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RESEARCH PAPERS | ALTERNATIVE INVESTMENTS

Placement Agents

INTERMEDIATION IN PRIVATE EQUITY: THE ROLE OF PLACEMENT AGENTS

Matthew D. Cain, Stephen B. McKeon, and Steven Davidoff Solomon
2017
Intermediation in private equity involves illiquid investments, professional investors, and high information asymmetry. We use this unique setting to empirically evaluate theoretical predictions regarding intermediation. Placement agent usage has become nearly ubiquitous, but agents are associated with significantly lower abnormal returns in the cross-section. However, returns are higher for funds employing a top-tier agent, and for first-time funds employing an agent. We also find evidence that agents may mitigate investment risk. Our results provide support for both the certification and influence peddling roles of intermediaries discussed in theoretical literature, suggesting heterogeneous motives for intermediation in the private equity industry. >more

Endowments

HOW DO FINANCIAL EXPERTISE AND NETWORKS AFFECT INVESTING? EVIDENCE FROM THE GOVERNANCE OF UNIVERSITY ENDOWMENTS

Matteo Binfarè, Gregory W. Brown, Robert S. Harris, and Christian T. Lundblad
2019
We examine the link between endowment investment performance and the expertise of university board members. Harnessing detailed information on 11,019 members for 579 universities, we find that expertise in alternatives and larger professional networks are associated with higher allocations to alternatives and better investment results. Expertise and networks appear particularly important in private equity and venture capital, which are difficult to analyze and manage. The improved investment performance arises because endowments capture higher returns that can accompany alternative assets, select or have access to high performing managers, and minimize fees by using direct funds rather than funds of funds. While identification of a causal effect of expertise and networks on allocations and performances is challenging, we conduct a novel survey of 132 endowment managers and boards (collectively over 60% of endowment assets), and confirm that board expertise is central in facilitating alternative asset investments. >more

Private Equity and Taxes

PRIVATE EQUITY AND TAXES

Marcel Olbert, and Peter Severin
2018
We study companies' tax avoidance behavior after being acquired in a private equity transaction. Using firm-level data from Europe, we analyze target firms' tax payments after the acquisition compared to a carefully selected control group in a matched-sample difference-in-differences setting. We find that target companies' effective tax rate decreases by 16.14% relative to the unconditional mean. This finding is in line with the hypothesis that private equity investors create shareholder value by extracting money from the government. While our evidence suggests that target firms engage more heavily in profit shifting, we do not find direct evidence in support of a tax-motivated leverage channel. We further show that those target firms that become more tax efficient experience significantly lower asset and employment growth than target firms with no or moderate tax savings after the buyout. This finding indicates that tax savings are not used to finance investment but are directly transferred to shareholders. >more

Carried Interest

MODIFYING THE CARRIED INTEREST TO DO WHAT IT IS SAID TO DO

Ludovic Phalippou
2019
The carried interest received by private equity fund managers (General Partners; GPs) generates some controversies. The three most debated claims are that carried interest i) aligns incentives, ii) should be treated as a capital gain for tax purposes, and iii) should not be reported as a fee charged to investors. The existence of two key principal-agent relationships within the private equity model might be at the root of these controversies. One relationship links the GP as principal and portfolio company management team as agent. In this first contract, the three claims hold true. The other relationship links fund investors (Limited Partners; LPs) as principal with the GP as agent. I show that modifying that second contract by introducing a first-loss feature and reducing significantly the catch-up rate makes the two contracts equivalent. Hence, the benefits of the limited partnership structure can co-exist in a setting where the three claims about carried interest hold true. >more

Corporate Venture Capital

THE LIFE CYCLE OF CORPORATE VENTURE CAPITAL

Song Ma
2019
This paper investigates why industrial firms conduct Corporate Venture Capital (CVC) investment in entrepreneurial companies. I test alternative views on CVC by exploiting the entry, investment, and termination decisions of CVC divisions. CVC entry concentrates in firms that experience deteriorations of internal innovation. At the investment stage, CVCs select startups with a similar technological focus but that have a non-overlapping knowledge base, and they integrate technologies generated from these ventures that create strategic value. CVCs are terminated when parent firms' innovation recovers. Overall, the strategic desire to fix innovation weaknesses after adverse shocks motivates firms to adopt CVCs. >more

Bitcoin

FROM MINING TO MARKETS: THE EVOLUTION OF BITCOIN TRANSACTION FEES

David Easley, Maureen O'Hara, and Soumya Basu
2019
We investigate the role that transaction fees play in the Bitcoin blockchain’s evolution from a mining-based structure to a market-based ecology. We develop a game-theoretic model to explain the factors leading to the emergence of transactions fees, as well as to explain the strategic behavior of miners and users. Our model also highlights the role played by mining rewards and by volume, and examines how microstructure features such as exogenous structural constraints influence the dynamics and stability of the Bitcoin blockchain. We provide empirical evidence on the predictions of our model and discuss implications for Bitcoin’s evolution. >more

Investment Skill

MEASURING INSTITUTIONAL INVESTORS’ SKILL AT MAKING PRIVATE EQUITY INVESTMENTS

Daniel Cavagnaro, Berk A. Sensoy, Yingdi Wang, and Michael S. Weisbach
2018
Using a large sample of institutional investors’ investments in private equity funds raised between 1991 and 2011, we estimate the extent to which investors’ skill affects their returns. Bootstrap analyses show that the variance of actual performance is higher than would be expected by chance, suggesting that some investors consistently outperform. Extending the Bayesian approach of Korteweg and Sorensen (2017), we estimate that a one standard deviation increase in skill leads to an increase in annual returns of between one and two percentage points. These results are stronger in the earlier part of the sample period and for venture funds. >more

Alpha

BUFFETT'S ALPHA

Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen
2018
Berkshire Hathaway has realized a Sharpe ratio of 0.79 with significant alpha to traditional risk factors. However, the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors. Further, we estimate that Buffett’s leverage is about 1.7-to-1 on average. Therefore, Buffett’s returns appear to be neither luck nor magic, but, rather, reward for leveraging cheap, safe, quality stocks. Decomposing Berkshires’ portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett’s returns are more due to stock selection than to his effect on management. >more

VC Syndication

VENTURE CAPITAL COMMUNITIES

Amit Bubna, Sanjiv Ranjan Das, and Nagpurnanand Prabhala
2018
While VCs can choose from thousands of potential syndicate partners, many prefer to co-syndicate with partners drawn from small groups of preferred partners, whom we term "VC communities." Using computational methods from the physical sciences, we identify communities from three decades of syndication data and characterize their number, size, composition, and economic activities. Communities comprise VCs similar in age, connectedness, and functional style and undifferentiated spatial locations. Machine learning tools classify communities into three groups roughly ordered by VC age and reach. Community VC financing is associated with faster maturation and greater innovation especially for early-stage firms without innovation histories. >more

Business Angels

THE PERFORMANCE OF ANGEL-BACKED COMPANIES

Stefano Bonini, Vincenzo Capizzi, and Paola Zocchi
2018
We provide empirical evidence of the post-investment performance and survivorship profile of angel-backed companies, filling a long-standing gap within the entrepreneurial finance literature. Using a unique database of 111 angel-backed companies that received angel investments between 2008 and 2012 and at least 3 years of post-investment financial data, we develop an innovative performance metric and show that the performance and the probability of survival of investee companies are positively affected by the presence of angel syndicates and the hands-on involvement of business angels, while they are negatively related to the intensity of angel monitoring and the structure of equity provision. Our results are robust to several endogeneity tests and provide insights on the multifaceted contributions of angel investors to the performance and survival of new ventures. >more

Buyouts and Innovation Activity

PUBLIC-TO-PRIVATE BUYOUTS AND INNOVATION

Douglas J. Cumming, Rejo Peter, and Monika Tarsalewska
2018
We study the effect of public-to-private buyout transactions on investments in innovation using an international sample from thirty-six countries over the 1997-2017 period. We use patent counts and citations to proxy for the quantity, quality, and economic importance of innovation. Our results are based on time analysis and matched sample regressions. The data indicate that buyouts are associated with a significant reduction in patents and patent citations, including a reduction of radical (i.e., more scientific) patents. When we split the sample into institutional and management buyouts, the negative effect of buyouts is confirmed only for institutional buyouts, suggesting that highly leveraged transactions prevent target firms from adopting long-term investments. This finding is confirmed by reductions in innovator employment and innovation efficiency subsequent to going private. Moreover, the data indicate that the negative effect is mostly prevalent for transactions where the cost of the deal’s debt financing is higher than the post-buyout cost of the debt. For deals financed only with private equity, this effect is aggravated in the post-2006 period, suggesting that the nature of deals has worsened innovation over time. We rule out alternative explanations for these findings, including but not limited to outliers, truncation bias, and endogeneity. >more

Secondary Market for Private Equity Funds

PRIVATE EQUITY INDICES BASED ON SECONDARY MARKET TRANSACTIONS

Brian H. Boyer, Taylor Nadauld, Keith Vorkink, and Michael S. Weisbach
2018
Measuring the performance of private equity investments (buyout and venture) has historically only been possible over long horizons because the IRR on a fund is only observable following the fund’s final distribution. We propose a new approach to evaluating performance using actual prices paid for limited partner shares of funds in secondary markets. We construct indices of buyout and venture capital performance using a proprietary database of secondary market prices between 2006 and 2017. These transaction-based indices exhibit significantly higher betas and volatilities, and lower alphas than NAV-based indices built from Preqin and obtained from Burgiss. There are a number of potential uses for these indices. In particular, they provide a way to track the returns of the buyout and venture capital sectors on a quarter-to-quarter basis and to value illiquid stakes in funds. >more

Initial Coin Offering

INITIAL COIN OFFERINGS (ICOS) TO FINANCE NEW VENTURES

Christian Fisch
2018
In an initial coin offering (ICO), new ventures raise capital by selling tokens to a crowd of investors. Often, this token is a cryptocurrency, a digital medium of value exchange based on the distributed ledger technology. Both the number of ICOs and the amount of capital raised have exploded since 2017. Despite attracting significant attention from ventures, investors, and policy makers, little is known about the dynamics of ICOs. This initial study therefore assesses the determinants of the amount raised in 423 ICOs. Drawing on signaling theory, the study explores the role of signaling ventures' technological capabilities in ICOs. The results show that technical white papers and high-quality source codes increase the amount raised, while patents are not associated with increased amounts of funding. Exploring further determinants of the amount raised, the results indicate that some of the underlying mechanisms in ICOs resemble those found in prior research into entrepreneurial finance, while others are unique to the ICO context. >more

Alternative Investment Vehicles

INVESTING OUTSIDE THE BOX: EVIDENCE FROM ALTERNATIVE VEHICLES IN PRIVATE CAPITAL

Josh Lerner, Jason Mao, Antoinette Schoar, and Nan R. Zhang
2018
This paper undertakes a comprehensive analysis of alternative investment vehicles in private equity, using unexplored custodial data about 112 limited partners over four decades. We differentiate between alternative vehicles that are GP-directed versus those where the LP has some discretion. Of the roughly 5500 distinct investments made by the LPs in our sample, 32% of investments (17% of capital commitments) were in such alternative vehicles; the allocation increased by more than 10 percentage points over the last decade. Alternative vehicles were far more likely to be offered by larger and North America-based buyout funds. The average performance of these alternative vehicles lagged that of the GPs’ corresponding main funds. The best LP performance was among endowments, private pensions, and insurers. Finally, LPs with better past performance invested in alternative vehicles with better performance, even after conditioning on the GPs’ past records. This result suggests that bargaining between GPs and LPs leads to gradation in investment performance based on the parties’ outside options. >more

Angel Investing

ARE EARLY STAGE INVESTORS BIASED AGAINST WOMEN?

Michael Ewens, and Richard Townsend
2018
We examine whether male investors are biased against female entrepreneurs using a proprietary dataset from AngelList that allows us to observe private interactions between investors and fundraising startups. We find that male investors express less interest in female-led startups compared to observably similar male-led startups. Female investors do not exhibit the same behavior, despite appearing to have similar investment objectives; female investors agree with male investors when comparing founders who are all men, or all women. Finally, the male-led startups that male investors express interest in do not outperform the female-led startups they express interest in—they underperform. Overall, the evidence is consistent with some form of gender bias. >more

Private Equity Commitments

CAN INVESTORS TIME THEIR EXPOSURE TO PRIVATE EQUITY?

Gregory W. Brown, Robert S. Harris, Wendy Hu, Tim Jenkinson, Steven N. Kaplan, and David T. Robinson
2018
Private equity performance, both for buyouts and venture capital, has been highly cyclical: periods of high fundraising have been followed by periods of low absolute performance. Despite this seemingly predictable variation, we find modest gains, at best, to pursuing more realistic, investable strategies that time capital commitments to private equity. This occurs because investors can only time their commitments to funds; they cannot time when their commitments are called or when their investments are exited. There is a high degree of time-series correlation in net cash flows even across commitment strategies that allocate capital in a very different manner over time. >more

Hedge Fund Returns

PUBLIC HEDGE FUNDS

Lin Sun, and Melvyn Teo
2017
Hedge funds managed by listed firms significantly underperform funds managed by unlisted firms. The underperformance is more severe for funds with low manager deltas, poor governance, and no manager co-investment, or managed by firms whose prices are sensitive to earnings news. Notwithstanding the underperformance, listed asset management firms raise more capital, by growing existing funds and launching new funds post listing, and harvest greater fee revenues than do comparable unlisted firms. The results are consistent with the view that, for asset management firms, going public weakens the alignment between ownership, control, and investment capital, thereby engendering conflicts of interest. >more

Investment Decisions

LOW INTEREST RATES AND RISK TAKING: EVIDENCE FROM INDIVIDUAL INVESTMENT DECISIONS

Chen Lian, Yueran Ma, and Carmen Wang
2018
How do low interest rates affect investor behavior? We demonstrate that individuals “reach for yield,” that is, have a greater appetite for risk taking when interest rates are low. Using randomized investment experiments holding fixed risk premia and risks, we show low interest rates lead to significantly higher allocations to risky assets among diverse populations. The behavior is not easily explained by conventional portfolio choice theory or institutional frictions. We then propose and provide evidence for mechanisms related to investor psychology, including reference dependence and salience. We also present results using observational data on household investment decisions. >more

Hedge Funds

SENSATION SEEKING AND HEDGE FUNDS

Stephen Brown, Yan Lu, Sugata Ray, and Melvyn Teo
2018
We show that motivated by sensation seeking, hedge fund managers who own powerful sports cars take on more investment risk but do not deliver higher returns, resulting in lower Sharpe ratios, information ratios, and alphas. Moreover, sensation-seeking managers trade more frequently, actively and unconventionally, and prefer lottery-like stocks. We show further that some investors are themselves susceptible to sensation seeking and that sensation-seeking investors fuel the demand for sensation-seeking managers. While investors perceive sensation seekers to be less competent, they do not fully appreciate the superior investment skills of sensation-avoiding fund managers. >more

Partnership Economics

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

Victoria Ivashina, and Josh Lerner
2018
The economics of partnerships have been of enduring interest to economists, yet it is not clear what profit sharing within a private partnership should look like. We examine over seven hundred private equity partnerships, and show that the allocation of fund economics to individual partners varies drastically even among the most senior partners and appears divorced from past success as an investor, being instead related to status as a founder. A smaller share of carried interest and ownership - and inequality in fund economics more generally - is associated with departures of senior partners, which, in turn, is negatively related to the funds’ ability to raise additional capital. >more

Hedge Fund Activism

HEDGE FUND ACTIVISM, FIRM VALUATION AND STOCK RETURNS

Martijn Cremers, Erasmo Giambona, Simone M. Sepe, and Ye Wang
2018
This paper studies the association between hedge fund activism and firm value, using matching procedures to incorporate the nonrandom selection of firms targeted by activist hedge funds. We find that targeted firms improve less in value (Q) subsequent to activism starts than ex-ante similarly poorly performing control firms that are not subject to activist campaigns. Further, long-term abnormal stock returns of both target and control firms are similarly positive and significant. However, activist hedge funds have strong stock selection skills as well as strong trading skills that allow them to outperform. >more

Start-up Formation

BUSINESS CYCLES AND START-UPS ACROSS INDUSTRIES: AN EMPIRICAL ANALYSIS OF GERMAN REGIONS

Alexander Konon, Michael Fritsch, and Alexander Kritikos
2018
We analyze whether start-up rates in different industries systematically change with business cycle variables. Using a unique data set at the industry level, we mostly find correlations that are consistent with counter-cyclical influences of the business cycle on entries in both innovative and non-innovative industries. Entries into the largescale industries, including the innovative part of manufacturing, are only influenced by changes in the cyclical component of unemployment, while entries into small-scale industries, like knowledge intensive services, are mostly influenced by changes in the cyclical component of GDP. Thus, our analysis suggests that favorable conditions in terms of high GDP might not be germane for start-ups. Given that both innovative and non-innovative businesses react counter-cyclically in ‘regular’ recessions, business formation may have a stabilizing effect on the economy. >more

Hedge Fund Activism

HOSTILE RESISTANCE TO HEDGE FUND ACTIVISM

Nicole M. Boyson, and Pegaret Pichler
2018
When facing hedge fund activists, target firms often fight back. Targets with agency problems and those confronting the threat of investor coordination frequently engage in hostile resistance by implementing governance changes associated with managerial entrenchment. The market negatively responds to hostile resistance, and unless hedge funds counter-resist, these campaigns have worse operating performance, faster activist exit, and fewer mergers than do campaigns without hostile target resistance. By contrast, when hedge funds counter-resist with proxy fights, lawsuits, or unsolicited tender offers, the impact of hostile target resistance is reversed, and these campaigns have similar outcomes to campaigns without hostile target resistance. >more

Private Equity Returns

ESTIMATING PRIVATE EQUITY RETURNS FROM LIMITED PARTNER CASH FLOWS

Andrew Ang, Bingxu Chen, William N. Goetzmann, and Ludovic Phalippou
2017
We introduce a methodology to estimate the historical time-series of returns to investment in private equity funds. The approach requires only an unbalanced panel of cash contributions and distributions accruing to limited partners, and is robust to sparse data. We decompose private equity returns into a component due to traded factors and a time-varying private equity premium. We find strong cyclicality in private equity returns that differs according to fund type. The time-series estimates allow us to directly test theories about private equity cyclicality, and we find evidence that capital market segmentation helps to determine private equity returns. >more

Fund of Funds

FINANCIAL INTERMEDIATION IN PRIVATE EQUITY: HOW WELL DO FUNDS OF FUNDS PERFORM?

Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Rüdiger Stucke
2017
This paper focuses on funds of funds (FOFs) as a form of financial intermediation in private equity (both buyout and venture capital). After accounting for fees, FOFs provide returns equal to or above public market indices for both buyout and venture capital. While FOFs focusing on buyouts outperform public markets, they underperform direct fund investment strategies in buyout. In contrast, the average performance of FOFs in venture capital is on a par with results from direct venture fund investing. This suggests that FOFs in venture capital (but not in buyouts) are able to identify and access superior performing funds. >more

Hedge Fund Investment Behavior

DO HEDGE FUNDS EXPLOIT RARE DISASTER CONCERNS?

George Gao, Pengjie Gao, and Zhaogang Song
2017
We find hedge funds that have higher return covariation with a disaster concern index, which we construct using out-of-the-money puts on sector indices, earn significantly higher returns. These funds have better skills in exploiting the market's ex ante rare disaster concerns (SED) that are not associated with disaster risk. In particular, high-SED funds on average outperform low-SED funds by 0.96% per month, but have less exposure to disaster risk. They continue to deliver superior future performance when SED is estimated using the disaster concern index purged of disaster risk premiums, and have leverage-managing and extreme-market-timing abilities. >more

Hedge Fund Flows

ALPHA OR BETA IN THE EYE OF THE BEHOLDER: WHAT DRIVES HEDGE FUND FLOWS?

Vikas Agarwal, T. Clifton Green, and Honglin Ren
2017
CAPM alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success. >more

Private Equity & Real Economy

IS PRIVATE EQUITY GOOD FOR CONSUMERS?

Cesare Fracassi, Alessandro Previtero, and Albert Sheen
2017
We investigate the effects of private equity on consumers using detailed price and sales data for an extensive number of consumer products. We find that firms acquired by private equity raise prices marginally---less than 1%---on existing products relative to matched control firms. Overall industry prices rise after buyouts, but again the price increase is on average very modest. More notably, target firms significantly increase sales due to more product additions and greater availability within and across cities. These results are stronger for private firm targets, suggesting that private equity could ease financial constraints and provide the expertise to manage growth. Contrary to the common view that private equity leads to substantial price increases, this evidence suggests that consumers could benefit from private equity deals through an increase in product variety. >more