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© Cumming & Johan (2009) Fundraising and Regulation

Fundraising and Regulation

Cumming & Johan (2009, Chapter 7)


Motivation

• 2003 CALPERS disclosure lawsuit

• Public pension funds must disclose venture capital and private equity returns, even on unexited investments

• Implications for understanding determinants of, and reporting of, returns


Chapter Objectives

• Examine institutional investor behavior in response to a dearth of private equity regulations

• Examine role of reporting standards (IFRS, as well as FTK and Basel II) in shaping institutional investor attitudes towards private equity


InstitutionalInvestor 1

Venture Capital Funds

Entrepreneurial Firms

Fundraising Returns

Supply ofInvestments

Demand forInvestments

Intermediation Issues for Fundraising

Different Types:-Pension-Insurance-Bank

And DifferentCountries

PensionPlanMembers(you and I)

Regulated(FTK, IFRS,BASEL II)(helps differenttypes & fromdifferent regions)

ScantlyRegulated(e.g., noreportingstandards)(discouragesinstitutionalinvestors)

Institutional Investor 2


Venture Capital and Private Equity Regulation

• No strict standards for valuing investments in unexited companies

• Recent international developments [indirectly] relevant for private equity investments:

– International Financial Reporting Standards (“IFRS”)(regulation of reporting standards and transparency)

b. Financieel Toetsingkader (“FTK”)(regulation of portfolio management standards such as of matching assets and liabilities)(analogous to Prudent Man Standards Rule for Pension Funds in US (ERISA 1979), which greatly stimulated US PE investment)

c. Basel II(regulation of risk management and disclosure standards)


Research Questions

• Does a lack of transparency in private equity disclosures inhibit institutional investors from investing in private equity?

• Have the IFRS, FTK and Basel II facilitateda. Investment in private equity?

b. International private equity investment?

c. The type of private equity investment (direct company, direct fund, fund or fund)?


Main Findings

• A comparative dearth of regulations, particularly in regards to reporting, inhibits investment in private equity

– This effect is large: if institutional investors were 20% more confident in private equity with better regulations, then they would contribute an extra 1% of their total assets (to 2.44% from a current average of 1.44%) to private equity

• IFRS, FTK and Basel II have partly facilitated institutional investor confidence in private equity, and stimulated international investment in private equity

– This effect is also statistically and economically significant (details to follow…!)


Data

DataEmpirical Tests

Conclusions

Sponsors for hand collecting data:AEI Brookings / Sciences PoAdveq


Data

DataEmpirical Tests

Conclusions

• 100 participating Dutch institutions (approximately 10% of all Dutch institutional investors)

• Extremely detailed data on their allocations to private equity, as well as other asset classes

• Information in regards to their view on a dearth of private equity regulations, and the IFRS, FTK and Basel II


Figure 1. Rank of Important Aspects of the Legal and Regulatory Environment for Private Equity Investment Strategy Among Dutch Institutions that will Invest in Private Equity 2006 - 2010

1.1

2.0

2.2

2.7

2.8

3.4

1 2 3 4 5

Others

Reform of Dutch bankruptcy laws in theperiod from 1997 to 1999

Implementation of Basel II (2004)

The new International FinancialReporting Standards (IFRS) (2005)

Dearth of Legal Restrictions forInvesting in Private Equity

The proposed new "FinancieelToetsingkader" (FTK) in 2006 by the

Pensioen & Verzekeringskamer

Unimportant Important


Figure 2. Perceived Risks and Hurdles Associated with Private Equity Investment Among Dutch Institutions that will Invest in Private Equity 2006 - 2010

1.2

3.1

3.2

3.2

3.3

3.4

3.4

3.5

3.7

3.7

3.7

1 2 3 4 5

Others

Reporting and corporate governance

Effort to convince internal committees (e.g., board of directors)

Long-term commitment

Management time and resource consumption

Legal and contractual issues

Governance (monitoring and managing) costs compared to other assets

Lack of own know-how

Risk of default

Lack of performance transparency

Illiquidity

Unimportant Important


Table 2.Panel A. Characteristics of the Institutional Investors in the Dataset

Type of Financial Institution

Number of Institutions in

the dataset

Average Assets

(millions of

Euros)

Average Targeted

Absolute Rate of Return for

Private Equity Investments (%) (as at 2005) for

institutions that will invest

in private equity ’06-10

Average Targeted Relative Rate of Return

for Private Equity Investments Relative to

Public Equity (basis points) (as at 2005) for

institutions that will invest in private equity

2006-2010

Pension Fund 56€

2,942.86 10.35 286.11

Insurance Company 25€

5,008.00 8.14 287.50

Bank / Financial Services 19€

9,752.63 13.17 440.00

All Types of Institutional Investors 100

€ 4,753.00 10.40 314.81


Panel B. Asset Allocations (Percentage of Assets Invested in Different Asset Classes)

...Current (as at 2005)


Publicly Traded Equities Bonds

Cash / Currencie

sIndex Funds

Private Equity

Other Types of

Alternative Investments

Other

Pension Fund 33.38 50.89 4.32 1.60 1.17 7.43 1.21

Insurance Company 23.80 55.72 9.56 0.48 0.73 6.23 3.48

Bank / Financial Services 27.32 48.43 5.11 0.58 1.36 16.05 1.16

All Types of Institutional Investors 29.83 51.63 5.78 1.13 1.09 8.77 1.77

…Planned (for the period 2006-2010)


Publicly Traded Equities Bonds

Cash / Curren

cies

Index Fund

sPrivate Equity

Other Types of Alternative Investments

Other

Pension Fund 31.51 51.73 2.86 1.97 1.67 9.53 0.73

Insurance Company 24.71 59.02 2.52 2.16 0.62 8.37 2.60

Bank / Financial Services 24.95 47.59 2.68 1.05 1.86 21.34 0.53

All Types of Institutional Investors 28.56 52.77 2.74 1.85 1.44 11.48 1.16


Table 2 (Continued) Panel C. Private Equity Investments

...Current (as at 2005)


Number of Institutions Investing in Private

Equity (All Regions)

Percentage of Private

Equity Investments in The

Netherlands


Equity Investment

s in Europe outside

The Netherland

s


Equity Investments in the

U.S.

Percentage of

Private Equity

Investments in Asia


Equity Investment

s in Rest of World

Percentage of Direct Company

Investments

Percentage of Direct

Fund Investmen

ts

Percentage of Fund of Fund

Investments

Pension Fund 14 23.00 43.43 25.71 4.86 3.00 8.57 41.86 49.57

Insurance Company 7 26.71 49.43 23.86 0.00 0.00 23.57 52.86 23.57

Bank / Financial Services 8 13.38 44.75 28.13 0.63 0.63 36.88 19.00 31.63

All Types of Institutional Investors 29 21.24 45.24 25.93 2.52 1.62 20.00 38.21 38.34

…Planned (for the period 2006-2010)


Number of Institutions Investing in Private

Equity (All Regions)


Equity Investments in The

Netherlands


Equity Investment

s in Europe outside

The Netherland

s


Equity Investments in the

U.S.

Percentage of

Private Equity

Investments in Asia


Equity Investment

s in Rest of World

Percentage of Direct Company

Investments

Percentage of Direct

Fund Investmen

ts

Percentage of Fund of Fund

Investments

Pension Fund 19 13.00 52.42 28.58 3.21 2.79 6.32 36.58 57.11

Insurance Company 8 35.00 40.00 23.75 1.25 0.00 32.25 31.50 36.25

Bank / Financial Services 8 10.63 40.63 35.00 0.63 0.63 31.88 23.13 32.50

All Types of Institutional Investors 35 17.49 46.89 28.94 2.17 1.66 18.09 32.34 46.71


DataEmpirical Tests

Conclusions

Empirical Tests


Comparison of Means and Medians

DataEmpirical Tests

Conclusions

• Greater private equity investment where:

Lower rank on importance of dearth of PE regulations

High rank on importance of IFRS, FTK and Basel II

Higher assets, higher PE return expectations


Table 4. Difference of Means and Medians Tests

Planning on Investing in Private Equity in 2006 - 2010

Not Planning on Investing in Private Equity in 2006 -

2010 Difference of Means

Test

Difference of Medians

TestNumber

of Observati

ons

Mean Median

Number of

Observations

MeanMedia

n

Assets (million Euros) 35 10114 2000 65 1866 500 3.70***p <=

0.000***

Rank of Importance of Dearth of Legal Restrictions

35 2.77 3 65 3.02 3 -1.55p <=

0.014**

FTK (2006) 35 3.40 4 65 2.17 2 5.77***p <=

0.003***

IFRS (2005) 35 2.71 3 65 1.97 2 3.68*** p <= 0.546

Basel II (2004) 35 2.20 2 65 1.25 1 4.58***p <=

0.008***

Expected Return on Private Equity in Excess of Public Equity (Basis Points)

35 252.57 250 65 48.62 50 5.91***p <=

0.000***


Econometric Tests

DataEmpirical Tests

Conclusions

• Logit models of likelihood of PE investment

• OLS models of extent of PE investment (relative to other asset classes)

• OLS models of PE investment in different regions (Netherlands, Europe, US and Asia)

• Various robustness checks


Table 4.6 Panel A

(see chapter for others)

Model (1) Model (2)

For Models (3) – (5), the LHS percentage variable is transformed as ln (Y/(1-Y))

Model (3) Model (4) Model (5)

Logit Probability of PE Allocation in 2006 – 2010

Logit Probability of PE Allocation in 2006 – 2010

OLS of % PE Allocation in 2006 – 2010

OLS of % PE Allocation in 2006 – 2010

OLS of % PE Allocation in 2006 – 2010 for subsample

that was in PE in 2005 and/or will allocate to PE in

2006-2010

Marginal Effect t-statistic

Marginal Effect t-statistic Coefficient t-statistic

Coefficient t-statistic Coefficient t-statistic

Constant -2.468 -3.483*** -0.897 -2.564** -5.914 -11.766*** -5.759 -11.524*** -3.731 -5.594***

Log (Assets) 0.199 3.231*** 0.088 1.794* 0.132 2.414** 0.121 2.442** 0.026 0.409

Log (Excess Expected Return on PE)

0.058 1.732* 0.100 2.806*** 0.029 1.991** 0.022 1.428 -0.020 -0.429

Pension Fund 0.513 2.921*** 0.136 0.992 0.472 2.660*** 0.293 1.306 0.755 3.120***

Insurance Company 0.378 1.281 0.099 0.556 0.065 0.364 -0.057 -0.275 -0.295 -1.061

Degree of Importance of Dearth of Regulations in PE

-0.323 -2.597*** -0.216 -1.787* -0.260 -1.885*

Dearth of Regulations Relative Rank

-0.014 -0.854 -0.019 -0.913

FTK 0.199 2.108** 0.214 2.616*** 0.222 2.257**

FTK Relative Rank 0.059 2.730*** 0.106 5.956***

IFRS 0.046 0.466 0.089 1.109 -0.031 -0.355

Basel II 0.370 2.601*** 0.246 2.587*** 0.152 1.333

Pseudo R2 (Adjusted R2 for Models (3) - (5))

0.605 0.547 0.469 0.471 0.248


DataEmpirical Tests

Conclusions

Conclusions


Comparative Dearth of PE Regulations

DataEmpirical Tests

Conclusions

• A comparative dearth of regulations, particularly in regards to reporting, inhibits investment in private equity

– This effect is large: – 20% more confident in private equity with better regulations,

contribute an extra 1% of their total assets (to 2.44% from a current average of 1.44%) to private equity


IFRS, FTK and Basel II

DataEmpirical Tests

Conclusions

• IFRS, FTK and Basel II have stimulated Private Equity investment

• An increase in rank of importance of these factors by 20% affects:– Investment in PE:

• Increases the probability of private equity investment by 16%• Increases the amount invested by up to 1% of total assets

– International investment in PE:• Increases international PE investment by 0.8% of institutions’ assets

– Mode of PE Investment:• Reduces direct fund investments by up to 0.8% of institutions’ assets• Increases fund-of-fund investments by up to 0.6% of institutions’ assets

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