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While private equity (PE) firms have seen considerable growth in the last two decades, academic inquiry into the mechanics of the industry has largely focused on outcomes, rather than the practices of fund managers.
Three academic researchers recently helped narrow this disparity. They conducted a two-year anonymous survey that was completed by 79 PE firms with $750 billion in assets under management. Paul Gompers (Harvard Business School), Steven Kaplan (University of Chicago), and Vladimir Mukharlyamov (Harvard University) asked PE investors questions about how they approach company valuation, governance, capital structure and value creation.
The results of the survey, published in April 2015, provide some compelling insights into how perception and reality don't always align in the case of PE management. The survey also offers a rare window into the day-to-day workings of PE firms.
Let's examine some of the more intriguing elements of the data.
What Drives Deal Selection?
Survey respondents said the most important factors in choosing an investment are the business model and the competitive position of the company. Next in terms of importance are the management team, the investor's ability to add value, and the valuation.
Far less important, are the industry or market of the company and the fit within the investor's fund.
Where Do Deals Originate?
Finding deals that are proprietary in some regard is a key determinant of value creation, according to those surveyed. Investors say 36 percent of closed deals are self-generated, 7.4 percent derive from management and 8.6 percent originate from the executive network. Such deals have the potential to become proprietary. In contrast, 33 percent are investment banking-generated, 8.6 percent come from deal brokers and 4.3 percent come from other PE firms. These are unlikely to be proprietary.
Smaller and younger PE firms tend to source more proprietary deals, though this is often linked to target deal size. Firms investing in large and mega deals are less likely to generate proprietary deals as their targets are more often sold via auction.
What is the Preferred Board of Director Size?
Among the PE investors who responded, 90 percent prefer a small board of directors with five-to-seven members. Larger PE firms typically have portfolio companies featuring larger boards. Generally, investors will claim three board seats, with up to two going to management and one or two going to an outside source with no firm affiliation.
Additionally, and perhaps unsurprisingly, the median PE investor claims to be actively involved in all deals.
Which Benchmark Is Most Important for Limited Partners?
In something of a surprise, two-thirds of investors reported that an absolute measure of performance, such as net IRR, is the primary benchmark. Performance relative to public markets is viewed as the most important benchmark in a mere eight percent of cases. Because relative performance is so prominent with regard to mutual funds and hedge funds, it's somewhat surprising to see it rank so low in this context. With regard to performance relative to other PE investors, 27 percent regard this as the most important benchmark.
What About Management Incentives?
Private equity investors allocate, on average, about 17 percent of company equity to employees and management, while the CEO receives an average of eight percent. For larger PE investors who invest in bigger firms, these percentages are somewhat lower. These numbers are significantly higher than equity ownership percentages enjoyed by senior management in public companies.
Though the survey is anonymous, the researchers admit the possibility exists that some of the respondents may not have been entirely truthful. They say there is some incentive to be less than candid in areas such as deal sourcing and growth. However, the three researchers say that patterns in the collected data give them no reason to suspect significant untruthfulness.
Given the relative lack of research into what private equity firms do and how their managers’ think, this survey offers an intriguing peek behind the curtain -- a rare glimpse at the practices and motivations that shape the industry.
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