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Bachelor Thesis
Disclosure in private equity firms
Bachelor Economie en Bedrijfskunde
Accountancy en Control
FEB
UvA
Timothy Alkemade
10195270
18 July, 2014
Supervisor:
Mario Schabus
2 Abstract
This paper looked for an answer to the research question what are the advantages and the disadvantages for the private equity backed company, the venture capitalist and the investors involved when a higher disclosure quality requirement is implemented?
Disclosure should inform investors about firms fundamentals and performance and therefore reduce information asymmetry between shareholders and managers which makes a performance evaluation of the firm possible, reduces risk and therefore demanded return by the shareholders. Therefore management has incentives to increase disclosure quality.
In firms backed by private equity, there is an intermediate investor, venture capitalist, who collects and invests money from a larger group of investors and invest this money in a portfolio of private, not listed, firms. The venture capitalist has mayor influence in the operations and considerable insight in the finances of the portfolio firms and does not often have to rely on the disclosure of the portfolio firms for evaluation of their performance. However, the group of investors investing in the venture capitalist may demand more disclosure to be able to make their own performance evaluation.
This thesis focuses on the disclosure in private equity backed firms. Most scientific articles about disclosure only look at the capital markets and do not look at the private equity based firms. Private equity backed firms are predominate in the economy, however there are relatively few scientific studies about these private equity based firms. Private equity backed firms are characterized by various information asymmetries and agency problems which inherently affect the business process and organization. The use of financial statement information is therefore even more important. These issues makes this topic interesting to investigate, by looking if these issues can be solved with a higher disclosure quality, and if this would be beneficial for the company, venture capitalist and the investors.
First was taken a look on the need for disclosure and the problems associated with disclosure if information asymmetry exists between two parties, such as the agency problem and the lemons problem. Disclosure is needed because otherwise the other party has more information and is able to take advantage of this information advantage by misleading the other party. Subsequently the venture capital industry and the role of the venture capitalist, the firm and the investors were explained to create a better understanding of the subject for the reader. Also, to see how the agency conflict looks like in the private equity firm with the venture capitalist and the investors. Next was taken a look at the determinants of disclosure quality, what is a good disclosure quality and what is a bad disclosure quality. This was all
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done to see in which situation a higher disclosure quality more beneficial is for each party involved in the venture capital. Lastly was looked in which circumstance a higher disclosure quality is preferable for each party involved.
How bigger the uncertainty and associated risks the more favorable information is to its parties. The advantage is that sharing information and relations maximizes the use of the following instruments, which are special for the relation in private equity, namely:
Active involvement, incentivizing and encouragement of management to disclosure. The setting of premiums for management by raising the size and valuation of the company, and by staging the commitment. Setting of procedures, rules for governance structures on disclosure of information. And the existence of governmental rules do help.
4 Abstract (Dutch)
Dit onderzoek zocht naar een antwoord op de onderzoeksvraag: Wat zijn de voordelen en de nadelen voor het private equity gedreven bedrijf, de venture capitalist en de investeerders die betrokken zijn als een hogere eis van disclosure kwaliteit wordt uitgevoerd?
Disclosure dient investeerders te informeren over de waarde en de prestaties van het bedrijf. Hierdoor wordt de informatie asymmetrie tussen aandeelhouders en managers verkleint, en wordt het mogelijk gemaakt om een prestatie beoordeling van het bedrijf te maken. Het management heeft daarom de drijfveer om de disclosure kwaliteit te verhogen.
In bedrijven gedreven door private equity, is er een tussenpersoon (venture capitalist) die geld verzamelt van een grotere groep van investeerders en dit geld investeert in een portfolio van private bedrijven (geen beursbedrijven). De venture capitalist heeft een grote invloed op het bedrijfsproces en heeft een goed inzicht in de financiën van de portfolio bedrijven en hoeft vaak niet te vertrouwen op de disclosure van het portfolio bedrijf om een prestatie evaluatie te maken. Echter, de groep van investeerders die in de venture capitalist investeren kunnen meer informatie openbaarmaking eisen om hun eigen prestatie evaluatie te maken.
Dit onderzoek richt zicht op de informatie openbaarmaking in private equity gedreven bedrijven. De meeste wetenschappelijke artikelen over informatie openbaarmaking richten zich alleen op de kapitaalmarkten en niet op de private equity gedreven bedrijven. Private equity gedreven bedrijven zijn overheersend in de economie, echter er zijn relatief weinig wetenschappelijke onderzoeken verricht naar de private equity gedreven bedrijven. Private equity gedreven bedrijven worden gekenmerkt door verschillende informatie asymmetrieën en agentproblemendie inherent invloed hebben op het bedrijfsproces en de organisatie. Het gebruik van financiële verklarende informatie is daarom nog belangrijker. Deze problematiek maken dit onderwerp interessant om te onderzoeken, door te kijken of deze problemen kunnen worden opgelost met een hogere disclosure kwaliteit, en of dit gunstig is voor het bedrijf, de venture capitalist en de investeerders.
Eerst werd er gekeken naar de noodzaak van disclosure en de problemen die te maken hebben met disclosure als er een informatie-asymmetrie bestaat tussen twee partijen, zoals het agency probleem en het lemons probleem. Disclosure is nodig omdat anders de ene partij meer informatie heeft dan de andere partij en hierdoor in staat is om te profiteren van dit informatie voordeel door misleiding van die andere partij.
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Vervolgens werd gekeken naar de venture capital industrie en de rollen van de venture capitalist, de onderneming en de investeerders werd uitgelegd om een beter begrip van het onderwerp voor de lezer te creëren . En daarnaast om te zien hoe het agency conflict eruit ziet in de private equity firm met de venture capitalist en de investeerders.
Vervolgens werd er gekeken naar de determinanten die disclosure kwaliteit beïnvloeden en wat zijn goede disclosure kwaliteiten en wat zijn slechte disclosure kwaliteiten. Dit werd allemaal gedaan om te zien in welke situatie een betere disclosure kwaliteit gunstig zijn voor alle partijen die betrokken zijn bij de venture capital.
Ten slotte werd gekeken in welke omstandigheid een openbaring betere kwaliteit oplevert voor iedere betrokken partij.
Hoe groter de onzekerheid en de daarmee samenhangende risico’s hoe waardevoller de informatie voor de partijen is. Het voordeel is dat het delen van informatie met de betrokken relaties het gebruik van de volgende instrumenten maximaliseert; namelijk: Actieve
betrokkenheid, beloning creëren en aanmoediging van het management om informatie openbaar te maken.
Het vaststellen van premies voor het management door het verhogen van de omvang en waarde van het bedrijf, en het faseren van het toegezegde kapitaal. Vaststellen van
procedures en regels voor governance structuren over het openbaar maken van informatie. En ten slotte de regels van de overheid zijn bewezen van hulp te zijn.
6 Index of contents
1 Introduction 7
2 Agency conflict and disclosure 8
2.1 Agency problem 9
2.2 Lemons problem 12
3 Conflict of interests and demand for disclosure in Private Equity (PE) firms 13
3.1 The Origins of the Venture Capital Industry 13
3.2 What Do Venture Capitalists 15
3.3 Relationship Venture Capitalist – Entrepreneur 16
3.4 Relationship Venture Capitalist – Firm 17
3.5 Agency problems in PE firms 18
4 Determinants of disclosure quality 19
5 Under which circumstances is voluntary disclosure in PE firms most valuable? 21
6 Conclusion 24
7 1 Introduction
Since decades, corporate decisions to disclose information to outsiders have been of interest for both analytical and empirical accounting researchers (Beuselinck, 2008). Corporate disclosure is critical for the functioning of an efficient capital market. Firms provide
disclosure through regulated financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings (Healy, 2001). Disclosure should inform investors about firms fundamentals and performance. This should reduce information asymmetry between shareholders and managers, which it possible for
shareholders to make their own performance evaluation of the firm. This reduces the risk of the investment, and the demanded return by the shareholders.
A venture capitalist collects money from a larger group of investors and invests this money in a portfolio of private firms. These private firms are not listed and there is little to no public information about these firms. The venture capitalist has a mayor influence in the operations and a considerable insight in the finances of the portfolio firms. This means he does not have to rely on the disclosure of the portfolio firms for the evaluation of their performance. However the group of investors investing in the venture capitalist may demand more disclosure to be able to make their own performance evaluation. This reduces the uncertainty and the risk for the investor and in return could require a lower demanded return for the venture capitalist.
This thesis focusses on the disclosure in private equity backed firms. Most scientific articles about disclosure only look at the capital markets and do not look at the private equity based firms. Private equity backed firms are predominate in the economy, however there are relatively few scientific studies about these private equity based firms (Beuselinck, 2008). Private equity backed firms are characterized by various information asymmetries and agency problems which inherently affect the business process and organization. The use of financial statement information is therefore even more important. These issues makes this topic interesting to investigate, by looking if these issues can be solved with a higher disclosure quality, and if this would be beneficial for the company, venture capitalist and the investors.
This leads to the research question of this thesis: What are the advantages and the disadvantages for the private equity backed company, the venture capitalist and the investors involved when a higher disclosure quality requirement is implemented? This research
question will be answered in the form of a literature review which is based on the study of scientific articles.
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In paragraph 2 disclosure and information asymmetry in general is described more in detail. Subsequently in paragraph 3 the venture capital industry is described and the conflict of interests and demand for disclosure is more focused on private equity firms. Following in paragraph 4 the different determinants of disclosure quality is explained. Finally in the
conclusion an answer will be formulated which tries to answer the research question as best as possible and potential suggestions are given for additional research.
2 Agency conflict and disclosure
In order to understand what the advantages and disadvantages of a higher disclosure quality requirement are, first will be looked at the need for disclosure in general and which problems are caused by not having a high disclosure quality.
Disclosure is the act of releasing all relevant information of a company that may influence an investment decision (Forker, 1992). To make investing as fair as possible for everyone, companies must disclose both positive and negative information. If selective disclosure is given, this is a serious problem for investors, because insiders would frequently take advantage of information for their own gain at the expense of the general investing public.
Corporate disclosure is critical for the functioning of an efficient capital market. Firms provide disclosure through regulated financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings (Forker, 1992). Secondly, some firms engage in voluntary communication, such as
management forecasts, analysts’ presentations and conference calls, press releases, internet sites, and other corporate reports. Thirdly, there are disclosures about firms by information intermediaries, such as financial analysts, industry experts, and the financial press.
Regulators, standard setters, auditors, and other capital market intermediaries, enhance the credibility of management disclosures.
Healy (2001) argues that demand for financial reporting and disclosure arises from information asymmetry and agency conflicts between managers and outside investors. Disclosure is needed because otherwise the other party has more information and is able to take advantage of the information asymmetry. Problems such as the agency conflict and the lemons problem, or also called the information problem, are examples of this information asymmetry.
9 2.1 Agency problem
The agency problem arises, because savers that invest in a business venture typically do not intend to play an active role in its management. That responsibility is delegated to the entrepreneur (Healy, 2001). Once savers have invested their funds in a business venture, the self-interested entrepreneur has an incentive to make decisions that expropriate savers’ funds. The entrepreneur can use those funds to acquire perquisites, pay excessive compensation, or make investment or operating decisions that are harmful to the interests of outside investors.
During the 1960s and early 1970s, economists explored risk sharing among
individuals or groups (Arrow, 1971). This literature described the risk-sharing problem as one that arises when cooperating parties have different attitudes toward risk. Agency theory broadened this risk-sharing literature to include the agency problem that occurs when
cooperating parties have different goals in mind (Jensen, 1976). Agency theory is directed at the agency relationship, in which one party, the principal, delegates work to another party, the agent, who performs the tasks which are assigned to him.
In an agency relationship, one party acts on behalf of another. In the classic agency theory is there are agency problems (Shapiro, 2005). These agency problems are caused by goal conflict and opportunism. To keep these risk-bearing problems under control there is a need for monitoring, governance, policies and sanction.
In this respect in the article of Eisenhardt (1989) is an example which explains the agent conflict and what incentives can achieve very well:
“One day Deng Xiaoping decided to take his grandson to visit Mao. “Call me
granduncle,” Mao offered warmly. “Oh, I certainly couldn’t do that, Chairman Mao,” the awe-struck child replied. “Why don't you give him an apple?” suggested Deng. No sooner had Mao done so than the boy happily chirped, “Oh thank you, Granduncle.” “You see,” said Deng “ (Capitalism, 1984; In: Eisenhardt, 1989).
An agency relationship is defined as a relationship in which one or more persons, also known as the principal(s), engages another person, also known as the agent, to perform a service on their behalf (Shapiro, 2005). This involves delegating decision-making authority to the agent. The core of the agency theory is the assumption that the interests of principles and agents diverge. According to agency theory, the principal can limit divergence from his interests by establishing appropriate incentives for the agent, and by incurring monitoring costs designed
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to limit opportunistic action by the agent. Further, it may pay the agent to spend resources, or bonding costs, to guarantee that he will not take certain actions that would harm the principal, or to ensure that the principal will be compensated if he does take such action. Despite the devices it is recognized that some divergence between agent’s actions and the principals interests remain. Information asymmetry will still exist.
Applications of agency theory to management mainly have been based on what Ross (1973) calls the principal’s problem. The principal delegates assigned tasks to the agent. In a perfectly certain world, rational economic principals would pay the agent simply for his output (Hendry, 2002). In an uncertain world where outcomes are influenced by external factors beyond either the principal’s or agent’s control, the principal will pay the agent for his effort, rather than for his output. If agents were perfectly honest and dutiful, this would not be problematic.
Agency theory is concerned with resolving two problems that can occur in agency relationships. The first is the agency problem that arises when the goals or desires of the principal and agent are conflicting (Eisenhardt, 1989). It is difficult or expensive for the principal to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately to perform the task correctly. The second is the problem of risk sharing that arises when the principal and agent have different attitudes toward risk. The problem here is that the principal and the agent may prefer different actions because of the different risk preferences.
The problem of limited competence is not recognized in agency theory at all
(Eisenhardt, 1989). This is because incompetence could act unpredictably in any direction and cannot be formally modeled. Therefore, in agency theory it is assumed that people are fully competent to achieve their desired outcomes, apart from the impact of external factors that are able to influence the outcome of a task.
Most people are self-seeking to some extent, and managers are no exception (Hendry, 2002). However, both organizations and agency relationships in general depend on other people’s behavioral characteristics. It is impossible for an organization to function effectively without some measure of honesty, cooperation, and trust, and it is impossible to delegate authority to agents without relying to some extent on their loyalty, honesty, and goodwill. This basic fact of life is recognized in traditional legal conceptions of agency, but is ignored in standard agency theory, which focuses on the consequences of opportunistic self-seeking (Duska, 1992). At the same time, standard agency theory also ignores a couple of issues that
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are central to management and organizational life, including those of power, complexity, bounded rationality, and the limited competence of managers to achieve desired outcomes.
The main problem perceived in the agency conflict is goal conflict, the departure of the interest of the agent from the interests of the principal (Shapiro, 2005). The solution to this agency problem is to come up with incentives that will align the interests of agents with those of the principal. Such an incentive could be that the payment is based on his output rather than on his effort. The agency problem looks quite different from the perspective of the agent. Conflicts between the interests of the agents and those of the principal are the least of the agent’s problems. The problem is that the agent is most likely serving many principals, many of them with conflicting interests. Even if the agent is able to silence his or her own interests, there is the matter of finding out what each principle desires and what to do satisfy each desire without hurting the other desires of the other principles (Shapiro, 2005).
Also asymmetry’s occur in a situation in which one party in a transaction has more or superior information compared to another (Brown, 2007). This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. This could be a harmful situation because one party can take advantage of the other party’s lack of knowledge. With increased advancements in technology, asymmetric information has been on the decline as a result of more and more people being able to easily access all types of
information. Information asymmetry can lead to two main problems (Shapiro, 2005). The first problem is adverse selection. This is immoral behavior that takes advantage of asymmetric information before a transaction. Adverse selection refers to the misrepresentation of the abilities of the agent. The agent may claim to have certain skills or abilities when he is hired. Adverse selection arises because the principal cannot completely verify these skills or abilities either at the time of hiring or while the agent is working. The second problem is moral hazard. This is immoral behavior that takes advantage of asymmetric information after a transaction. Moral hazard refers to a lack of effort of the agent. The agent may simply not put in the required effort.
Information asymmetry occurs when one or more investors possess private information about the firm’s value while other uninformed investors only have access to public information. The presence of information asymmetry creates an adverse selection problem in the market when privately informed investors trade on the basis of their private information.
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In the venture capital industry, the entrepreneur, agent, may have better information than the investor, principal, regarding the prospects of his business, technology, and
managerial skills (Pratt, 1985) . It is in the best interest of the entrepreneur to create the highest valuation possible of the firm, so he is more likely to highlight the positive
information while neglecting the negative information of his firm. This private information is especially common in the venture capital industry, where entrepreneurs may not have a proven track record and are not required to issue public financial statements.
Moral hazard problems can arise throughout the normal business operation of the business, when the investor, principal, cannot directly observe the effort levels exerted by the entrepreneur, agent. The entrepreneur can take actions that give themselves private benefits at the expense of the investors, if not appropriate incentives are given by the investor. The entrepreneur may shirk and invest in for his own gain rather than productive investments. In order to prevent this, the goals of the entrepreneur and the investor should be aligned. This can be done by having both the entrepreneur and the investor retain an adequate equity stake in the firm. Both will benefit if the value of the firm goes up.
2.2 Lemons problem
Another problem is the lemons problem or also called the information problem that arises when no full disclosure is given and an information asymmetry exists between two parties.
Akerlof (1970) relates quality and uncertainty. There are good cars and bad cars, which in America are known as lemons. Most of the cars traded will be the lemons, and good cars may not be traded at all. The existence of products of many grades poses interesting and important problems for the theory of markets (Akerlof, 1970). In this case there is an
incentive for sellers to market poor quality merchandise, since the returns for good quality are only beneficial for the entire group participating in the market as a whole rather than the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, and therefore governmental intervention may increase the welfare of all parties.
Good products may be driven out of the market by the bad product, the lemons. (Akerloff, 1970). Trust is important in the business world and in economic models. The difficulty of distinguishing good quality from bad is inherent in the business world.
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The information or lemons problem arises from information differences and conflicting incentives between entrepreneurs and savers. Optimal contracts between
entrepreneurs and investors will provide incentives for full disclosure of private information, thus mitigating the miss valuation problem.
Being aware of the possibility of a lemons problem in itself is a warning for the
venture capitalist to look for correct information disclosure. Also, it helps being aware that the banks and other stakeholders have the same need for correct information is important. Having the right information will lead to the best financial valuation, will be proven later on from existing literature in this thesis. The instruments to get the right information is covered in chapter 4 after explaining the venture capitalist industry in chapter 3.
3 Conflict of interests and demand for disclosure in Private Equity (PE) firms
To determine the answer to the research question, first will be looked at the origins venture capital industry. Then will be looked at what a venture capitalist is and what he does.
Subsequently will be looked at what the role of external investors and the role of the venture firm are. Finally, there will be looked at how the agency conflict looks like in private equity firms.
3.1 The Origins of the Venture Capital Industry
The first true venture capital firm was American Research and Development (ARD),
established in 1946 by MIT President Karl Compton, General Georges F. Doriot, who was a professor at Harvard Business School, and local business leaders (Gompers, 2001). This small group made high-risk investments in emerging companies that were based on technology developed for World War II. The success of the investments ranged widely: almost half of ARD’s profits during its 26-year existence as an independent entity came from its $70,000 investment in Digital Equipment Company in 1957, which grew in value to $355 million. ARD was structured as a publicly traded closed-end fund. A closed-end fund is a mutual fund whose shares trade from investor to investor on an exchange like an individual stock. These funds raise capital up front by selling shares to investors. If investors no longer desire to hold the investment, they can sell the shares on a public exchange to other investors (Gompers,
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2001). This provision allowed the fund to invest in illiquid assets, secure in the knowledge that they would not need to return investors' capital in an uncertain time frame.
Looking at the past two decades there have been both good moments and bad moments for venture capitalists (Gompers, 2001). Venture capitalists backed many of the most successful high-technology companies during the 1980s and 1990s, including Apple Computer, Cisco Systems, Genentech, Microsoft, Netscape, and Sun Microsystems.
A substantial number of service firms, including Staples and Starbucks, also received venture financing.
Also combinations between firms grew over time. Relationships with corporations were increasingly seen as a source of differentiated competitive advantage (Gompers, 2001). Venture groups were increasingly willing to consider working with these investors, not only accepting money from them as limited partners, but also in structuring various types of collaborations (Gompers, 2001).
Invention and innovation drive the U.S. economy (Zider, 1998). Most of the
entrepreneurs and management teams that start new companies come from corporations or, more recently, universities. This is logical because nearly all basic research money, and therefore invention, comes from corporate or government funding (Zider, 1998). But those institutions are better at helping people find new ideas than at turning them into new businesses.
Venture capital has developed as an important intermediary in financial markets, providing capital to firms that might otherwise have difficulty attracting financing (Gompers, 2001). These firms are typically small and young, and are faced by high levels of uncertainty. They are also characterized by a large information asymmetry between the entrepreneurs and the investors. These firms typically possess few tangible assets and operate in markets that change very rapidly. Venture capital organizations finance these high-risk and potentially high-reward projects by purchasing equity or equity-linked stakes while the firms are still privately held. The venture capital industry has developed a variety of mechanisms to
overcome the problems that emerge at each stage of the investment process (Gompers, 2001). Financial intermediaries such as venture capital organizations are increasingly
understood to play a role distinct from that of other capital providers (Lerner, 1995). Because they gain a detailed knowledge of the firms that they finance, these inside investors can provide financing to young businesses that otherwise would not receive external funds.
15 3.2 What Do Venture Capitalists
In general venture capitalists activities are finding new investment opportunities. They spend around half of their time monitoring portfolio investments for which they are personally responsible, and serve the board of some of the firms (Gorman, 1989). They visit their companies relatively frequently, though for reasonably short periods each time. The venture capitalist works on the company’s behalf by attracting new investors, evaluating strategy against new conditions, and recruiting new management candidates. When venture-backed companies fail, the venture capitalist sometimes is led to dismiss current management and seek new leadership. Venture capital has become a major vehicle for the funding of start-up firms (Gompers, 2001). In many countries, venture capital is now the financing mode of choice for projects where learning and innovation are important. Because of their innovative nature, venture projects carry a substantial risk of failure. Only a minority of start-ups are high-return investments, mostly through initial public offerings. Of the remaining the majority is liquidated implying a complete write-off of the investment.
One of the most challenging problems in venture financing is to determine when to release funds for continued development and when to abandon a project (Bergemann, 1998). The entrepreneur controls the allocation of the funds and the investment effort is unobservable to the investor. The control of funds means that the entrepreneur also controls the flow of information about the project.
The venture capital industry has evolved operating procedures and contracting practices that are well adapted to environments characterized by uncertainty and information asymmetries between principals and agents (Sahlman, 1990). Venture capital is a
professionally managed pool of capital that is invested in equity-linked securities of private ventures at various stages in their development. Venture capitalists are actively involved in the management of the ventures they fund, typically becoming members of the board of directors and retaining important economic rights in addition to their ownership rights. The most seen organizational form in the industry is the limited partnership, with the venture capitalists acting as general partners and the outside investors as limited partners.
Venture capital partnerships enter into contracts with both the outside investors who supply their funds and the entrepreneurial ventures in which they invest (Sahlman, 1990). The contracts share certain characteristics. The contracts contain rules about staging the
commitment of capital and preserving the option to abandon, use compensation systems directly linked to value creation, and preserve ways to force management to distribute
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investment proceeds. These elements of the contracts address three fundamental problems. Firstly, the sorting problem gets addressed regarding how to select the best venture capital organizations and the best entrepreneurial ventures. Secondly, the agency problem gets addressed regarding how to minimize the present value of agency costs. Thirdly, the operating-cost problem gets addressed regarding how to minimize the present value of operating costs, including taxes.
3.3 Relationship Venture Capitalist - Entrepreneur
Professional venture capital is best defined as active investment in private companies with high growth potential (Leleux, 2003). Venture capitalists typically play an important role on the board of directors of the companies in which they invest, including helping to set strategy and to recruit key employees. They structure their investments in a way which provides strong controls and appropriate incentives for managers. Their interests and those of managers are aligned in ways not usually seen in the large public corporations.
There are three striking aspects of the deals venture capitalists cut with entrepreneurs (Sahlman, 1994). First, they entail staging the commitment of capital. Then, the venture capitalist will preserve the right to invest more in a second stage that involves building a pilot plant. Ultimately, if and only if the project and the team make sense, will the venture capitalist agree to fund the entire project. By staging the commitment of capital, the venture capitalist gathers new information about the team, the environment and the project while preserving the option to abandon and to change the management.
A second characteristic of the relationship between venture capitalist and entrepreneur is the use of high required rates of return (Sahlman, 1994). The venture capitalists tries to invest in projects with a high expected rate of return, usually in excess of 30 percent per year. For the entrepreneur the high cost of capital imposes a strong discipline on the use of capital.
A third feature of the contractual relationship between the venture capitalist and
entrepreneur relates to compensation and incentives (Sahlman, 1994). The risk-reward sharing scheme makes sure that both the entrepreneur and the venture capitalist benefit when the venture does well. However, when the venture does poorly the entrepreneur bears most of the risk. This is accomplished by two instruments. Firstly, the investment security used is a convertible preferred with liquidation preference, which means that the venture capitalist will capture most if not all of the liquidation proceeds when the firm is folded. Secondly, the
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entrepreneurial team members receive common stock or options that vest over time. The vesting requirement means that if employees are terminated, they will likely lose their stock.
Staging capital commitments, making capital expensive and scarce, and structuring incentives are mechanisms to alleviate the inherent agency problem that exists between the venture capitalist and the entrepreneur. This agency problem will be one of the major topics to be detailed in this thesis later on. In venture capital projects, uncertainty exist for one party while wealth exist for the other.
3.4 Relationship Venture Capitalist - Firm
In addition to structuring the deal with the entrepreneur to mitigate the inherent agency problem, the venture capitalist also works actively with the venture to increase the likelihood of success (Fried, 1998).
The venture fund typically has a life of ten years: in the initial years, the money is invested in ventures (Gompers, 2001).. Then, as these investments are harvested, the proceeds are distributed to the limited partners. Venture capitalists typically receive 20 percent of the gains on the partnership and receive an annual management fee for running the partnership (Gompers, 2001). Under almost all circumstances, the most important form of compensation is the carried interest, the 20 percent share of profits. Because venture capitalists are
compensated based on the performance of the fund they manage, they have every incentive to increase value. This is why their interests and those of the companies they back are aligned. All parties benefit if and only if value is created.
Venture capitalists are generally seen as value-added investors who have played a significant role in the development of many entrepreneurial businesses (Leleux, 2003). One of the most significant value-added activities of the venture capitalist is involvement with
strategy. Several studies have examined the value-added role of venture capitalists. Using a variety of measures and data sources, these studies have consistently found that principal involvement with strategy is significant. Monitoring operating performance and monitoring financial performance were rated as the next most useful activities. The study of Fried (1998) confirms that boards of venture capital-backed firms have active boards.
The relationship between investors and managers of the venture funds is governed by a partnership agreement that spells out the rights and obligations of each group (Bergemann, 1998). Venture capital has become a major vehicle for the funding of start-up firms. In many
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countries, like the United States, venture capital is the financing mode of choice for projects where learning and innovation are important.
3.5 Agency problems in PE firms
There is a large academic literature on the principal–agent problem in financial contracting. This literature focuses on the conflicts of interest between an agent, who is an entrepreneur with a venture that needs financing, and a principal, who is the investor providing the funds for the venture (Kaplan, 2001). Theory has identified a number of ways that the investor or principal can mitigate these conflicts. Firstly, the investor can structure financial contracts between the entrepreneur and investor to provide incentives for the entrepreneur to behave optimally. Secondly, the investor can engage in information collection before deciding whether to invest, in order to screen out unprofitable projects and bad entrepreneurs. And thirdly, the investor can engage in information collection and monitoring once the project is being undertaken.
The venture capitalist structures the deal with the entrepreneur to mitigate the inherent agency problem, the venture capitalist also works actively with the venture to increase the likelihood of success (Fried, 1998). Venture capitalists acquire knowledge about how to help rapidly growing ventures do better. They know about how to attract and motivate talented, committed individuals. As stated earlier they provide credibility with resource providers, including suppliers and customers. They know about the process of raising capital from private and public sources. They are active board members, whose interests are closely aligned with those of the entrepreneurial team.
The interests of the investor and entrepreneur are aligned, because of the structure of the contract between venture capitalists and the principals who invest in the venture capital fund (Fried, 1998). As these investments are harvested, the proceeds are distributed to the investors.
Because venture capitalists are compensated based on the performance of the fund they manage, they have every incentive to increase value (Sahlman, 1994). This is why their interests and those of the companies they back are aligned. All parties benefit if and only if value is created. Admittedly, interests are not always perfectly aligned: an individual
company founder who is fired, for example, might take exception to the notion that his or her interests and those of the financial backer are congruent. On the other hand, at least the agent and principal can agree at the beginning of the project about what the goal is.
19 4 Determinants of disclosure quality
This chapter focuses on the determinants of disclosure quality. The findings of seven papers are discussed, leading to the deductions made together with the information from the previous discussed literature.
Aitken (1997) explores the determinants of management’s decision to voluntarily disclose segment information. Aiken’s study explores the effect of differences in data, differences in samples, and differences in measurements of diversification on the McKinnon (1993) results of the determinants of voluntary disclosure. Using an alternative definition of diversification, Aitken (1997) finds diversification strategy, firm size, and the level of minority interest to be related to disclosure while the result of ownership diffusion and strategy are mixed. In the case of voluntary provision of data, management has incentives, from both agency and information perspectives, to disclosure the data to facilitate investors earnings predictions.
Kaplan’s (2005) study on private equity performance investigates the performance and capital inflows of private equity partnerships. Better performing partnerships are more likely to raise additional funds and larger funds. Generally, better performing partnerships have better governance structures who provide more value added.
Beuselinck’s (2007) study on reporting quality in private equity backed companies concentrates on the impact of ownership concentration. Companies in which private equity investors have a high equity stake produce lower quality accounting information than companies in which private equity investors have a low equity stake. Beuselinck (2007) explains his findings by arguing that private equity investors with low equity stakes have a higher need for high quality accounting information whereas private equity investors with high equity stakes have other instruments to closely monitor their portfolio companies. The findings are explained from basic agency theory and the importance of financial reporting in monitoring entrepreneurial actions (Beuselinck, 2007). Since entrepreneurs have an incentive to manage the performance of the venture, this is reflected in financial reporting. Private equity investors with low share ownerships know the danger of unmonitored financial reporting and react by strongly disciplining the financial reporting and internal accounting control system. This results in better external financial reporting quality for portfolio firms in which private equity investors have low equity stakes. This finding is important for external stakeholders who financial accounts of companies yield important input for their decision
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making process. These include banks, suppliers, customers, employees and credit rating agencies, but also prospective later-round equity investors or acquirers.
Beuselinck (2008) study investigates private equity investments and disclosure policy. Economic theory suggests that a firm’s disclosure policy is negatively related to its cost of capital since disclosure reduces information asymmetries. Analytical studies have modeled the discretionary disclosure of information in various settings resulting in full disclosure and partial disclosure. Empirical work on corporate disclosure is rooted in the 1960s and typically examines the effect of increased levels of disclosure on a firm’s ability to reduce agency costs. Beuselink (2008) studies the impact of changes in ownership structure and corporate governance on a firm’s disclosure policy. Survey evidence shows that more than 70% of professional investors labels accounting disclosure as the most important item which impacts their investment decision (McKinsey, 2002; In: Beuselinck, 2008).
Beuselinck (2008) finds clear evidence that firms switch to a higher disclosure policy one year before they receive private equity. This increase in disclosure is interpreted as an entrepreneurial attempt to reduce the information asymmetries inherent to the private equity application. The commitment to this high disclosure is further intensified from the private equity investment date onwards, suggesting a governance of professionalization impact of private equity investors on their portfolio firms financial reporting behavior.
Beuselinck (2009) study about private equity involvement and earnings quality. It is often argued that financial reporting by private firms is much more based on insiders preferences than financial reporting by public firms, because in private firms financial reporting serves as a lesser instrument for resolving information asymmetries and for communicating with outside parties. That is why private equity investments create agency problems induced by the separation of ownership and control. Beuselinck’s (2009) findings suggest that private equity ownership increases the relevance of financial reporting by private firms. This affects various external stakeholders that rely on the financial accounts. These stakeholders consist of banks for loan granting decisions, suppliers, customers, employees, credit rating agencies, and possible future equity investors.
Cumming (2006) finds that the private equity fund, entrepreneur, investment
characteristics, and the economic environment all contribute significantly to the success of the investment. The study also shows that the different legal frameworks in the different countries significantly contribute to the performance of the investment. If the reporting standards satisfy the legal conditions more, it is more likely the internal rate of returns are higher.
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Cumming’s (2010) study on the same subject about private equity returns and disclosure around the world concludes the data shows a significant impact of the accounting standards and the legal framework on the reporting behavior of private equity managers. This finding is consistent with the central theoretical prediction. Private equity funds are less inclined to overvalue unexited investments since the introduction of the Sarbanes-Oxley legislation in 2002. The data shows that less experienced private equity managers and those involved in early-stage high-tech investments are more inclined to overvalue unexited investments.
Determinants in the discussed above studies are: provision of data, better performing partnerships have better governance structures, lower equity stake partnerships provide better quality of information, importance of financial monitoring, disclosure reduce information asymmetries and economic environment. When the determinants are combined with the discussed subjects in earlier chapters, there can be seen that these findings and the need of financial reporting in monitoring entrepreneurial actions are explained from basic agency theory.
5 Under which circumstances is voluntary disclosure in private equity firms most valuable?
To answer the research question there will be taken a look in which situation a higher disclosure quality is more beneficial for each party firm, venture capitalist and investors involved.
How bigger the uncertainty and associated risks the more favorable is information to its parties. The advantage is that sharing information and relations maximizes the use of the following instruments which are special for the relation in private equity.
Venture capitalists take a measurement of how cooperative, trustworthy and honestly the management of the firm is (Sahlman, 1990). The venture capitalist works actively with the firm to increase the likelihood of success. They will attract and motivate talented people. Better performing partnerships are more likely to raise follow-up funding.
Voluntary disclosure is executed more when the structure in which the firm operates fulfills certain conditions. More shareholders leads to more information sharing and more voluntary disclosure (Verrecchia, 1990). Likewise by buying and selling parts of the firm there is more attention to information gathering and sharing. If there is an encouragement for
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financial reports, regulatory fillings including statements, footnotes, analysis, voluntary disclosure is executed more. In the case of voluntary provision of data, management has incentives, from both agency and information perspectives to disclosure of data to facilitate investors earning predictions. In a voluntary communication culture, there will be more information about management forecast, analyst presentations, press releases, conference calls, which usually is found on the firm’s internet sites. If the firm wants to show how strong its staging of the commitment is, the firm will give more voluntary disclosure.
Literature shows when there is more disclosure the value of the firm is better (Kaplan, 2005). The risk for the financing is lower and with that the cost or expected reward.
All in all information disclosure helps the company to professionalize and avoids the lemon problem that also could hurt the investing firm on his track record.
Voluntary disclosure helps the management to structure a durable deal between the firm, the venture capitalist and the investors. The contracts share certain characteristics to keep the goals of all parties involved aligned (Sahlman, 1994). By staging the commitment of capital and preserving the option to abandon and by using compensation systems directly linked to value creation, will keep the agency problems in private equity firms under control and their goals aligned. They structure their investments in a way, which provides strong controls and appropriate incentives for managers. This is accomplished by using a convertible preferred investment security with liquidation preference. This means that the venture
capitalist will capture most if not all of the liquidation proceeds if the firm is folded. Also, the entrepreneurial team members will receive common stock or options that vest over time. There is an incentive for growth, common stock or options that vest over time, which aligns the common goals of the firm, venture capitalist and the investors. Investors want to work with an investment company with a longer track record, which has policies for to execute voluntary disclosure, which will increase the valuation of the firm. Voluntary disclosure mitigates information asymmetries and as a results lead to lower risk for the investors.
The combination of the mentioned factors maximizes the knowledge of both the investors and management of the company and out beats the regular way of working. Maximum joint effort delivers maximum outcome, a combination of knowledge, entrepreneurship, relations, trust, contacts and credibility to the market.
On the other hand the company should be careful with spreading information not to make an advantage known by the competition. The role of the accountant together with a risk paragraph signed off by the accountant gives the needed checked transparency.
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External stakeholders rely on the financial accounts being not only loan granting banks but also suppliers, customers, employees, credit rating agencies and even later-round equity investors or acquirers.
Gompers (1999) describes 3 major reasons of the growth in capital commited to venture capital funds over the last decades. The first one was the prudent man rule amendment governing the types of investments allowable for pension funds. This rule permitted pension funds to make significant investment in high-risk assets, and thus opened the possibility for pensions funds to invest in venture capital.Secondly the use of investment advisors by institutional investors became more common, which helped to monitor venture capital funds and advise investors on choosing appropriate venture capital funds in which to invest. These advisors would pool capital from their many clients in order to gain more bargaining power when contracting with the private equity fund managers, which caused the fundraising costs to be much lower.
The final reason is that the organizational innovations provided by the limited partnership structure has allowed for the mitigation of principal-agent problems between investors and entrepeneurs, and proves that this structure works and adds value. The main factors in this are the governance items, namely: The use of experienced equity mangers to solely engage in contracting and monitoring activities. The use of incentives for performance rather than effort to alleviate the information assymetry for both the principal and
entrepreneur. The use of governance obligations, like how much a fund is allowed to invest in a single firm, restricting certain asset classes, the principal monitoring the agent how much effort level is exerted, and using incentives to increase the commitment.
In most cases voluntary disclosure from the entrepreneur is not necessary. This is mainly caused by the fact that the parties in the venture partnerships enter into a contract, which aligns the goals of the entrepreneur, the venture capitalist and the investors. The contracts contain rules about staging the commitment of capital and preserving the option to abandon, use compensation systems directly linked to value creation, and preserve ways to force management to distribute investment proceeds.
The entrepreneur has an incentive to put effort in the firm, because the structure of the contract allows him to benefit if the value of the firm goes up. Agency problems like adverse selection and moral hazard are also not a problem anymore, because the structure of the contract makes that the entrepreneur bears most of the personal risk when the firm does poorly. With the risk-reward sharing scheme of the contract goal conflict is no longer a problem
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Also, the venture capitalist usually has already a mayor influence on the firms operations and a considerable insight in the firms finances, as he serves on the board of the portfolio firm and employs talented people and knows how to motivate them. Therefore, he does not need additional voluntary disclosure about the firm.
Investors with high equity stakes are usually the ones who have the most power in the firm, and therefor also have a considerable insight the firms operations and finances and do not need additional voluntary disclosure about the firm. However, private equity investors with low equity stakes have a higher need for high quality accounting information and voluntary disclosure. These private equity investors with low equity stakes do not have the insight that the mayor players in the firm have and know the danger of unmonitored financial reporting. Therefore, voluntary disclosure is most valuable in firms with private equity investors with low equity stakes and firms that want to attract potential investors. Voluntary disclosure will give a more trustworthy view to outsiders and attract overall more potential investors.
6 Conclusion
There is a large academic literature on the principal–agent problem in financial contracting. This literature focuses on the conflicts of interest between an agent, who is an entrepreneur with a venture that needs financing, and a principal, who is the investor providing the funds for the venture. The empirical studies of venture capitalists indicate that they attempt to mitigate principal agent conflicts in the three ways suggested by theory: through sophisticated contracting, pre-investment screening, and post-investment monitoring and advising.
The evidence also suggests that contracting, screening, and monitoring are closely interrelated. In the screening process, the venture capitalists identify areas where they can add value through monitoring and support. In the contracting stage, the venture capitalists allocate rights in order to facilitate monitoring and minimize the impact of the identified risk factors or make founder cash-flow rights and release of funds contingent on management actions. Also, the allocations of equity to venture capitalists provide incentives to engage in costly support activities that increase the value of the venture, rather than just minimizing potential losses. This paper looked for an answer to the research question what are the advantages and the disadvantages for the private equity backed company, the venture capitalist and the investors involved when a higher disclosure quality requirement is implemented?
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First was taken a look on the need for disclosure and the problems associated with disclosure if information asymmetry exists between two parties, such as the agency problem and the lemons problem. Disclosure is needed because otherwise the other party has more information and is able to take advantage of this information advantage by misleading the other party.
Subsequently the venture capital industry and the role of the venture capitalist, the firm and the investors were explained to create a better understanding of the subject for the reader. And to see how the agency conflict looks like in the private equity firm with the venture capitalist and the investors.
Next was taken a look at the determinants of disclosure quality, what is a good disclosure quality and what is a bad disclosure quality. This was all done to see in which situation a higher disclosure quality more beneficial is for each party involved in the venture capital.
Lastly was looked in which circumstance a higher disclosure quality is preferable for each party involved. Private equity investors with low equity stakes do not have the insight that the mayor players in the firm have and know the danger of unmonitored financial reporting. Therefore, voluntary disclosure is most valuable in firms with private equity investors with low equity stakes and firms that want to attract potential investors.
For further research there could be looked at the additional costs of providing
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