The relative performance of private equity and venture capital
investments after the 2008 financial crisis: Evidence from
Western Europe
Amsterdam Business School
Name Jill Theuns Student number 10765751
Bachelor Economics & Business Track Finance and Organization Number of ECTS 12
Supervisor Shivesh Changoer
Completion 12/06/2018
Abstract
I investigate the relative performance of private equity and venture capital investments in Western Europe in the period after the financial crisis. I measure the performance of these investments using the Internal Rate of Return (IRR) and the Public Market Equivalent (PME). I find that both private equity and venture capital investments perform less than average returns on the FTSE 100, CAC 40 and DAX indices. Furthermore, I find that when firm size and number of employees increase, the relative performance of private equity deteriorates.
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Statement of originality
This document is written by Student Jill Theuns who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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1. Introduction
The advantages and disadvantages of investing with private equity (PE) is a popular topic. Proponents of this type of investment, point at the higher returns that can be achieved due to higher risk. Critics, on the other hand, argue that this higher risk has a negative effect. PE firms make excessive use of debt
financing which can result in bankruptcy (Boot et al., 2017). Despite these concerns, the PE market increased immensely over the last three decades (Robinson & Sensoy., 2016). However, this growth has not been at the expense of public stock markets (Strömberg, 2008). Considering this, the question arises if PE-backed investments, as alternative source of financing, perform less than public equity investments. In this study, I examine whether private equity and venture capital investments result in a higher return compared to investments in the public market. I assess the performance of PE-backed investments by examining the internal rate of return (IRR). These returns are compared to the performance of three European public indices during the same time period, using the Public Market Equivalent (PME). Subsequently, I test the relative performance of PE in comparison with size and number of employees of the firm, by using a cross-sectional regression approach.
I find that the IRR and PME of both private equity and venture capital investments show a negative result. This indicates that these investments are not profitable in this time period. Therefore, I conclude that PE performs less than the public markets in Western Europe in the period after the financial crisis. Furthermore, I find that size and number of employees are negatively correlated with the relative performance of PE. Hence, the relative performance is less when these variables increase.
My thesis builds on the work of Kaplan and Schoar (2005). They show that PE funds perform less relative to the public market, using IRR and PME. I extend their work by focusing on Europe instead of the U.S., but mainly by focusing on a very recent period. Achleitner et al. (2010) assume that the consequences of the recent financial crisis will result in a persistent decrease in the accessibility of leverage for the PE market. Furthermore, a debate is going on about increasing tax rates on carried interest, which is the compensation a PE firm gets once the investment is realized. Because of this investors could suffer from reduced returns (Field, 2012). Moreover, increased regulation regarding PE investments after the crisis makes this industry currently less attractive (Broby, 2012). I research countries in Western Europe, since these countries become more interesting within the PE industry (Groh et al., 2010).However, I cannot essentially assume these results apply to the U.S. market as well, due to differences in maturity of the market, regulations and liquidity of the leverage market (Achleitner et al., 2010).
This paper is organized as follows. In section 2, I define PE and summarize previous literature and I motivate the hypotheses. In section 3, I describe the method. This section is followed by the data.
4 Thereafter I present my results. Finally, in the last section, I draw the main conclusion and discuss the implications for future research.
2. Literature
2.1 Private Equity explained
Private equity investment is defined as non-publicly traded equity. These investments primarily consist of Venture Capital (VC) and Leveraged Buyouts (LBO). These two types involve different kinds of
companies and investment amounts.
Investing in PE is usually performed through a limited partnership structure. In which the investor, the supplier of capital, serves as the Limited Partner (LP) and the PE firm operates as the General Partner (GP), which manages the capital. LPs typically include institutional investors, such as pension funds, insurance companies and high-net-worth individuals. The LP invests an agreed upon amount (committed capital) in the fund and the GP tries to return the capital invested within a time frame of 10-12 years (Kaplan & Schoar., 2005).
Axelson et al. (2013) show that in times when credit is easy to obtain, PE investors excessively make use of leverage and focus on short-term results. The higher leverage in PE transactions is affiliated with an increase in transaction prices and a decrease in fund returns. This suggests that PE investors contribute to excessive defaults and increase financial distress costs. In contrast, Jensen (1989) argues that PE investors can take a positive position in avoiding defaults. This paper states that PE managers have strong motives to lead their companies efficiently and profitably, to decrease the risk of financial distress. Besides, PE firms hold reserve funds to be able to recapitalize a portfolio in order to moderate distress risk.
Private equity firms have two income streams: management fees and carried interest.
Management fees are typically paid by the investors and are a percentage of the capital that they have committed. Most firms maintain a percentage of 1.5-2.5 (Kaplan and Schoar., 2005). The second compensation, carried interest, is a percentage of the profit of the fund. This is paid out once the
investment is sold. It usually comes down to 20 percent according to Kaplan and Strömberg (2009). The remaining 80 percent of the profit goes back to the LPs.
PE investment can also be executed through venture capitals (VC). Venture capitalists are concerned with investments in young and high-risk entrepreneurial firms, often, small companies or start-ups. These organizations are financed through wealthy individuals and financial institutions. These are outside investors. Investment is made in entrepreneurial ventures that have high potential returns
5 (Hellman and Puri., 2000). However, the novelty of the firm and the expectation of high returns provide high risk too. There are several stages in VC investing. This gives the investors the opportunity to revalue the investment after every stage and to exit when the net present value is not desirable any longer.
Sahlman (1990) discusses these stages. In the first stage, referred to as the seed-stage, a small amount of capital is provided. Besides, it is determined whether an idea is profitable enough for further investment. This is followed by the early stage, in which the investment is used for testing the prototype. Hereafter, stages follow in which the product will be developed and more investment is needed due to rapid expansion. Risk decreases and there is a rapid growth toward the point where profit is made. Agency conflicts diminish too due to the various moments in which new capital is provided. This gives the company a greater stimulation to be careful with the money, without having the opportunity to spend it all at once. In the final stage the company decides how to exit the market. This happens on average after 5-10 years. At this point the VC investor starts making money. One way is through an Initial Public Offering (IPO), in which the company’s stock is offered to the public. Another possibility to exit the market is through a merger or acquisition. In this way liquidity can be in the form of cash, shares in a public company, or short-term debt (Sahlman, 1990). Due to the several stages VCs require, investments across funds is more problematic for VCs, than it is for LBOs (Kaplan and Schoar., 2005).
In a leveraged buyout (LBO), a PE firm acquires a company, financed with debt. The acquiring targets are large and mature companies. Companies, which have predictable cash flows (Barry et al., 1990). The level of debt takes on a high percentage, typically 60 to 90 percent. The remaining percentage is a small amount of equity. When the company is acquired, the LBO has a majority of the voting rights too. This means that high concentrated ownership is involved in LBOs, which does not apply to VCs (Kaplan and Strömberg., 2009). The high level of leverage and concentrated ownership create an
incentive structure that leads to value maximization (Holthausen and Larcker., 1996). The most common way LBOs are financed is through commercial banks. This usually happens in the form of short-term loans (Demiroglu and James, 2007). An advantage of debt finance is the possibility of tax saving that arises when making use of leverage. However disadvantageous, the excessive use of leverage increases the risk of bankruptcy and increases agency costs (Kaplan and Strömberg., 2009).
2.2 Related literature
Due to the considerably growth in PE investment, several academic studies investigated whether PE investments outperform the public equity market. The results are mixed, which can partly be explained by differences in the various datasets, databases and performance measures that are used.
6 Kaplan and Schoar (2005) use a dataset of 746 U.S. PE funds, between the years 1980-2001. The sample consists of 78% VC funds and 22% LBO funds. For the sample firms, they measure the
performance of the funds using the IRR. The PE performance is compared to the performance of the S&P500, using the so-called Public Market Equivalent (PME). They find that the PE funds perform less than the S&P500 because of disappointing outcomes for the PME. Furthermore, they find that VC fund and LBO fund perform more or less the same.
A recent research on PE performance is done by Harris, Jenkinson and Kaplan (2013), whose dataset consists of almost 1400 U.S. PE funds active from the year 1984 until 2008. They find that on average U.S. buyouts outperform the S&P500 by more than 3% per year. Meanwhile VC funds generated excess returns over public equities in the 1990s, but underperformed them in the 2000s.
The most recent study on performance of PE investments is done by Robinson and Sensoy (2016). This paper studies the liquidity of PE cash flows in the period from 1984 till 2010, using a dataset from 837 PE funds. 85% of which are U.S. funds and the remaining 15% are European funds. They used a cross-sectional performance measure on IRR, TVPI and also on the PME. Although in this research the PME evaluates the performance of the PE fund against the Nasdaq index. TVPI is a well-known
performance measure for PE research. Results show that buyout funds have an average IRR of 12%, TVPI of 1.57 and PME of 1.18. This suggests that the average PE fund outperforms the Nasdaq index.
2.3 PE performance during economic up- and downturns
Throughout the existence of PE, there have been several so-called PE waves. The first PE wave began in 1982 and ended in 1989. Mainly the U.S. and Canada took advantage of the first wave. In the years 1985-1989, almost 90 percent of worldwide PE transactions occurred in these countries (Kaplan and
Strömberg., 2009). It took about 10 years to restore for the PE market (Rizzi, 2015)
The second wave took place from 2003-2007, as investors were lured by higher returns that could be generated due to higher risk. By the end of 2007, capital invested in funds exceeded the amount of $240 billion. Moreover, during this second wave U.S. PE firms were twice as profitable compared to the S&P500. However, history repeated, only to a greater extent. Transactions were extremely over-priced due to the immense capitalized deals. Consequently, investors had trouble to invest any longer.
Nevertheless, the PE industry strongly survived the first year of the financial crisis. No major PE-backed breakdowns were counted in 2007. However, transactions declined and by 2009 the PE industry reached rock bottom (Rizzi, 2015).
Taking this into consideration, it can be stated that PE performs excellent during economic upturn, but really poor in times of economic downturn. Furthermore, this proves that it takes a while for
7 the PE market to recover from a crisis. Phalippou and Zollo (2005) acknowledge this. In their research they try to test whether business cycles and stock-market cycles affect PE performance. They show that the performance of PE funds is indeed correlated with returns on the public market. When public stock-market returns are high, PE returns increase as well. Thus, they conclude that returns of PE funds are pro-cyclical.
2.4 Hypotheses
The main purpose is to find an answer if PE-backed investments perform less relative to the public equity market after the financial crisis. This paper distinguishes between private equity and venture capital. The performance of the PE market is tested within 3 countries in Western Europe.
H1: PE-backed investments perform relatively less than investment in the public equity market, in the period after the financial crisis, 2010-2016.
As a consequence of the financial crisis, a debate is going on about increasing tax rates on carried interest (Field, 2012). Carried interest is the compensation a GP gets once the investment is realized, which is reflected in a share of the fund’s profit (Kaplan and Strömberg, 2009). A raise in the tax rate increases the risk a GP takes. It would try to raise management fees, by taking more risk with the funds assets, to compensate for the decreasing profitability. Sequential, investors may suffer reduced returns if taxes increase (Field, 2012).
Likewise, the global financial crisis shapes the future regulation of the fund management industry according to Broby (2012). LPs in Europe had to adapt the Alternative Investment Fund Managers regime, which involved a lot of regulatory obligations. Control on PE funds tightened; European
institutional investors are mandatory to reveal their business plan to the portfolio company and make the information public. Besides, this paper furthermore states that it is more difficult to obtain leverage from banks due to increased capital requirements after the crisis. These reasons make the PE industry less attractive to invest in and therefore I expect PE-backed investments to perform less than investment in the public equity market, in the period after the financial crisis.
8 Secondly, I test how the relative performance of the PE market is linked to Size.
H2: The relative performance of PE is inferior when log Size increases
According to Fama and French (1992) the variable of size can clarify the cross-section of average returns really well. Furthermore, they state that size allows for sensitivity to common risk factors in returns and that size is affiliated with profitability. They conclude that size and average return are negatively
correlated due to the common risk factor. Therefore, I expect the PE performance to be less when log Size increases.
Finally, I test how the relative performance of the PE market is linked to number of employees.
H3: The relative performance of PE is inferior when number of employees increases
Cascio et al. (1997) argue that companies decrease their employment levels in order to perform better. Labor costs should decline when reducing the workforce. This ensures efficiency and results eventually in an increase of the firm’s return. They conclude that decreasing employment is a good manner to improve performance, due to lower labor costs. Therefore, I expect the PE performance to be less when number of employees increases.
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3. Method
For testing my first hypothesis, I calculate the IRR and PME of the private equity and venture capital investments to measure their performance.
PE = the subsample for private equity investments only. These investments involve mature companies and are often leveraged with debt (Groh et al., 2010).
VC = the subsample for venture capital investments only. These investments involve young and small companies in markets with high growth potential (Groh et al., 2010).
IRR = based on actual cash inflows and outflows of the investment in the years 2010-2016, following the study of Kaplan and Schoar (2005).
Calculating the IRR is the most common way to calculate the return on PE investments. IRR is defined as the discount rate, which makes the Net Present Value (NPV) of a series of cash flows equal to zero according to Phalippou et al. (2008).
There are two limitations when calculating the IRR. The calculation can result in multiple IRRs or can be nonexistent (Berk and DeMarzo, 2011). As most of the cash flows in the dataset were negative, indicating losses or reinvestments, mathematical iteration of the IRR was not possible. As an alternative the IRR was calculated based on the assumption that 2010 is the base year for investments. The
cumulative return each year, from 2011 onwards, is accumulated for each year passing and is then divided by the initial amount to determine the growth factor on the initial investment. This growth factor includes cash inflows and cash outflows. For example, the data for 2011 is divided by the initial investment to determine the factor. For 2016 the accumulated cash flows were divided by the seed and then factored for the 5 years of possible returns, leading to an IRR.
Most studies do not show a calculation for IRR, because they use a database that provides the IRR already or they just do not mention it.
PME = calculated by discounting the actual cash inflows and outflows with the returns in the public markets over the same time period, following the study of Kaplan and Schoar (2005). The benchmarks I use to discount the investments are the returns on the FTSE 100, CAC 40, and DAX indices.
The PME is a performance measure of PE, which compares PE investments to an investment in the public market in the same time period (Harris et al., 2014). In essence, PME calculates the amount of euros needed to invest in one of the public indices to generate a one euro return on an investment in PE. So, it basically divides the IRR of a PE investment by the return you would get on a public investment in the
10 same time period. A PME less than one shows that PE relatively performs less than the public market and vice versa (Ick, 2005). A PME of 0.80, for example, suggests that, investors ended up with 20% less compared to what they would have had if they invested in the public market (Harris et al., 2014).
However, I do not adjust for differences in systematic risk for both performance measures. Due to the illiquidity of PE funds and reporting the performance of it, it is inconvenient to estimate the market risk of a PE investment (Kaplan and Schoar., 2005). Therefore my results can be different than the results of previous studies.
Furthermore, I use two multiple regression analyses to test my second and third hypotheses, in which I link the relative performance of PE to log Size and number of employees.
IRR =
β
0+β
1Market Return +β
2log(Size) +β
3log(DealValue) +β
4NumberOfEmployees +ε
iPME =
β
0+β
1log(Size) +β
2log(DealValue) +β
3NumberOfEmployees +ε
iWhere IRR measures the absolute performance and PME measures the relative performance of PE.
Market Return = the average return of three indices, FTSE 100, CAC40 and DAX, over a time period from 01/01/2010 to 31/12/2016.
Log (Size) = total assets of each company, in the years 2010-2016.
Log (Deal Value) = value of new investments made per year from 2010 to 2016. This gives an insight in the entry and exit of capital into the PE market.
Number Of Employees = used as proxy for firm size. The study of Peschel et al. (2014) argues that number of employees as a proxy for firm size is interesting relative to other size variables such as total assets.
Finally I should mention that fixed year effects are included in the regression analyses. They are taking into account in such a way that 2010 is the base year and the cumulative return each year is calculated from 2011 onwards. Therefore these years are not included in the table. This follows the study of Kaplan and Schoar (2005), which takes fixed year effects in account to control for variation between years in the
11 returns. Company fixed effects are included as well. The company fixed effects indicates that the
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4. Dataset
The sample of PE-backed investments is obtained from the Zephyr database of Bureau van Dijk. Zephyr is a database with information on worldwide financial transactions, regarding PE deals (Engel and Stiebale, 2014). Information about the size, deal value and number of employees used in my regression analyses is gathered from the Orbis database of Bureau van Dijk. This database comprises the
unconsolidated accounts of firms worldwide. Observations from both databases can be merged due to the Bureau van Dijk firm identifier.
The criteria selection in Zephyr is as follows:
1. Private Equity and Venture capital deals in the period from 01/01/2010 to 31/12/2016, thus after the financial crisis.
2. Acquiring company is located in Western Europe.
3. Only completed deals are taken into account (no rumored or announced deals)
The first criteria I explained in the hypotheses and method section.
Regarding the second criteria; limited partners, the suppliers of capital to the PE firm, allocate their capital among specific countries. Motivation to choose for certain a country is that there exists a professional community to support PE transactions and second that there is demand for the committed capital in this country. The U.S. market satisfies these reasons for over the existence of the PE industry. However, due to an increase in protection of the LPs and the size and liquidity of the capital market, Western Europe becomes more attractive within this industry (Groh et al., 2010). This paper concludes that countries in Western Europe met these requirements just before the crisis, which leads to an increase in the attractiveness for LPs to invest in these countries. Therefore I find it interesting to look at this relatively new area within the PE industry. Finally, only competed deals are included to account for reliability (Demiroglu and James, 2007).
The performance data of the public stock indices is obtained from Datastream. This data covers the average returns of three indices, FTSE 100, CAC40 and DAX, over a time period from 01/01/2010 to 31/12/2016. FTSE 100 is included, following the study of Kanas (1998) and Nikoskelainen and Wright (2007). The CAC 40 index is included, following the study of Sahut and Mnejja. (2011). Finally, the DAX index is included, following the study of Ick (2005). Specifically these indices are used because my data selection includes the United Kingdom, France and Germany.1 With these countries being the three
major European markets (Antoniou et al., 2006). Moreover, PE transactions within Western Europe are largely concentrated in these three countries (Acharya et al., 2007). I study the average of the indices
1
13 together, because I am not interested in which country performs better. Besides, these indices are
relatively small when taken separately.
The initial sample consisted of 2975 observations, however due to a lack of available data for a large part of the companies only 525 observations remained for the IRR regression. The PME regression counts 559 observations. The higher amount for the latter is due to the absence of the coefficient of Market Return in this regression. Apparently values are missing when the Market Return is paired to IRR.
Table 1: Descriptive statistics
Variables N Mean SD Median Min Max
Year 2,975 2,009 3.146 2,008 2,006 2,016
Country 2,975 2.501 0.689 3.000 1.000 3.000
Number of Employees
1,450 680.8 5,342 19.000 1.000 97,535
Log (Deal Value) 892 38,034 98,071 0.000 0.000 709,555
IRR 731 -0.483 0.979 -0.892 -0.998 5.848 Log (Size) 1,929 9.687 2.784 9.364 -6.228 20.281 PE 2,975 0.620 0.486 1.000 0.000 1.000 VC 2,975 0.114 0.318 0.000 0.000 1.000 PME 783 -0.571 21.421 -3.205 -36.976 324.8 Market Return 955 0.174 0.163 0.174 -0.197 0.927
See Appendix 1 for a description of the variables
Table 1 presents the number of observations, mean, standard deviation, minimum and maximum outcomes for selected variables for the sample of PE investments in the years 2010-2016. This table shows the data of Year, Country, PE, and VC is complete. I make subsamples in my regression analysis for both types (PE and VC) of investment. Eventually I exclude investments that have missing data on cash flows. As table 1 shows there is missing data regarding Number of Employees, Deal Value and Size as well.
The negative mean for IRR implies losses on the investment. This is due to many negative and unavailable cash flows. The same applies to the negative PME, since this is calculated on the basis of IRR. In conclusion, the investments in this period are not profitable. Moreover, the public market performed not that good either, given the low mean (0.174) for Market Return.
14 Finally, I should mention that the data for number of employees, log size, log deal value, IRR, PME and market return is trimmed throughout this research; this eliminates outliers for the top and bottom 1%. Furthermore, the variables of size and deal value are logged.
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5. Results
This section presents the results of my tests. First, I present the results of my first hypothesis. Then, I provide a univariate analysis. Furthermore, I prove that there is no disruptive correlation between the variables by presenting the test on multicollinearity. Finally, I provide an interpretation of the output of my regression analyses. This final part includes the results on my second and third hypotheses.
Table 2: PE and VC performance
Table 2 presents 3 cells for the IRR. The first cell is the average return, the second the standard deviation, the third the distribution of returns on the 25th and 75th percentiles. Furthermore, the fourth cell reports the average PME. The first
panel of the table reports private equity performance and the second panel venture capital performance. The IRR is calculated based on actual cash inflows and outflows of the investment in the years 2010-2016. The PME is calculated by discounting the actual cash inflows and outflows with the returns on the public indices (FTSE 100, DAX and CAC 40) over the same time period
Sample Private Equity Venture Capital
IRR -0.510 -0.792
(0.910) (1.312)
[-0.983;0.186] [-0.985;0.351]
PME -0.050 -0.078
N 382 56
See Appendix 1 for a description of the variables
Table 2 provides the two performance measures for both private equity-backed investments. The negative results of the average IRR show that the PE investment is not profitable. Although a negative IRR is a bit strange, it is possible because the returns are measured in an isolated way. It basically means that the sum of the cash flows is less than the initial investment. As most of the cash flows are negative, IRR is negative. Table 2 shows furthermore that venture capital performs worse than private equity, because of the lower average IRR.
Moreover, this table provides the PME measure. The PME is calculated by dividing the IRR by the average rate of risk free return for each year for each of the markets in the sample. These risk free returns are based on the average long-term interest rates for the FTSE 100, DAX and CAC 40. A PME less than 1 proves that the PE market performs inferior relative to the public market. Table 2 suggests that both investment types relatively perform less than the public market based on PME, which confirms my first hypothesis. Though private equity performs better than venture capital. Finally, the returns on the 25th and 75th percentile show that there are large differences in returns of investments.
Yet, I acknowledge, that the average return results are potentially biased, as I do not control for differences in risk.
16 5.1 Univariate Analysis & Test on Multicollinearity
Table 3: Univariate Analysis
Table 3 presents the correlations between the variables used in the regression analyses. The correlations are pairwise computed.
IRR PME Market
Return
Size Deal Value Number of Employees
IRR 1
PME 0.520* 1
Market Return -0.019 -0.025 1
Log (Size) 0.381 0.192* 0.073* 1
Log (Deal Value) -0.078 -0.063 -0.007 0.118 1 Number of
Employees 0.171* 0.225* 0.074 0.228* 0.013 1
See Appendix 1 for a description of the variables
Deal value is negatively correlated with the IRR, this makes sense because the majority of the cash flows turned out to be negative and therefore it will not be profitable to invest again. IRR and PME are
moderately correlated, with a significant correlation of 0.520. A moderate correlation suggests that my calculations regarding IRR and PME can indicate the actual performance of the investments to a certain extent. Finally, IRR and Market Return move in an opposite position.
Table 4: Multicollinearity test
Table 4 presents the test on multicollinearity. The ‘VIF’ command in Stata is used to check for multicollinearity. Variables with a VIF value that exceeds the amount of 10 require further research. The command 1/VIF is used to check on tolerance. This value should not be lower than 0.1.
Variable VIF 1/VIF
Log (Size) 4.691 0.213
Number of Employees 4.234 0.236
Log (Deal Value) 2.522 0.398
Market Return 1.401 0.714
Mean VIF 3.211
See Appendix 1 for a description of the variables
The VIF command is used, following the study of Mehmood and Mustafa (2014). In conclusion, table 4 shows that there exists no disruptive multicollinearity between the variables.
17 5.2 Output Regression Analyses
Table 5: Absolute performance: IRR (Internal Rate of Return)
The dependent variable is the absolute performance measure IRR. The IRR is calculated based on actual cash inflows and outflows of the investment in the years 2010-2016. The first panel presents the results of the full sample. The second panel presents the results of the full sample including fixed effects. The third panel presents the results of the sample with private equity investments only. The fourth panel presents the results of the sample with venture capital investments only.
Full Sample Full Sample PE only VC only
Market Return -0.586*** -0.580* -0.151 -0.367
(0.163) (0.319) (0.231) (0.900)
Log (Size) -0.052 -0.054 -0.081** -0.558***
(0.044) (0.043) (0.034) (0.137)
Log (Deal Value) -0.004 -0.004 -0.006*** -0.003
(0.004) (0.004) (0.002) (0.002) Number Of Employees -0.0002 -0.0002 -0.0003 0.0008 (0.0002) (0.0002) (0.0003) (0.0009) Constant 0.133 0.226 0.635* 5.570*** (0.457) (0.463) (0.359) (1.388) Observations 525 525 382 56 R-squared 0.066 0.081 0.215 0.438 Number of id 156 156 109 18
Company FE NO YES YES YES
Year FE NO YES YES YES
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
See Appendix 1 for a description of the variables
Table 5 shows the absolute performance of PE-backed investment. The dependent variable is the Internal Rate of Return (IRR) of these investments. Standard errors are corrected for heteroskedasticity. I make subsamples for PE only investments and VC only investments.
Log deal value and number of employees seem to have little influence on the IRR, since all coefficients are practically zero. Nevertheless, the coefficients of number of employees are completely insignificant. The coefficients on log Size regarding both investment types are negatively significant. IRR declines when total assets increase, only to a larger extent than deal value. This is in line with the
predictions made in de study of Rizzi (2015). This study predicts that returns of the PE market are less, relative to the public market, due to the crisis. The burst of the PE bubble will be essential on the amount of transactions. Besides, it predicts the PE industry to minify. PE companies with large portfolios will experience problems with raising new funds. Moreover, Kaplan and Schoar (2005) state that performance declines when funds become very large. Furthermore, I conclude that the R-squared increases when fixed effects are included.
18 Finally, the IRR and the Market Return are negatively correlated, which means that the IRR of PE investment decreases when Market Return increases. This is not in line with the pro-cyclical appearance of the PE market according to Kaplan and Strömberg (2009) and Phalippou and Zollo (2005). However, this contributes to the inferior performance of the PE market relative to the public market. This table shows furthermore that the IRR of PE investments decreases less with regard to the Market Return compared to VC, as -0.151 > -0.367, which is in line with the results of table 2.
Table 6: Relative performance: PME (Public Market Equivalent)
The dependent variable is the relative performance measure PME. PME is calculated by discounting the actual cash inflows and outflows with the returns on the public indices (FTSE 100, DAX and CAC 40) over the same time period The first panel presents the results of the full sample. The second panel presents the results of the full sample including fixed effects. The third panel presents the results of the sample with private equity investments only. The fourth panel presents the results of the sample with venture capital investments only.
Full sample Full sample PE only VC only
Log (Size) -1.485 -1.451 -1.589 -1.678**
(1.230) (1.215) (1.314) (3.730)
Log (Deal Value) -0.006 -0.003 -0.005 -0.006
(0.004) (0.004) (0.006) (0.005) Number of Employees -0.001 -0.002 -0.012 0.019 (0.003) (0.003) (0.010) (0.024) Constant 14.981 9.867 16.482 5.119*** (12.493) (13.471) (13.823) (37.741) Observations 559 559 403 58 R-squared 0.008 0.036 0.033 0.557 Number of id 165 165 115 19
Company FE NO YES YES YES
Year FE NO YES YES YES
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
See Appendix 1 for a description of the variables
Table 6 shows the relative performance of PE-backed investment. The dependent variable is the Public Market Equivalent (PME) of these investments. Standard errors are corrected for heteroskedasticity. I make subsamples for PE only investments and VC only investments.
From this regression I conclude that the relative performance of PE is less when log Size increases, which confirms my second hypothesis. This is in line with the statement of Fama and French (1993) that size and average return are negatively correlated due to a common risk factor. Furthermore, I conclude that the relative performance of PE is less when number of employees increases, which confirms
19 my third hypothesis. However, to a much lesser extent compared to log Size. This is consistent with the research of Cascio et al. (1997). They state that an increase in number of employees indicates a worse relative performance of PE, due to higher labor costs. Finally, I state again that the R-squared increases when fixed effects are included.
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6. Conclusion
This paper analyzed the performance of private equity and venture capital investments compared to investments in the public market in the period after the financial crisis, 2010-2016. Performance is tested using IRR and PME. For the calculation of IRR and PME the study of Kaplan and Schoar (2005) was implemented.
A negative outcome for the IRR implies that private equity-backed investments were not
profitable in this time period. Hence, PE performs relatively less than the public market after the financial crisis, concluded from the negative result of the PME. Furthermore, the relative performance of PE is negatively correlated with log Size and number of employees.
A couple limitations for this research should be mentioned. Firstly, the relative performance is measured and therefore risk is not taken into account, because of this the results could be biased. Besides, not all results are statistically significant. An explanation for this could be the lack of available data. Zephyr is a proper database to use when testing the performance of PE-backed companies, however it does not provide optimal output. Unlike public companies, private companies are not required to exempt their financial information. Thus, there exists a lack of data in this database. Moreover, the Orbis database suffers from this problem too. Information regarding, mainly, cash flows was not available for a lot of companies.
This research focuses solely on the U.K., Germany and France. Including more countries in Western Europe with a high PE investment ratio could be interesting. Besides, only completed deals are included in the sample. Rumored and announced deals might be interesting to include as well, since the share prices of these deals may be influenced. Furthermore, it cannot be assumed that the results I find also apply to the U.S. market. Thus, a comparison of returns between the European and U.S. market after the financial crisis is of interest for further research. Finally, it might be interesting to start the research a longer period after the financial crisis to get different results, since it takes a while for the PE market to recover.
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Appendix
Appendix 1: Variable definitions
Variables Definition
Year This variable is included in the descriptive statistics table to correct for fixed year effects
Number of Employees
Number of employees in the company for each year
Log Deal Value Value of new investments made in each year. I use the natural logarithm of the average of the variable
IRR Internal Rate of Return. The IRR is calculated based on actual cash inflows and outflows of the investment in the years 2010-2016
Log Size Total assets in the company for each year. I use the natural logarithm of the average of the variable
PE Private Equity investments
VC Venture Capital investments
Country Acquirer company location, either U.K., France or Germany
PME Public Market Equivalent. PME is calculated by discounting the actual cash inflows and outflows with the returns on the public indices (FTSE 100, DAX and CAC 40) over the same time period
Appendix 2: sample characteristics
Sample characteristics
Number of initial observations
Number of actual observations in the period 2010-2016 for IRR Number of actual observations in the period 2010-2016 for PME Number of observations in the U.K.
Number of observations in France Number of observations in Germany
2975 525 559 382 26 117
