedge Fund Activism

THE RETURNS TO HEDGE FUND ACTIVISM: AN INTERNATIONAL STUDY

Marco Becht, Julian R. Franks, Jeremy Grant, and  Hannes F. Wagner
2016
This paper provides evidence that returns to hedge fund activism are driven by engagement outcomes. We use a sample of 1,740 activist engagements from 23 countries to estimate performance of activism across North America, Europe and Asia. Striking differences emerge across countries in outcomes of the engagements. It is these differences that explain the variation in performance of activism. Although there is evidence that activists put companies into play, frequently those takeovers are preceded by significant and profitable governance changes. While the U.S. model of activism has been copied by foreign activists, non-U.S. activists outperform U.S. activists in their domestic markets. >more


Culture and Performance in PE

DOES CULTURE AFFECT OPERATING PERFORMANCE IN PRIVATE EQUITY BUYOUTS?

Benjamin Hammer, Heiko Hinrichs, and Bernhard Schwetzler
2016
Using a dataset of 583 private equity (PE) leveraged buyouts (LBOs) from 14 European countries, we examine the moderating impact of national culture on the operating performance of PE portfolio companies. We argue that high performance orientation of a society positively affects operating performance development because it aligns incentives with PE sponsors who need to satisfy high return expectations in a short period of time. In our baseline estimates, we find that PE-backed firms outgrow their respective industries significantly in terms of total assets and employment post-LBO. A country’s performance orientation reinforces this effect: A one standard deviation increase in countries’ performance orientation is associated with an industry-adjusted rise of about 11% in total assets and more than 6% in employment over the course of four years, respectively. Independent of a country’s performance orientation, PE-backing does not meaningfully impact post-LBO profitability, which suggests a growth profitability tradeoff. We also test whether growth comes at the expense of higher leverage and thus higher risk, but cannot find a significantly higher debt burden in performance oriented societies. Thus, our findings indicate that portfolio firms in performance oriented societies grow faster but at similar risk as their peers in non-performance oriented societies. >more


PE Return Reporting

DO PRIVATE EQUITY FUNDS MANIPULATE REPORTED RETURNS?

Gregory W. Brown, Oleg Gredil, and Steven N. Kaplan
2016
Private equity funds hold assets that are hard to value. Managers may have an incentive to distort reported valuations if these are used by investors to decide on commitments to subsequent funds managed by the same firm. Using a large dataset of buyout and venture funds, we test for the presence of reported return manipulation. We find evidence that some under-performing managers boost reported returns during times when fundraising takes place. However, those managers are unlikely to raise a next fund, suggesting that investors see through much of the manipulation. In contrast, we find that top-performing funds likely understate their valuations. >more


Angel Investors

ATTRACTING EARLY STAGE INVESTORS: EVIDENCE FROM A RANDOMIZED FIELD EXPERIMENT

Shai Bernstein, Arthur G. Korteweg, and  Kevin Laws
2015
This paper uses a randomized field experiment to identify which start-up characteristics are most important to investors in early stage firms. The experiment randomizes investors’ information sets of fund-raising start-ups. The average investor responds strongly to information about the founding team, but not to firm traction or existing lead investors. We provide suggestive evidence that team is not merely a signal of quality, and that investing based on team information is a rational strategy. Altogether, our results indicate that information about human assets is causally important for the funding of early stage firms, and hence, for entrepreneurial success. >more


Credit Spreads

LEVERAGED BUYOUTS AND CREDIT SPREADS

Yael Eisenthal-Berkovitz, Peter Feldhütter, and  Vikrant Vig
2016
This paper studies the impact of LBO restructuring risk on corporate credit spreads. Using an extensive dataset of LBOs, CDSs and bonds, we first study the reaction of credit spreads of target firms to LBO announcements in the US during the years 2001-2015. We find that CDS spreads increase by almost 60% for investment grade bonds and we document a significant negative reaction in the prices of corporate bonds. We then proceed to show that LBO risk is priced ex-ante by investors in debt markets. Results of a panel regression imply that firms more likely to undergo an LBO have significantly higher spreads. Moreover, we show that intra-industry CDS spreads increase in response to an LBO announcement, consistent with investors updating the probability of future LBOs when an LBO occurs. Based on this empirical evidence, we propose an extended structural Merton (1974) model incorporating LBO risk to study the impact on credit spreads over time and across maturities. Model estimation implies an increase of 30-35 bps in credit spreads due to LBO risk in periods with high LBO activity. The average contribution of LBO risk to credit spreads is as high as 15 bps at a 10-year maturity. >more


Partnerships

PAY NOW OR PAY LATER? THE ECONOMICS WITHIN THE PRIVATE EQUITY PARTNERSHIP

Victoria Ivashina and Josh Lerner
2016
The economics of partnerships have been of enduring interest to economists, but many issues regarding intergenerational conflicts and their impact on the continuity of these organizations remain unclear. We examine 717 private equity partnerships, and show that (a) the allocation of fund economics to individual partners is divorced from past success as an investor, being instead critically driven by status as a founder, (b) that the underprovision of carried interest and ownership — and inequality in fund economics more generally — leads to the departures of senior partners, and (c) the departures of senior partners have negative effects on the ability of funds to raise additional capital. >more


Impact Funds

IMPACT INVESTING

Brad M. Barber, Adair Morse, and Ayako Yasuda
2016
We study investments in impact funds, which we define as venture or growth private equity with a stated intent to generate both financial returns and positive externalities. In a choice-of-funds framework covering 3,500 limited partners, 5,000 funds, and 25,000 capital commitments and controlling for general determinants of fund choice, we find a 13.5% higher investment rate for impact funds compared to the benchmark investment rate of traditional venture funds. Our results imply that the supply of impact funds is incomplete, failing to meet demand. We find the demand for impact relative to traditional investments is three times as high in Europe as in North America; likewise, it is three times as high for a United Nations Principles for Responsible Investment (UNPRI) signatory as for a non-signatory. Certain types of investors drive these effects: development organizations, foundations, banks, insurance companies, and public pension funds generally tilt towards impact, as well as UNPRI signatories among private pensions and institutional asset managers. We explore demand factors that explain the heterogeneity across investor types and find evidence consistent with positive demand for impact by: (i) investors whose ultimate constituents are households (rather than organizations); (ii) investors whose primary objective is impact (rather than financial return); and (iii) investors that face political or regulatory pressure to invest in impact. We also find that investors that face legal restrictions against impact investment (e.g., U.S. ERISA) exhibit lower demand for impact. >more


VC Decision-Making

HOW DO VENTURE CAPITALISTS MAKE DECISIONS?

Paul A. Gompers, Will Gornall, Steven N. Kaplan, and Ilya A. Strebulaev
2016
We survey 889 institutional venture capitalists (VCs) at 681 firms to learn how they make decisions across eight areas: deal sourcing; investment decisions; valuation; deal structure; post-investment value-added; exits; internal organization of firms; and relationships with limited partners. In selecting investments, VCs see the management team as more important than business related characteristics such as product or technology. They also attribute more of the likelihood of ultimate investment success or failure to the team than to the business. While deal sourcing, deal selection, and post-investment value-added all contribute to value creation, the VCs rate deal selection as the most important of the three. We also explore (and find) differences in practices across industry, stage, geography and past success. We compare our results to those for CFOs (Graham and Harvey 2001) and private equity investors (Gompers, Kaplan and Mukharlyamov forthcoming). >more


Economic Policy

ECONOMIC POLICY UNCERTAINTY, LEARNING AND INCENTIVES: THEORY AND EVIDENCE ON MUTUAL FUNDS

Laura T. Starks, and Sophia Yue Sun
2016
Using the mutual fund industry as a laboratory, we demonstrate theoretically and empirically that economic policy uncertainty affects investment decisions through an information rather than real options channel. Specifically, we find that fund flow-performance sensitivity decreases in uncertainty and does so more strongly for funds with shorter track records. The evidence supports the implication of our model that investor learning about manager ability weakens when uncertainty increases. Further, the effect of uncertainty on learning impacts managerial incentives. Consequently, managers are less likely to engage in active management during periods of greater uncertainty, an effect increasing in career concerns. >more


Litigation in VC

ENTREPRENEURIAL LITIGATION AND VENTURE CAPITAL FINANCE

Douglas J. Cumming, Bruce Haslem, and  April M. Knill
2016
This paper empirically examines the interaction between entrepreneurial plaintiff firm litigation and venture capital (VC). The data indicate that, relative to non-plaintiffs, firms that litigate prior to [after] obtaining VC (1) receive financing from less [more] reputable venture capitalists (VCs), (2) are subject to greater [similar] oversight by VCs, (3) receive less [more] VC funding, (4) are more likely to exit through an initial public offering than through an acquisition, and (5) when litigation occurs after VC financing, they are also less likely to be liquidated. The results are robust to different specifications, methodologies, and endogeneity checks. >more


LBO Impact on Industries

WHAT DOES AN LBO SIGNAL FOR THE TARGET'S INDUSTRY?

Jarrad Harford, Jared R. Stanfield, and  Feng Zhang
2016
We document the follow-on acquisition, governance, investment, and alliance implications of an LBO for target firm peers. LBOs tend to lead overall merger activity, predicting both more LBOs and strategic acquisitions in the industry. Additionally, LBOs predict significant changes to investment outlays, strategic alliances, and anti-takeover provisions. Further tests show that our evidence is most consistent with LBOs causing or signaling private information about a shock rather than LBO sponsors simply selecting into changing industries. Our study sheds light on the role of LBOs in merger activity as well as the motivation of LBOs. >more


Portfolio Company Fees

PRIVATE EQUITY PORTFOLIO COMPANY FEES

Ludovic Phalippou, Christian Rauch, and Marc P. Umber
2016
In private equity, General Partners (GPs) may receive fee payments from companies whose board they control. This paper describes the related contracts and shows that these fee payments sum up to $20 billion evenly distributed over the last twenty years, representing over 6% of the equity invested by GPs on behalf of their investors. Fees do not vary according to business cycles, company characteristics, or GP performance. Fees vary significantly across GPs and are persistent within GPs. GPs charging the least raised more capital post financial crisis. GPs that went public distinctively increased their fees prior to that event. We discuss how results can be explained by optimal contracting versus tunneling theories. >more


Public Pension Funds

PENSION FUND BOARD COMPOSITION AND INVESTMENT PERFORMANCE: EVIDENCE FROM PRIVATE EQUITY

Aleksandar Andonov, Yael V. Hochberg, and Joshua D. Rauh
2016
We examine the governance of public pension funds and its relationship to investment performance. Pension fund board composition is strongly related to the performance of private equity investments made by the fund. Funds whose boards have high fractions of members who either sit on the board by virtue of their position in state government (ex officio) or were appointed by a state official underperform the most, followed by funds whose boards have a high fraction of members elected by participants. This underperformance is related both to investment category allocation and to selection of managers within category. Funds with worse-performing governance structures invest more in real estate and funds of funds, explaining 20-30% of the performance differential. Poorly governed pension funds also choose poorly within investment categories, overweighting investments in small funds, in-state funds, and in inexperienced GPs with few other investors. Lack of financial experience contributes to poor performance by boards with high fractions of participant-elected board members, but does not explain the underperformance of boards heavily populated by state oofficials. Political contributions from the finance industry to state officials on pension fund boards are strongly and negatively related to performance, but do not fully explain the performance differential. >more


CEO Turnover

CEO TURNOVER IN LBOS: THE ROLE OF BOARDS

Francesca Cornelli, and Oguzhan Karakas
2015
We examine the CEO turnover in LBOs backed by private equity funds. When a company is taken private, we find that the CEO turnover decreases and is less contingent on performance. We also find that a higher involvement of the LBO sponsors, who replace the outside directors on the board after transition to private, reduces the CEO turnover and its sensitivity to performance, but improves the operating performance. These findings suggest that more inside information and effective monitoring allow private equity funds to assess CEOs' performance over a longer horizon relative to their publicly-traded counterparts. >more


Delistings

PRIVATE EQUITY'S UNINTENDED DARK SIDE: ON THE ECONOMIC CONSEQUENCES OF EXCESSIVE DELISTINGS

Alexander Ljungqvist, Lars Persson, and  Joacim Tåg
2016
Over the past two decades, private equity has contributed to a shrinking of the U.S. stock market. We develop a political economy model of private equity activity to study the wider economic consequences of this trend. We show that private and social incentives to delist firms from the stock market are not always aligned. Private equity firms could inadvertently impose an externality on the economy by reducing citizen-investors' exposure to corporate profits and thus undermining popular support for business-friendly policies. This can lead to long-term reductions in aggregate investment, productivity, and employment. >more


VC Boards

MORE THAN MONEY: VENTURE CAPITALISTS ON BOARDS

Natee Amornsiripanitch, Paul A. Gompers, and Yuhai Xuan
2015
We explore whether venture capitalists add value to portfolio companies in which they invest by identifying important recruiting decisions they make when they serve on portfolio company boards of directors. We find that a prior relationship with the founder, lead investor status, the size of a venture capital firm’s network of managers and outside board members, and geographic proximity between the venture capital firm and its portfolio companies are positively correlated with taking a board seat in an investment round. We also find that venture capitalists are far more likely to recruit managers or outside board members in portfolio companies on whose boards they serve. Furthermore, we find that these recruiting activities are only done by successful and well-connected venture capital firms on the board and not by their less successful and less connected counterparts. We control for potential endogeity by using the enactment of SOX as an instrument which exogenously increased the demand for sophisticated venture capital directors. This study provides evidence to support the notion that venture capital investors are active investors who take actions to enhance portfolio firm value. >more


Asset Management

PICKING WINNERS? INVESTMENT CONSULTANTS' RECOMMENDATIONS OF FUND MANAGERS

Tim Jenkinson, Howard Jones, and Jose Vicente Martinez
2014
Investment consultants advise institutional investors on their choice of fund manager. Focusing on U.S. actively managed equity funds, we analyze the factors that drive consultants’ recommendations, what impact these recommendations have on flows, and how well the recommended funds perform. We find that investment consultants’ recommendations of funds are driven largely by soft factors, rather than the funds’ past performance, and that their recommendations have a very significant effect on fund flows. However, we find no evidence that these recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless. >more


Crowdfunding

THE INFORMATIONAL ROLE OF CROWDFUNDING

Ting Xu
2016
The recent rise of crowdfunding begs the question of what unique value the crowd brings to entrepreneurs compared with sophisticated intermediaries. This paper proposes an answer to this question by focusing on the informational role of crowdfunding. I argue that a distinct role of crowdfunding is the provision of early feedback to entrepreneurs that facilitates their learning. Using a large dataset from Kickstarter, I first document that entrepreneurs adjust their expectations about their projects based on feedback from the crowd, and that such adjustments are stronger when entrepreneurs face higher uncertainty or when the crowd is more experienced. The crowd’s feedback affects entrepreneurs’ subsequent continuation decisions and project choices, and influences the aggregate entry pattern of future entrepreneurs on the platform. I then establish the learning advantage of crowdfunding leveraging the entry decisions of heterogeneous entrepreneurs. I show that, when crowdfunding becomes more costly relative to alternative financing (bank borrowing), entrepreneurs choosing crowdfunding shift to those that benefit particularly from early feedback, i.e., those facing high uncertainty or high fixed costs. These results suggest that crowdfunding is not merely a financing tool, but also a learning device that improves the information environment faced by entrepreneurs. >more


VC Performance Measurement

RISK-ADJUSTING THE RETURNS TO VENTURE CAPITAL

Arthur G. Korteweg, and  Stefan Nagel
2015
We adapt stochastic discount factor (SDF) valuation methods for venture capital (VC) performance evaluation. Our approach generalizes the popular Public Market Equivalent (PME) method and it allows statistical inference in the presence of cross-sectionally dependent, skewed VC payoffs. We relax SDF restrictions implicit in the PME so that the SDF can accurately reflect risk-free rates and returns of public equity markets during the sample period. This generalized PME yields substantially different abnormal performance estimates for VC funds and start-up investments, especially in times of strongly rising public equity markets and for investments with betas far from one. >more


Angel Investing

THE GLOBALIZATION OF ANGEL INVESTMENTS: EVIDENCE ACROSS COUNTRIES

Josh Lerner,  Antoinette Schoar, Stanislav Sokolinski, and Karen E. Wilson
2015
This paper examines investments made by 13 angel groups across 21 countries. We compare applicants just above and below the funding cut-off and find that these angel investors have a positive impact on the growth, performance, and survival of firms as well as their follow-on fundraising. The positive impact of angel financing is independent of the level of venture activity and entrepreneur friendliness in the country. But we find that the development stage and maturity of start ups that apply for angel funding (and those that are ultimately funded) is inversely correlated with the entrepreneurship friendliness of the country, which may reflect self-censoring by very early stage firms who do not expect to receive funding in these environments. >more