the information deficiency problem of private equity fund-of

UNIVERSITY OF BIRMINGHAM

MBA IN INTERNATIONAL BANKING AND FINANCE 2001/2002

A dissertation/thesis submitted in part fulfilment of the requirements of the degree of Master of Business Administration in International Banking and

Finance

The Information Deficiency Problem of Private Equity Fund-of-Funds: A Risk and Monitoring Management Perspective

Student:

Gregor Diem, ID 459139

Supervisor:

Kean Ow-Yong

Department of Accounting and Finance

Word count: 12040 words


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Acknowledgements

I am grateful to my supervisor, Kean Ow-Yong, who provided a great deal of help in crystallising my ideas and keeping me encouraged. Special thanks to Thomas Meyer from the European Investment Fund who not only suggested the idea of studying the Information Deficiency in Private Equity but also supported me in every way. I am especially thankful to the contacts whom Mr Meyer could provide me with and to his helpful conversations, hints and encouragement. I seem to have spent a good deal of time on the telephone or on e-mail trying to find interviewees. I have to thank the various people who were willing to participate in this research and I am very grateful that these people gave me a chance.


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Abstract Risk and monitoring management of Private Equity investments has become increasingly important due to the malaise of the equity markets and the perception of Private Equity as an attractive investment alternative by institutional investors. This dissertation starts with a consideration of the theoretical background to the information deficiency problem and the particularities of Private Equity investments within a literature review. The empirical part of the study is based on 14 semi-structured interviews covering risk and monitoring management peculiar to Private Equity: Initially the present state of Private Equity monitoring management from of a Fund-of Funds perspective is explored. This is followed by a discussion of the monitoring requirements of these investment vehicles. Finally potential improvements, especially regarding Information Technology and Electronic Data Interchange as sources of potential improvement are discussed. The conclusion puts forward some recommendations to advance the maturity of the asset class by means of improved automation and the establishment of common standards within the industry, which presupposes improved intra- industry co-operation.


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Content

1 Introduction .....................................................................................................................6

1.1 Definition of PE Specifics and Delimitation to other Asset Classes ...............................8

1.2 Definition of Information Deficiency ..........................................................................9

1.3 Presentation of the Information Deficiency Problem in the PE Industry....................... 10

2 Literature Review and Theoretical Framework ................................................................. 13

2.1 Data Availability and Opacity of this Asset Class....................................................... 13

2.2 The (Double) Agency Problem and Asymmetric Information...................................... 15

2.2.1 Transaction Cost ............................................................................................... 15

2.2.2 Adverse Selection ............................................................................................. 16

2.2.3 Moral Hazard.................................................................................................... 17

3 Assumptions, Research Method and Research Evaluation ................................................. 19

3.1 Assumptions ............................................................................................................ 19

3.2 Research Method ..................................................................................................... 20

3.2.1 Research Design ............................................................................................... 20

3.2.2 Conceptual Framework: Qualitative Method and Semi-Structured Interviews ....... 21

3.2.3 Data Collection and Studied Interviewees........................................................... 22

3.3 Research Evaluation................................................................................................. 23

4 Empirical Findings / Data Analysis .................................................................................. 25

4.1 Status Quo............................................................................................................... 25

4.1.1 Monitoring Policies and Process......................................................................... 25

4.1.2 Monitoring Factors............................................................................................ 29

4.1.3 Interaction between LP and GP and Standards .................................................... 30


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4.2 Requirements .......................................................................................................... 32

4.2.1 Reporting ......................................................................................................... 32

4.2.2 Monitoring Factors............................................................................................ 34


4.3 Improvements.......................................................................................................... 39

4.3.1 Monitoring Policies and Process......................................................................... 39

4.3.2 Monitoring Factors and Particularities of the PE industry..................................... 42


4.3.4 Introduction of Potential Improvements and Automated Reporting....................... 45

5 Conclusions and Recommendations ................................................................................. 49

Bibliography ..................................................................................................................... 53

Appendix .......................................................................................................................... 58


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1 Introduction

Private Equity (PE) as an asset class has experienced a dramatic growth over the last

20 years throughout the world and is now broadly accepted as established asset class

(Bance 2002). In the US, PE funds investment grew from $5 billion in 1980 to $175

billion in 1999 (Lerner 2000b). In Europe €121.7 billion was raised from 1996 to 2000

alone (Bance 2002). Investing into PE offers the investor the chance to generate higher

absolute returns and at the same time improve the diversification of his portfolio (Bance

2002). It is expected that PE will continue to out-perform public equity benchmarks by

3% to 5 % (Maxwell 2002)1. However, notwithstanding the extraordinary development

in the PE industry, disquiet has shown itself about declining returns, unknown

performance and obscure fee structures. A recent study of AltAsset, a specialist UK PE

research and publishing group, has revealed in a PE study that two-thirds of

respondents consider the lack of transparency - in particular the lack of standardised

and comparable data - to be the biggest obstacle to investing in PE (Campbell 2002).

Fund-of-funds investments 2 , however, seem to be an attractive alternative to

participating in PE without the concern of diversification and the need to have specific

PE knowledge for selecting, managing and monitoring the investment. In 2001, fund-

of- funds, which accounted for 12% of the total, continued to be a major contributor to

PE fundraising (EVCA 2002b). During the last decade, Fund-of-Funds investing

experienced the highest growth of all PE capital sources (Lerner and Hardymon 2002)

and it seems that this trend is continuing. This development is also the reason why this

research adopts a Fund-of-Funds perspective 3 . Recently a paradoxical situation has

arisen in which criticism (i.e. the transparency) of PE as an asset class among

institut ional investors is growing although the proportion of investments made in this

asset class is significantly increasing (Tassel 2002).

1 Please refer to Appendix Figures 1 and 2. 2 Private Equity funds whose principal activity consists of investing in other Private Equity and Venture Capital funds. 3 To my knowledge there is no academic study which specifically addresses specifically Fund-of-Funds investing. Some PE information providers such as AssetAlternatives and Venture Economics, however, cover the development of fund-of fund investing in special publications.


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The emphasis on personal relationships in this industry is a predicament for large PE

players since with the increase in the number of engagements, risk and monitoring

management is becoming more and more difficult to handle without an advanced

information management system. Thus, large PE players, in particular on the Limited

Partner (LP) side, require an improved transparency and structures to make the

numerous investments in various PE funds (the General Partner, GP) manageable. It is

important to note that there are three aspects which need to be distinguished: one is

methodological, which is concerned with the semantics of PE monitoring management,

i.e. information management in terms of content, frequency, granularity, quality etc.;

the second aspect is technical, which considers aspects of the use of data exchange

formats, platforms and applications. These two, however, cannot be seen completely

independently of each other, since the methodological aspect determines the

requirements of the technical aspects, i.e. the degree of granularity, for instance, will to

some degree determine technical aspects; the third dimension which needs to be

considered reflects the attitudes of the players in the industry, which comes back to the

opaqueness and the agency problem in this asset class: improving the management of

qualitative and quantitative monitoring in this asset class implies that the distribution of

investment returns and associated risk will move closer to the asset class average.

Thus the main objective of this study is to determine the driving forces, attitudes and

requirements of the players in the market place concerning improved reporting by

means of improved monitoring standards and the use of Information Technology (IT),

including industry-wide Electronic Data Interchange (EDI): Firstly, it aims to highlight

the information deficiency problem in this asset class, addressing data availability and

the agency problems produced by asymmetric information. Secondly, it aims to

determine the current status of monitoring, explore common requirements and to derive

the potential characteristics of an improved monitoring management.

This research is structured as follows: in the introduction and the literature review

information is provided to create a theoretical framework for the information deficiency

problem. The empirical part of this research which is derived from 14 semi-structured

interviews is based on this knowledge and has three major sections: in section one the


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status quo regarding the monitoring of the industry is presented; section two looks into

the requirements of the interviewees in order to bring out common needs and

requirements for potential automated reporting; and section three presents possible

approaches and limitations concerning the introduction of a potential standard and

automated reporting in this asset class.

1.1 Definition of PE Specifics and Delimitation to other Asset Classes

PE is considered as a form of alternative investment including buyout/in investing,

mezzanine debt/equity investing, venture capital and finally special situation investing4.

Very broadly speaking, PE can be defined as “investing in securities through a

negotiated process” (Bance 2002), which emphasises the non-standardisation of the

investment process5. Thus, PE refers to a wide range of alternative investments when

capital is made available to companies or investors but not publicly available by means

of a stock market quotation; so far, the average individual investor has not generally

had access to PE because it requires a very large investment.

The characteristic of PE is in some aspects quite different from other asset classes

(Erturk, Cheung and Fong 2001). Firstly the investment horizon is long-term orientated

(normally 10 years) and investments cannot be revoked during this time, i.e. PE

investments are illiquid. Thus the investment style is limited to a buy and hold strategy.

Investments are normally made by the determination of a committed sum, which

consequently will be requested or drawn down at a later stage on a deal-by-deal basis.

Furthermore risk and return characteristics are quite different from ordinary capital

market investments. Due to the unavailability of standardised and public available

information, traditional risk measures such as volatility or correlations are not easy to

obtain and thus it is difficult to objectify the quality of an investment. Additionally, PE

investments show a J-Curve return characteristic due to negative cash flows during the

4 Please refer to Appendix Figure 3. 5 The term Private Equity might be misleading, since it tempts one to think merely in accounting terms, i.e. funds contributed by stockholders through direct payment. This assumption may be wrong since “...private equity is not an ideal term, and can cause some confusion. Using the word “equity” suggests it excludes the very important role that providers of debt and other forms of “non-equity” finance play” (Temple 1999, 5).


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first years of fund initiation (i.e. a negative return in the first years is over-

proportionally made up in subsequent years) and the at-cost approach of reporting,

which emphasises the long-term perspective of this asset class6.

For this research, definitions of the European Venture Capital Association (EVCA)

are used7. Institutional investors typically focus on the organized PE market, in which

professional management is provided by intermediaries, as opposed to “angel capital”

or the informal PE market where funds are provided by private persons (Fenn, Liang

and Prowse 1995). This research paper focuses on the formal PE market.

1.2 Definition of Information Deficiency

Investors can choose among various asset classes, each of which has its specific

characteristic concerning, for example, risk, liquidity and potential return. In order to

optimize the utility for the investor, an optimal asset mix for the investor must be

identified. As shown, PE investments have some unique characteristics which clearly

differentiate this asset class from other asset classes. The evident differences, however,

imply that the decision-making process needs also to be different from orthodox

investment appraisals 8.

6 Please refer to Appendix Figure 4. 7 EVCA defines Private Equity as the equity capital of enterprises which is not quoted on a stock market and is used for the following purposes: to develop new products and technologies; to expand working capital; to make acquisitions; or to strengthen a company’s balance sheet; resolve ownership and management issues; for succession in family-owned companies; or for the buyout and buying of a business by experienced managers. This definition includes venture capital, which is used to finance high-risk and potentially high-reward projects of start-up and growth firms which require substantial capital and are unlikely to receive bank loans or other debt financing (Lerner 2000a). Thus Venture Capital can be seen as a subset of Private Equity, which is limited to investing in companies which have undeveloped or developing products or revenues with a particular emphasis on entrepreneurial undertaking in less mature businesses, i.e. equity investments made for the launch, early development, or expansion of a business (EVCA Glossary). It can be described as the “business building of businesses” (Bance 2002). 8 Orthodox investment decisions such as investments in stock exchange listed equity or bonds can be reduced to two dimensions, namely risk and return, since there are well developed mechanisms for residual investment decision variables. For the most popular exchange traded investments, insufficient liquidity does not expose the investor to risk since established mechanisms such as the market maker reduce the illiquidity risk. In addition, the stock exchange listing of an asset reduces the transaction costs if the investor concludes that he or she has to change the investment constituency to remain optimally invested. Next, for every investment decision information is needed about the investments for appraisal. Stock-listings do not only reduce liquidity risk and transaction cost but also provide various frameworks


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Relevant information can be defined as information which is able to influence an

economic decision likely to be made by the user of that information. To be relevant,

information must have the qualitative characteristics of timeliness and must either have

predictive value or act as confirmation or correction of earlier expectations

(www.xrefer.com, 30/06/02). Information deficiency therefore can be defined as

informational uncertainty and informational asymmetries which arise for investors in

respect to the assessment of the investment . The uncertainty aspect refers to the

potential existence of information which is not foreseeable (i.e. its state of outcome is

unknown) and therefore not included in the investment decision9. The informational

asymmetry aspect, which is different from the uncertainty aspect, refers to a situation

where one party (here the entrepreneur or the GP) has more information than the

investor and thus prevent the investor from allocating the funds most efficiently; hence,

information asymmetries can disrupt the PE market10.

1.3 Presentation of the Information Deficiency Problem in the PE Industry

Since the start-up investments cannot be realized in the form of IPOs and returns in

two- to three-digit value increases, investors have expressed their discontent about the

transparency of the asset class and its opaque return and performance measurement to a

high degree (Tassel 2002). Currently a few in the industry conceive that the evolution

of this industry - in particular if a wider range of investors is thought to be addressed –

can only take place if investing prerequisites in terms of transparency and investor

protection are comparable with those in other existing asset classes. In practitioners’

journals, discussions about the missing standards highlight the deficiency in the

reporting of this asset class: “IRR are inconsistent and misleading. Since IRRs are

based on valuations of privately held companies, two funds can calculate different

valuations - and different IRRs – for the same investment. A cash- in and cash-out

for the respective asset class so that every investor has in theory a fairly good chance to be equally well-informed in order to come to an investment decision. 9 as opposed to known risks, for example, the liquidity risk of the investment which are included in the investment decision and accepted due to a known degree of compensation. 10 For example, the entrepreneur may take detrimental actions which investors cannot observe: an undertaking might be a riskier alternative then initially indicated (Gompers and Lerner 2002).


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reporting standard could eliminate those inconsistencies with a simple and transparent

method of calculating the returns” (Richard Hayes in: Braunschweig 2002). This shows

that, in contrast to the situation in well-developed asset classes, in PE the requirement

for improved transparency is merely to become an issue. The reason for the lack of

transparency is multi- layered: a private investment is exempt from registration with

authorities such as the SEC registration in the US, which basically implies that due to

the lack of scrutiny by the authorities the pressure by regulatory entities is less. Thus

the development of standards for investor protection is not primarily driven by

legislation.

Secondly, until the late 1970s, PE investments were mainly undertaken by investors

investing directly in issuing firms, which monitored their investments directly. The

development of limited partnerships with general partners and limited partners arose

from the need for greater institutional participation (Fenn, Liang and Prowse 1995).

Institutional investors need intermediaries who specialize in finding, structuring and

managing the equity investment in order to diversify their investments by investing in

several PE investments. By doing so, the use of the limited partnership as an investment

vehicle might overcome some of the information asymmetries in connection with

equity investments due to the special knowledge of a go-between; the investor, however,

is exposed to so-called agency problems, which may result in conflicts between

entrepreneur and GP and between GP and investor i.e. the LP. Thus, one has actually to

acknowledge that the investor, in particular the Fund-of-Funds investor is exposed to

multiple agency problems. The agency theory assumes that the nature of human

behaviour is self- interested, subject to bounded rationality and risk adverse (Eisenhardt

1989). Due to an existing conflict of interests (e.g. about fees) and information

asymmetry, it can be argued11 that the agent is only willing to disclose information if

this information reveals him or her in a favourable light.

Since the asset class is opaque and therefore benchmarking with other investments in

this asset class is very difficult, the agent might fear that further disclosure of

11 Even so it is not empirically proven, although indications from various discussions point to this direction of argument.


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information might lead to prying further into the management of the investments and,

in consequence, the discretionary power might be pruned. Thus since it is difficult to

justify out-performance (due to the peculiarities of this asset class) because the agent in

the stage in question (i.e. the entrepreneur, the GP of the Venture Capital Funds or the

management of the fund-of-funds) is not willing to disclose any information more than

the minimum, as a result of the bargaining power between agent and principal. It is

obvious that this industry structure does not promote the development of standards

which would then prevail12. In the long run, nonetheless, an improved transparency will

be merely necessary due to a higher exposure of institutional investors in this asset

class. Since institutional investors are subject by law to higher monitoring standards,

further exposure will inevitably require improved monitoring in this asset class, which

is only attainable by relevant uniformly applied standards in this asset class13. Some of

the PE representatives have already recognized this and have proactively tackled the

impediments to the development of the asset class: “We felt the industry should set its

own standards before they are dictated to us” (Jose Sinai: in Burns 2002)14.

12 Whereas three years ago the main concern in the industry was the lack of availability of attractive investments, now it is the increasing scrutiny of institutional investors who are debating whether to continue to inject additional cash streams. In particular, additional follow-up financing is needed in order to keep start-up investment alive and lower valuation is apt to startle institutional investors. Nevertheless, the fact that institutional investors have discovered this asset class as a means to increase their portfolio returns and diversification alleviates the pressure: Funds continue to flow in (though at a lower level) regardless of the unease at declining returns, transparency and fees (Tassell 2002). 13 For instance, due to the lack of risk classification methodology under the new Basle II Accord, PE would be classified as high-risk, which would imply that banks have tied up more of their own capital funds than they could bring into a PE investment. In consequence, the financing for this asset class would be an unattractive proposition for banks and thus this source of funds, which after all represents 22% of all PE financing, might not be available for the PE as an asset class (EVCA 2002a). 14 Mr Sinai is a member of the Standard Board for the PE industry.


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2 Literature Review and Theoretical Framework

Information deficiency problem in respect to:

2.1 Data Availability and Opacity of this Asset Class

Information on the PE investment is difficult to obtain from public sources. Unlike

mutual funds, PE is typically exempt from laws which require companies to publicly

disclose their portfolio structure and investments in annual reports or filings with the

authorities. Thus, information on both invested companies and limited partnerships is

difficult to identify (Gompers and Lerner 2002). Currently, two major professional

information provider services are available: VentureOne and the Venture Intelligence

database. VentureOne 15, a unit of Reuter’s, collects data on firms which have obtained

venture capital financing16. Venture Intelligence17 offers a similar service to retrieving

PE data. However, Gompers and Lerner (2002) found that some of these are not

completely accurate. Thus the opacity problem of this asset class stems from the lack of

reliable market information.

Another problem area is the disclosure of financial information. Entrepreneurs and

GPs tend to limit the information made available or tend to be extremely reluctant to

disclose information. The availability of information makes it difficult for investors but

also for investment managers to monitor and manage their investments. Additionally,

the information available is limited in explanatory power due to the unknown

underlying assumptions and methodology used. In order to improve the transparency of

this asset class, the industry can adopt a common set of valuation guidelines and

disclosure standards (Beaudoin 2002).

15 Please refer to http://www.ventureone.com. 16 VentureOne's research tracks the business progress and financing plans of venture-backed entrepreneurial companies. VentureOne conducts both primary and secondary research on organizations which are primarily VC companies. In addition, they carry out research resulting in a quarterly survey of venture capital and private equity firms. First one has to acknowledge that information retrieved by interviews is strongly driven by the interviewer-interviewee relationship which potentially has problems of bias. Especially in this context, the interviewee may not tell the truth or may over- or understate certain facts and thus information retrieval in PE is exposed to elements of uncertainty. 17 Please refer to http://www.venturexpert.com.


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This however, does not address the whole of the problem, since mere comparability is

insufficient. Additionally, the industry needs to consider how mechanisms can be

established for the provision of comparable data in order to determine a PE investment

performance. It is plausible to argue that sophisticated IT will form their basis in

achieving this objective. The use of information technology may form such a basis, but

the major success factor for improved monitoring in PE will be determined not by the

use of technology, but by the willingness of all participants to indeed remedy the

opaqueness, which might be the most important obstacle to the maturing of this asset

class. This is due to the so-called prisoner’s dilemma: each participant in the investment

chain (i.e. the entrepreneur, the GP, the LP and finally the investor in the case of fund-

of- funds) is acting in its own self- interest. What is unknown, however, to each

participant is the action and reaction of the others, which often leads to the strategy of

non-disclosure18. Thus, since action and reaction patterns are not known between the

parties a typical prisoner’s dilemma situation is established, which is logically

counterproductive in terms of improved transparency and information disclosure within

the industry. The fact that in this industry we have to deal with inefficient asymmetric

information worsens the situation, since asymmetric information allows supernormal

returns to be attained as a function of the possession of asymmetric information (in

respect to both quality and quantity).

18 For instance, entrepreneurs may decide to invest in a new machine (i.e. they make use of the funds in a way which benefits them). The entrepreneurs do not know the reaction of the Venture Capitalist. The Venture Capitalist may object or become more concerned and therefore could require more monitoring actions or refuse additional capital. But if the Venture Capitalist does not know the entrepreneurs’ reaction to this decision, the entrepreneurs may become less motivated or may change their strategy (which thus ceases to be optimal from their point of view). Similar action/reaction may also apply between the Venture Capitalist and the LP and between the LP and the investor.


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2.2 The (Double) Agency Problem and Asymmetric Information

2.2.1 Transaction Cost

Individual investors have only a relatively restricted amount of funds available and

therefore can undertake only a restricted number of investments. This leads to an

inability to diversify risks. Financial intermediaries evolved over time in order to

reduce transaction cost. In the case of Fund-of-Funds investments there are two

intermediaries: The VC as GP and the Fund-of-Funds as LP. Both exist, since their

intermediation leads firstly to economies of scale and secondly to improved decision-

making on the part of the investor. The former reduces transaction costs, since both LP

and GP bundle the funds of many investors, so that they can take advantage of

economies of scale. Without the intermediaries, each individual investor would need to

invest a (relatively small) sum in each company. Since transacting in PE brings with it

even higher transaction costs (since there is no such thing as a standardized contract as

there is in the stock exchange), the necessity to bundle transactions becomes even

stronger than it is for mutual funds. The latter arises from informational asymmetries.

Financial intermediaries in the form of Venture Capitalists exist additionally because

they are able to specialise and thus develop expertise. In PE above all this holds true.

Lerner (2000b) argues that other potential financial intermediaries (e.g. banks) lack the

necessary skills to evaluate and monitor this kind of projects. Additionally, the

individual competition which is known in this kind of intermediaries is inadequate for

monitoring since individual compensations are not linked to the funds’ returns. Thirdly,

intermediaries from other areas have to obey regulations and cannot freely invest in PE.

Lastly, the nature of the business makes it impossible for banks to grant orthodox

means of financing, such as loans, since the risk associated with the project makes it

impossible to use debt for financing, the level of risk associated with the investments

would lead to interest rates which were out of touch with reality and unsuitable VC

investments. The existence of transaction costs only partly explains why intermediaries

- that is, Venture Capitalists and Fund-of-Funds - exist (Mishkin 1995). In order to


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attain a comprehensive understanding, the factor information needs to be considered in

more detail. Asymmetric information exists when one party has insufficient knowledge

about the other party involved in a transaction to make accurate decisions (Mishkin

1995). Thus, asymmetric information is information concerning a transaction which is

unequally shared between the two parties to the transaction. The most famous

application of the problems which asymmetric information can create has been

Akerlof's discussion of the second-hand car market. Other important applications relate

to the principal-agent problem and moral hazard (www.xrefer.com, 10.07.2002).

2.2.2 Adverse Selection

Akerlof (1970) showed with the so-called “lemon problem” that the result of

information asymmetry is adverse selection, i.e. that in the venture capital market bad

investments force good ones out of the market, since investors cannot distinguish high

from low quality investments. Consequently, both kinds of investment must be being

offered at the same price (for equity capital) which reflects the average price for the

project on offer. As a consequence, first, bad projects might tend to be overvalued

which would result in lower returns than demanded by the investor for undertaking a

highly risky investment. Second, the price for which the entrepreneur sells the equity

stake for superior projects might be too low and the entrepreneur would not be willing

to commence a highly risky project if the potential reward were not high enough to

compensate for this. Thus, due to the lack of incentives, superior projects might be

forced out by inferior projects and information asymmetry. Thus the adverse selection

phenomenon applies directly to the PE market (Milhaupt 1998) and reduces the

efficient allocation of funds within this industry. Investor therefore claim high hurdle

rates to compensate for the informational risk involved within the asset class (Smith

and Smith 2000, 399). Since PE investments are in competition with all other asset


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classes, it is obvious that this characteristic has an adverse effect on the asset class so as

to attract funds at reasonable cost19.

2.2.3 Moral Hazard

Moral Hazard arises after transactions are completed (Mishkin 1995). The investor

runs the risk that the entrepreneur will engages in activities which are undesirable from

the investor’s point of view. For instance, the entrepreneur might misuse the funds of

the investor. One interviewee for instance told a story in which the Venture Capitalist

did not partic ipate in the payback of an invention since the patents were held in a

different company; however, a certain portion of his funds was used in the development

of the product since the company which the VC fund was invested in had incurred a

significant portion of the development costs.

Akerlof (1970), Mishkin (1995) and Gompers and Lerner (2002) show that if the

information asymmetries could be eliminated, financing constraints would disappear.

Thus improved transparency by improved disclosure and monitoring can alleviate the

information deficiency problem. Although it might address the adverse selection in the

initiation phase of an investment, monitoring might reduce information asymmetries at

a later stage. Normally PE investments, in particular in venture capital, are not

undertaken in one major investment but divided into various financing rounds where

the committed capital of the investor is drawn down. Thus the investor has the chance

of reducing the risk of adverse selection since the time between the financing rounds

may produce further information. If a sustainable monitoring system is in place this can

be used to reduce informational gaps to allow an investment appraisal.

It is apparent that for PE to become mature, current monitoring procedures and

practices need to be improved to overcome the deficiencies of this asset class. Sensible

standards for the interchange of both monitoring and investment data will be one

fundamental element for fostering PE without ignoring the idiosyncrasy of this asset

19 This inhibits to some extent the development of this asset class and can be seen as one of the reason why – in particular in continental Europe – the percentage of investments in relation to GDP is rather low. Please refer to Appendix Figure 5.


18

class. It is the objective of this research to shed some light on this barely considered

issue. The literature review and theoretical framework together provide a sound

theoretical basis for extending the research into practice. Summarizing, it is now clear

why the PE industry is so opaque, what its features characteristics are and what

characterises the relationship between LP and GP 20. Given the theoretical framework

and its impact, I want now to discuss the empirical findings.

20 Further information may be found in the Appendix about different guidelines in the industry and the potential impact of standards.


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3 Assumptions, Research Method and Research Evaluation

3.1 Assumptions

The views studied are not meant to be truth in the sense of quantitative and

statistically backed research. Rather the suggested observations and conclusions are

offered more modestly as tendencies or crude generalizations for which they might be

many exceptions. However, I believe to formulate inductive conclusions in form of

finding communalities from various interviews is beneficial to our understanding of the

hardly researched PE area.

Diagram 1: The Information Deficiency Problem of Fund-of-Funds

Secondly, as can be seen in Diagram 1, the research was conducted from the Fund-of-

Funds perspective. The research sought to improve the understanding of LP and GP

relationship in order to improve monitoring of Fund-of-Funds investments.

Information deficiency problem of Fund of Funds

Fund of Funds

(Limited Partner)

Venture Capitalist(General Partner)

Investee

Interest Reporting of capital commitmentsFund PerformancePortfolio ReportingStock DistributionCapital AccountRisk exposure

Company PerformanceFund PerformancePortfolio ReportingRisk exposure

Double sided principal agentwith informational asymmetries and potential adverse selection / moral hazard

Usage of funds for investmentNot willing to disclose information

Double sided principal agentwith informational asymmetries and potential adverse selection / moral hazard

Degree ofinfluence

ReportingFunding

Specific Industry knowledgeSpecific management knowledgeRepresentation on boardVisitsPersonnel decisionsStrategic decisionsFunding

Information avail on actualcompany state

Emphasis of the research(including influence of VC ? Investee relationshipon LP ? GP relationship)

DeterminantsContent: What?Granularity: How detailed?Frequency / Timing: How often / When?Delay of disclosure: Lack of disclosure on time


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3.2 Research Method

3.2.1 Research Design

The research conducted in this thesis is based on an approach which combines the

descriptive, exploratory, explanatory and prescriptive. It is the aim of this thesis to

contribute to knowledge in the area of PE since academics so far have paid little

attention to it. The reason for this is the relative unavailability of data and the need to

use intricate methods such as interviews for data collection. The aim which is

highlighted in this research therefore is to:

1. Describe and highlight the nature of the information deficiency problem in

this asset class

2. Present the current status quo of monitoring and reporting approaches in this

asset class, using examples from several Fund-of-Funds organisations in

Europe

3. Determine the requirements and needs for an improved risk and monitoring

system for a Fund-of-Funds organisation and suggest potential improvements

Question Research Design Conceptual Framework21

Source of Data

1 Combination of descriptive, explorative and explanatory

approach

Qualitative Secondary data, literature review

2 Combination of descriptive and explanatory approach

Qualitative Primary (interviews with questionnaire) and

secondary data 3 Explorative and prescriptive

approach Qualitative Primary (interviews with

questionnaire) and secondary data

Table 1: Research Design

In the literature review and in the status quo section of the empirical findings the

characteristics of PE are presented using a descriptive approach, where the major

known theoretical frameworks of information problems are presented. The explanatory

21 It is assumed that the amount of data and the scope of the project makes it impossible to retrieve statistically significant propositions


21

and explorative approach is used to show the causal relationship of the theories in PE

and to hint at further research directions. For the second aim, the same approach is used

in order to derive generalisations about specific informational requirements for the

monitoring of various participants in the industry. For the third aim, a combined

explorative and prescriptive approach is used in order to forecast the future

development of in PE monitoring management. These methods are used since the goal

is not drawn from any statistical conclusions derived from the empirical findings.

3.2.2 Conceptual Framework: Qualitative Method and Semi-Structured Interviews

In a qualitative approach the researcher aims to understand or find a specific pattern

within the investigated area. In this approach information is collected and then analysed

and interpreted within the aim of answering questions without converting the data into

numbers and statistical inference. Thus in a qualitative approach the researcher’s

conception or interpretation of real world phenomena is critical.

The method used in this research is of a qualitative nature and drawn from semi-

structured interviews. According to White (2000), interviews have advantages because

their face-to-face nature can reduce misunderstandings for instance by re-wording or re-

ordering questions. Semi-structured interviews are particularly advantageous if a

complex stock of knowledge about the topic under study need to be extracted from

interviewees who can answer questions spontaneously (Flick 2002). The interviewer

guides the discussion by asking specific question. The questionnaire used during the

interview ensures that the content and development of the interview reaches a minimum

standard to serve as a basis for later analysis. In this way, the advantages of an open

interview leading to a sound structure for the analysis can be secured. Since the

Research Design is of a descriptive, explanatory, explorative and predictive nature, I

believe the semi-structured interview is the most appropriate method to collect

qualitative data which will show up specific patterns in the PE industry.


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3.2.3 Data Collection and Studied Interviewees

The study is based on primary data which was collected by means of 14 semi-

structured interviews in the period July to August 2002. Most of the interviews were

conducted in person in order to maintain the explanatory, explorative and prescriptive

approach best. I found that the conduct of an interview was easy and effective, since I

was able to get immediate, though indirect, feedback from the interviewee.

Potential interviewees were identified by means of the EVCA membership directory.

Since the research focuses on fund-of-funds, only LPs which were classified as Fund-

of-Funds in the EVCA directory were contacted, except for two GPs. The reason for

this exception was my speculation that, in order to understand the LP-GP relationship,

views from GPs might give additional valuable insights. Another source was the

Internet, where I could identify potential interviewees from quotations in the press. In

this way, for instance, I found the PE consultancy, which turned out to give some

valuable insights, since the consultancy is completely detached from the actual business.

In addition, I was able to talk to several PE houses. I made contact with them directly

by telephone and potential interviewees were asked if they would participate in the

research. At this point, I soon found out that it was much more difficult than I had

expected to persuade potential interviewees to take part. I learned that many of the

investment managers I contacted were quite reluctant to support such research, which

might shed some light on this opaque asset class. It is also possible that some of the

interview candidates might have not believed that the intention of this interview was

merely academic research and might have supposed it a ruse by a competitor. All in all,

this seems to confirm that the industry has to some degree the tendency not to move

towards transparency, due to the adverse effects on established LPs or GPs, as

described in the literature review; hence, this confirms to some extent the theoretical

framework. This was also the reason for shifting the research from methodological to

technical aspects, which immediately improved the willingness of potential

interviewees to participate in the research.


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3.3 Research Evaluation

In order to minimize possible errors which might impair the empirical findings, every

research evaluation must discuss its own validity and reliability. Validity addresses the

issue of whether the research measures what it should measure, i.e. does the research

design fully address the research questions and aims thought to be achieved? (White

2000). Reliability considers the quality of the measurement, i.e. to what extent findings

can be replicated by another researcher using the same research design (Flick 2002).

This does not, however, imply that the new interpretation and conclusions will be the

same (White 2000).

Type In Person Telephone EVCA Abbreviation22 PE Conglomerate / Independents

2 1 18 A

Captive Bank / Mutual Fund

2 - 6 B

Captive Insurance 2 - 1 C Professional Institutional 1 - 7 D Association - 1 - E GP 1 - - F Consultancy 1 - 5 G Academic 1 - - H Software Vendors - 2 - I Table 2

As can be seen from Table 2, the interviewed institutions represent a fairly diverse

body 23 . Therefore the cluster sampling method should be adequate. I used the

classification of Temple (1999) to delimit the sub-classes from each other. Although

admittedly the interviews were not determined by exact representation of the market

place but by mere availability, I still believe that it provided a representative selection

for determining tendencies and attitudes by qualitative means. Clearly, the data has an

inevitable bias towards institutions which were willing to participate in the interview,

which is undoubtedly one of the limitations of the research. Furthermore, it must be 22 Used for the quotations in the data analysis part of this research. 23 Please note that the interviewees are located in London (5), Munich (3), Birmingham (2), Frankfurt (2), Brussels (1), and Paris (1). One might consider the country-specific differences within the sample as a limitation of the study.


24

acknowledged that the outcome of the research very much depended on each interview,

all of which were very different from one another. It should not be forgotten that while

some interviews, even though they were kind enough to participate, may have not made

their true opinions apparent at all times during the interview.

In the EVCA directory, 37 Fund-of-Funds companies are listed, which supposedly

represent the majority of European fund-of- funds. Of the 7 Fund-of-Funds interviewed,

4 are EVCA members or associates. When the 37 EVCA Fund-of-Funds members are

compared with the sample, one can see that there is a slight under-representation of

conglomerates, consultants and professional investors and an over-representation of

captive investors. Additionally, one should note that the classification was made

according to my judgement of the companies’ internet pages which I viewed. It does

not imply that the companies would have classified themselves in the same way and

this should be seen as an additional limitation.

The main concern of this study was to obtain a sample which would allow the

research problem to be fully addressed rather than establishing a statistical acceptable

level of inference. The sample does not only include investment professionals but also

people from related professions, academics and software vendors, since these might

potentially contribute by giving their own specialised views in the area of methodology

and technical aspects.


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4 Empirical Findings / Data Analysis

4.1 Status Quo

4.1.1 Monitoring Policies and Process

Concerning the status quo of monitoring policies one has to recognize that there is no

single common standard. This is a major problem for LPs, since they receive the

information in different formats, predominately paper-based, and this complicates

monitoring management. Additionally there is no consistency in reporting i.e. the way

in which information is reported or financial reports are presented, how valuations are

made and how much information on the underlying portfolio companies is made

available. This incoherence must also have an impact on the LP’s monitoring policies

and processes.

Monitoring approaches of the different players

Many of the interviewees made clear that their company has a quite unique approach

and that this unique approach is considered to be a source of competitive advantage.

“I haven’t come across a GP or LP with really efficient and effective seamless

monitoring policies and processes which everybody followed” (G)

Obviously, the initiation of a deal attracts most attention since the characteristic of

this asset class makes it difficult to revoke an investment once made. However the

concomitant monitoring should not be underestimated since the early identification of

trends allows the LP to potentially influence its investment to move in a desirable

direction and thus can significantly reduce sudden surprises. With respect to content,

most of the respondents agreed that the EVCA are reflecting what is most commonly

used in PE for monitoring management. However one could sense that the opinions on

the EVCA guidelines were quite diverse. A small majority stated that the EVCA

guidelines are a good approach, facilitating monitoring management. Companies


26

interviewed in the UK unanimously preferred the BVCA guidelines. But criticism of

the proposed guidelines could be clearly be observed:

“All guidelines proposed by associations are so opaque that they are almost

valueless.” (C)

Contrariwise one interviewee bewailed the inflexibility of the EVCA reporting

guidelines. What can be concluded from this is that the views on reporting guidelines

are inconsistent and subjective. Thus the industry seems to be far from a consensus in

this area. It is acknowledged on the association level that the guidelines are not used in

a coherent way. However in terms of content, most of the GPs strive to provide the

information proposed in the EVCA guidelines, although some methodology issues in

this industry remain a sore point, such as the IRR calculation. Additionally during the

interviews it was often noted that different reporting frameworks (including different

formats, terms and reporting principles) make it sometimes cumbersome to find the

information needed by monitoring management from PE fund reports which are not in

line with the EVCA guidelines. However, the tendency is that whereas for larger, more

professional funds the introduction of the EVCA guidelines did not lead to a noticeable

improvement in the reporting quality, smaller funds, in contrast were forced to improve

their overall reporting and disclosure quality, which lead to less difference in reporting

quality in line with the size of the PE organisation.

Reporting Frequency

Regarding reporting frequency, there was almost a unanimous vote on quarterly

reporting. It is important to note that some of the interviewees emphasised the fact that

in PE it is more important to identify a clear trend than a point-of-time snapshot of the

fund investments which is more relevant in public equity investments. Therefore

monthly reporting was considered not to provide any additional benefit, i.e. it was

merely considered to impose “additional noise”. The majority of the interviewed LPs

remarked that the mainstream of its GPs provides quarterly reporting, though some

European GPs still struggle to maintain this interval.


27

Monitoring Procedures

Monitoring procedures were quite different in detail, but some major tendencies can

be determined: whereas captive and profession investors tend to make a clear

distinction between investment management tasks and back-office tasks, independent

PE houses tend to see these two functions as not distinctly separated. Thus the typical

monitoring process for the former consists of a dual process approach, which separates

formal from informal reporting24. Generalizing, one can say that there is a tendency for

larger players to differentiate between obtaining qualitative data by direct interaction of

the investment managers and quantitative data represented by internal systems provided

by a back-office functionality. For smaller PE conglomerates in particular, the lack of a

distinct back-office implies that there is no separation of the financial data gathering

and information obtained by specifically informal means.

If the monitoring processes on the LP side are considered, the interviews revealed that

there are differences between PE captives and conglomerates/independents. Whereas

captives tend to have a more formalized and stringent monitoring process due to

regulatory requirements25, for conglomerates the monitoring information is more driven

by potential return and cash-flow (draw-downs) deliberations than by the regulatory

and risk aspect26. Conversely, a typical process in a conglomerate is completely driven

by the investment manager’s perception of how to monitor the investments for which

he or she is responsible. This implies that the monitoring processes, too, need to be

structured differently. For captives, the process is very much formalized and seems to

24 Formal reporting by the means of quarterly reports is often supported from the back-office by providing the GP’s fund information within the internal system, whereas informal reporting and analysis are normally carried out by the investment teams using both informal information which is gathered by means of personal interaction and financial information provided by the back-office. 25 for instance in Germany the „Mindestanforderungen an das Kreditgeschäft der Kreditinstitute“ (MaK) and the Basle II Accord. 26 For instance one interviewee of a captive depicted an internal process which included the appraisal of funds according to some objective criteria. Additionally, some standardised qualitative data are used to build an overall assessment of the investment into this fund. Furthermore an independent second rating takes place which results in an assessment. Both assessments need to be in line, otherwise the investment will evaluated further. Another example from an insurance company shows that for the internal group, risk reporting of certain assessments and evaluations must be carried out, such as the impact of currency deviations on the investment.


28

be closer to a risk management approach for loans with quite narrow rating criteria. The

emphasis of conglomerates, however, is more informal with emphasis on future

oriented information. 27

Data Availability

Asked about the how they treated the difficulty of obtaining data most respondents

made clear that the contractual obligation of information disclosure is in most

participation agreements defined in a very fuzzy and loose way and thus it is difficult to

derive a formal entitlement of specific reporting information from it. Therefore the vast

majority of respondents agreed that the most valuable information is acquired by

nurturing personal contacts between LP and GP, which was also considered to be the

only really feasible way of overcoming data ava ilability.

Accounting Standards

To the question whether accounting standards are an issue in PE monitoring

management, a clear majority replied that differences in accounting standards are not an

impediment. GPs are expected to represent its portfolio irrespective of the accounts and

give an objective view of the situation of the investment within the portfolio, i.e. it is

expected that differences in accounting standards will be eliminated in the GP reporting.

However, one significant shortcoming in reporting was considered by most

interviewees in the valuation methodologies. Current difficulties concerning reporting

and monitoring were considered mainly in ambiguous valuations i.e. the valuation

methodology/guidelines and not the disclosure of the information i.e. the reporting

methodology/guidelines per se.

27 For instance the process for a conglomerate Fund-of-Funds often includes a deviation analysis and a personal feedback-loop. The qualitative feed-back is then used to enrich official reported information with the intuitive impression and derive an own specific assessment of the investments; for captives, however, there is the tendency for assessments to be based on a more objectified basis (i .e. quantifiable information and formal scoring models).


29

“If you cannot compare what is happening in relation to other funds you have a big

problem.” (E).

4.1.2 Monitoring Factors

Measures

Concerning monitoring factors, there were quite different views on the current

methodology. Most of the interviews clearly preferred multiples28 to IRRs29, since the

IRR methodology is an imperfect measure for comparisons.

“I don’t care what the internal rate of return is. I care about multiples.”(C)

Surprisingly, most of the interviewees were not much concerned about the

methodology issues which discuss the deficiency in the PE area in measuring

performance. Currently the emphasis is clearly on the valuation and provisioning of the

funds, although one has to acknowledge that this issue has an impact on the calculation

of returns. While in the technical literature the issue is at present extensively discussed

(“LP become more concerned with how returns are getting reported”, Bhaktavatsalam

(2002)), the practitioners interviewed seemed not to urge strongly for changes. It seems

that investment managers are aware of the shortcoming of the lack of a standardised

methodology and accept the limitation associated with it. One reason for this might be

the fact that the actual performance can in any case only be determined objectively

when the fund has been closed.

28 The most common multiples mentioned were Distribution to Paid-in, Residual Value to Paid-in, Total Value to Paid-in 29 The most common IRR factors mentioned were Average IRR, Capital Weighted IRR, Pooled IRR and its statistical indicators Median IRR, Standard Deviation, Maximum and Minimum IRR, Upper and Lower Quartile, Median IRR


30

Portfolio View vs. Individual Investment View

As already indicated, some interviewees again made clear that it is more important to

identify the trend than to have a snapshot of the portfolio. One explanation might be

that larger PE Fund-of-Funds due to their size alone have a more portfolio management

view of their investments and are therefore less interested in specific information. This

is due to the improved diversification effects of larger portfolios.

4.1.3 Interaction between LP and GP and Standards

Relationship LP <=> GP

The emphasis on personal relationships in this industry is a predicament for large PE

players, since with the increase of the number of engagements, risk and monitoring

management becomes more and more difficult to handle in the absence of an advanced

information management system

The relationship between LP and GP was characterised in varying ways, i.e. a

common opinion on the relationship between LP and GP cannot be found in the

interviews. Most of the interviewees considered the relationship to be a combination

between reactive and passive, i.e. most of the GPs send out their quarterly or annual

reports on a continuous basis and respond to ad hoc queries reactively. There is a

consensus that it very much depends on the individual relationship and the professional

advancement of the PE organisation and the sub- industry classification.

Standards in the Industry

Concerning standards, the vast majority of interviews paradoxically recognized the

problem area and welcomed the idea of improved standards, but nobody actively

supported such development.


31

“The real big problem is a missing standard around the world; sometimes you don’t

get the information in a feasible way.” (B)

“There is a real issue of information management in PE. And this between Portfolio

Company and GP but also between GP and LP. Because there are no standards you get

ad hoc requests. If you standardise, the number of ad hoc requests fall. In terms of

efficiency this has be more efficient” (G)

Many of the interviewees pointed out that the possibility of generalising is limited by

the fact that each LP and GP relationship is unique. In particular PE Fund-of-Funds

seem to emphasise this and take advantage by requiring additional information

according to their specific informational needs30. Thus one can observe the tendency

that many of investment managers interviewed considered the establishment of a

standard to be insufficient to fulfil their individual information requirements. It is

believed that the most value adding information to portfolio management can in any

case be acquired only informally.

Secondly, some of the interviewees argued that before an industry-wide standard can

be achieved, an additional maturing of the industry - in particular in Europe - is

necessary. Currently the level of sophistication in reporting is very variable. Many

interviewees therefore thought that once a higher level of sophistication is achieved

throughout the industry, the introduction of improved common standards might become

possible.

On the association level the establishment of an electronic standard for data exchange

is considered to be premature. The greatest challenge is currently considered to be in

the area of valuation and related problems 31 . Generally speaking, the major current

problem in reporting is that the content of the report is normally defined by the GP and 30 The research shows that additional qualitative information is often retrieved in an informal way, which allows the Fund-of-Funds to gain a fuller overall picture of the investments, in particular where forward monitoring information is concerned. Some PE conglomerates interviewed use a kind of balanced scorecard which determines the additional information in a systematic way. 31 Especially on the association level it is believed that until these issues are resolved, standardisation by the means of electronic data exchange will not be not feasible. Since valuation is at the midpoint of all the efforts to improve, EVCA is convinced that it is not at present feasible to consider a subcommittee.


32

the contractual obligation of reporting normally does not specify the quality of

reporting, i.e. the reporting clauses are normally quite vague. The availability of

information was mostly considered to be determined by the relative bargaining power

between the parties and the extent of personal relationships.

“The reason why there is no standard is primarily most of the power is at the GP not

the LP. Every organisation has different needs. The GPs play on this by saying ‘That is

just how we report’. Nobody else asked for it and thus you don’t get an answer. And

thus they stick to their own methodology and thus there is a lot of inertia there” (B)

4.2 Requirements

4.2.1 Reporting

The EVCA reporting guidelines have been derived by the best practice in the market-

place and represent the most common information used for monitoring management in

the PE industry. The questionnaire divided the requirements into content, volume,

granularity, frequency, speed of response, data quality, access and presentation.

Concerning content, most of the interviewees considered the EVCA guidelines to be

sufficient in general32.

“The EVCA guidelines represent a good framework how to structure a report. Most of

the report might have different layouts, but the respective information can normally be

extracted from the reports.” (A)

However when asked for risk management information, most of the interviewees

remarked that for this area, the EVCA reporting guidelines are quite vague and the

information disclosure depends very much on the GP’s willingness to disclose this

32 i.e. the informational partition in capital commitments, fund performance, portfolio reporting, stock distribution and capital account covers the aspects which are necessary to monitor the respective investments.


33

information in its reporting framework33. Concerning the volume and frequency, there

is a firm consensus that reporting should be on a quarterly basis from the GP, with

quarterly data34. An increase in reporting frequency was not considered to be beneficial

but counterproductive, firstly due to the nature of the asset class (illiquidity) and

secondly because it would not help to identify long term trends. The real issue, however,

was considered to be the granularity of the information given.

“What is missing is transparency. Some information is hidden in some aggregated

figures” (C).

This was in particular the case when fees were considered 35 . In addition, many

interviewees wanted an improved breakdown on the portfolio company level36 . For

Fund-of-Funds which are engaged in VC, cash figures were considered as being in

particular important, which complemented the information supplied by ratios 37 .

However since the accounting data is merely a snapshot of the company rather than a

change in time, it is not astonishing that interviewees who required additional

information by means of higher granularity made clear also that the most interesting

information is the deviation (i.e. the dynamic of change).

“It is more important to identify trend than the point in time and why. It is about am I

going where I intended to go rather then where I want to be today” (A)

33 One investment manager remarked that there is a dilemma for GPs: On the one hand they are obliged to disclose information so that the LP is able to get an idea about the risk exposure, but on the other hand further information on risk may potentially reduce the chance for the LP to engage in future undertakings. Thus there is a tendency for risk exposure disclosures to be quite vague and bland. In additional to the disclosure problem itself, it is difficult to present each specific investment case objectively in the absence of a common risk framework. 34 The input of the quarterly reporting data (e.g. for the calculation of IRR) was required to be based on monthly data however. 35 One investment manager complained that the management fee breakdown is so different from fund to fund that one cannot really obtain a clear picture of how the overall costs are incurred. Therefore it was considered beneficial to have common standards with an exact classification of the different costs, which would in turn improve transparency and comparability. 36 In particular information on sales, profit and margins, overheads, and interest were most commonly required as performance indicators. Moreover, information from the balance sheet such as overdraft, cash, stock, debtors, creditors, net assets and total borrowings were found necessary to comprehend the capital structure of the portfolio company. 37 such as liquidity, gearing, interest coverage, stock turnover and debtor/creditors coverage


34

Therefore the amount of information does not in itself improve the understanding of

the investment in the absence of actual, budget and previous period information. Given

this the current situation can be appraised and the longer term trend can be determined.

What was pointed out by several interviewees was the need to have the underlying

assumptions available for any disclosure38.

Concerning speed of response, one has to differentiate between on-going reporting

and ad hoc queries. For on-going timely reporting, it was considered to be very

important for Fund-of-Funds since Fund-of-Funds need time to consolidate the

investments and then report to their investors. Most investment managers said that they

allow the GPs 60 to 90 days for quarterly reporting. For ad hoc queries, most of the

interviewees said they needed the information instantly or within 24h at the latest.

Regarding access and presentation most interviewees voted for an integrated solution

which stores all the necessary information centrally. This however should be flexible

enough for ad hoc queries and customized report generation. Additionally, some

wanted to download certain information in a spreadsheet format for additional analysis.

4.2.2 Monitoring Factors

Differences in the Monitoring Factor Requirement

This section asked the interviewees where they see potential improvements for

improved monitoring factors. First of all it is important to note that a major difference

can be seen between larger Fund-of-Funds captive institutions and Fund-of-Funds

conglomerates. Whereas the former seem to have a more portfolio management point of

view, the latter rather emphasise individual interaction. The emphasis on each

38 Information is only meaningful if the underlying assumptions are known. One issue concerns the definition information, i.e. how it was retrieved. For instance, there are various ways to define “gearing”. An appropriate appraisal without the exact or even using changing definitions is not feasible. Other types can be explained by the bounded rationality theory of human beings: only if the entire circumstances of the appraised portfolio company are known can the optimum decision making be achieved. For instance the closure of a company’s plant might be misinterpreted as worsened sales and profit margin if the entire picture is not provided. However, it should be made clear that fund of funds are not supposed to interfere in the GP’s decision making in the interests of increased transparency.


35

individual investment leads to a closer review of the actual investments which the GP

undertook, i.e. the portfolio companies. It is not surprising that this difference in the

management of the investments in PE funds has also a direct impact on the information

required. Thus monitoring factors for large captive Fund-of-Funds are more similar to

the one in public market portfolios with an emphasis on diversification factors such as

industry, currency and style39 exposure, vintage year and performance measures.

However, monitoring factors for smaller Fund-of-Funds tend to be more qualitative

and often require this information in order to prepare a SWOT analysis for the

investments undertaken40 . Furthermore, smaller Fund-of-Funds tend to require more

quantitative information of the portfolio companies, as mentioned earlier. The major

problem was considered to be identifying investments which are “on or off the track”

rather then a snapshot.

“All you need to know for us is whether the data is used consistent and what is the

trend” (B)

Nonetheless, by merely looking to the individual companies, it is difficult to derive an

overall view of the different investments. As one investment manager pointed out, he

needs somehow an aggregate view of the portfolio in order to infer the state of the

investments.

“What is interesting me is the condition of the portfolio. How can I measure this?” (A)

The comparison of actual, planned and previous budget measures stated by the

individual portfolio company, however, does not give an overall picture of the portfolio.

Therefore some interviewees proposed to develop new measures which would describe

the overall condition of the portfolio. The idea brought up was to develop certain ratios

39 For instance Early/Seed Stage, Balanced Venture, Later Stage Venture, Venture, Buyouts, Mezzanine. 40 It is important to note that the interviewees who advocated the SWOT analysis also make clear that the important monitoring factors result from comparing previous SWOT analysis with current ones in order to identify major deviations.


36

for the entire portfolio similar to already common used pooled IRR41, which would then

constitute an indicator for the entire portfolio42.

Information on Future Developments

In addition to this some interviewees would have liked to have more information

about future potential developments, since this formation is normally extracted on an

informal basis. It is obvious that this requirement is difficult to standardise. The use of a

balanced scorecard approach, however, might be an option to represent both qualitative

and quantitative aspects. One interviewee considered this approach as being the right

one to improve monitoring:

“Essentially, I think the monitoring factors will be around some kind of balanced

scorecard” (G)

Some interviewees, however, considered monitoring and risk management as being a

job which is carried out by the investment managers themselves through their personal

and informal relationships with the GPs. In their opinion, risk management cannot be

supported by improved reporting standards or additional figures.

“[Risk Management] I don’t think you can do anything with standards. That’s my job

as an investment manager. I know my portfolio, I know where my risk is and I know

where I am - ought to be. The real value added is to talk to the GPs personally on how

the companies are doing. This is where my value added is coming in.” (C)

Both statements are quite representative of the divergent opinions in the entire

interview body. The difficulty of measuring risk in PE consequently makes it difficult

to apply objective measures. Balanced scorecard approaches try to reconcile both

41 The pooled method is a measure which attempts to capture investment timing and scale. The pooled return is calculated by treating all funds as a single "fund" by summing their monthly cash flows together. This cash flow series is then used to calculate a rate of return (NVCA Methodology) 42 For instance for a start-up fund, a “pooled burn rate” might give an indication how far the fund is exposed to the liquidity risk of invested companies in comparison with the market average.


37

qualitative and quantitative measures by means of defined dimensions which represent

the success factors of the investment. Since the actual advantageousness of a PE

investment can only be derived after the closure of the fund, many interviewees

considered the attempt to improve entropy by including additional qualitative

information to be futile.

“You end up with a series of exceptions which makes the underlying systemic approach

more difficult” (B)

The majority however agreed that there is the potential to standardise formal,

quantitative information i.e. quantifiable accounting information.


Concerning interaction between LP and GP, the interviewees generally agreed that

most importantly standardisation and automation in the reporting should lead to two

major advances: improved information management should reduce the necessity for ad

hoc queries, i.e. more relevant and better information would be available for investment

appraisal which would reduce the number of further inquiries for routine monitoring

and risk management tasks. As a consequence, however, the overall interaction

between LP and GP is not thought likely to be reduced, but it should allow the

investment managers to make better use of their time with more value adding tasks in

the investment process43. Secondly, cost advantages are sought. Currently most LPs

receive reports in a paper-based format with no uniform definition of content or clearly

defined semantic. Many LPs convert this information into their internal view, which

includes the tedium of working out how the presented figures and information have

been derived. This is very time consuming, error-prone and resource-intensive and thus

very costly. It also retards the reporting to the investor, which in some cases has to be

content with information which depicts the situation of an investment six months ago. 43 For instance the time could be used for more informal meetings which would allow the investment manager to improve monitoring management by including more informal, future orientated information in their investment appraisals.


38

Most of the interviewees agreed that easier transfer of standardised information could

lead to major productivity gains not only in information provision but also in the

analysis of the data.

“Most LP would like to see improved reporting and ideally direct electronic feeds from

GP to LP to eliminate manual data entry. The technology exists to make this flow

possible, but the missing link is a set of standards for data content and format to make

it work” (I).

Furthermore there is organisational inefficiency in the PE due to the failure to use

appropriate technology.

“It is very clear in the PE market the same piece of information is aggregated in

different ways (....) it is unbelievably inefficient due to the proliferation of

spreadsheets” (G)

Thus it is obvious that the augmented use of Information Technology, together with

precise standards for reporting, performance measurement and data exchange, has a

potentially huge prospect of improving the efficiency and transparency of this asset

class.

“The transparency that a standardized process provides definitely takes away

impediments for potential investors to invest in the PE class and increase their

exposure to this type of investments. It is a key part of the end investor’s and the limited

partner’s ability to see how well the portfolio is diversified and to what extent there is a

specific vulnerability to industry groups or geographic areas” (de Klerk, 2002)

Thus, in particular for large institutions with more than 100 funds to manage, the

administrative complexity of monitoring investments without the support of an

integrated system becomes increasingly difficult. Proponents of standardizing PE are


39

the LPs of institutional and large conglomerates whose call for timely and consistent

investment information can no longer be ignored.

4.3 Improvements

4.3.1 Monitoring Policies and Process

Automation and Software caveats

A significant number of interviewees (30%) doubted that the changes which can be

observed in many PE houses towards the introduction of business process orientated PE

software and the integration of information management within the company, will

extend to intra-company integrations. The reasons for this are multifaceted. Firstly,

many established players consider their informal relationship as a competitive

advantage.

“Obviously the good relationship to the GPs is our competitive advantage“ (A)

Since they have good informal relationship with their GPs, they are able to gather the

information they need as things stand. Every additional piece of relevant information

which is included into a standard would diminish their ability to judge the market in a

superior way, which consequently implies that their relative advantage to a novice

entrant into PE would be reduced.

“It is difficult to find a systematic way to deal with these fundamentals in a

standardized way. And in a way I am pleased that it is that way. There is always the

requirement to create more efficiency. If you start doing this then the returns would fall

and then there would be no difference to public markets” (B)

Secondly, a major drawback was envisaged if the analysis process were delivered

electronically. Some interviewees said that the fact that the reporting is done in a non-


40

standardized way is not necessarily a disadvantage in the analysis of the information

provided by the GP. Since the information presented is so diverse, the analyst has to

work through the details and make the information comparable. This tedious work

however is a learning process, which improves the overall understanding of each

investment. If the information was presented in a standardised format within its own

system, there is the fear that it would be analysed superficially. Clearly, this might

reduce the overall in-depth understanding of each investment. Thirdly, the question of

the cost remains, since improved processes imply that both the GP and LP would need

to agree on a cost sharing arrangement.

Electronic Data Interchange (EDI) and Sought Improvements

There is no clear trend of opinion that the objective and the outcome of further

automation would be improved efficiency in processing or an improved effectiveness in

data management. When questioned on the expectations of the electronic data

interchange and improved standards the interviewees expressed quite divergent views.

The question asked whether the interviewee would expect improvements in information

and data management (effectiveness) or improvements in cost reductions (efficiency) as

being the primary benefit. The majority expected efficiency gains as the primary

improvement, but around 40% were in favour of effective gains by means of the

provision of higher quality, more detailed and more timely information for decision

making44.

Integrated Platform as a Prerequisite

The majority of interviewees agreed that an integrated electronic platform is a

prerequisite for an electronic data interchange. Whereas most of the captive

organisations interviewed already had integrated systems which reflect to some degree

the entire PE investment process, some smaller conglomerates are still in a scattered

44 One interviewee said he expected the improvement in two steps: The first automation will lead to improved efficiency. In a second step, when improvements on the methodology of reporting can be implemented, the improvements will lead to an increase of effectiveness. In the short run, however, in particular in the absence of a clear agreement on methodological issues and industry wide agreed standards, the efficiency benefits are expected to prevail.


41

Excel world, which either is in process of being replaced or will soon be replaced by an

integrated software solution. The tendency is that larger organizations have homemade

IT systems which were developed in previous years, whereas smaller institutions tend

to buy ready made PE packages which are now available and have an acceptable degree

of sophistication. Nevertheless although an integrated system is in place, the problem of

linking LP and GP remains.

“The issue of course is the platform and compatibility” (B).

Excel spreadsheets are easy to use and are considered to have some advantages when

it comes to a specific analysis; their major drawback, however, is that they do not

support the investment process in a coherent way. The reason for this is that

spreadsheet computing was designed for individual data processing. But if Excel is

used to represent workgroup and process-related tasks, the limitations regarding group

wide information management, security issues and the integration of information

become obvious. When it comes to inter-organisational automated data exchange, in

particular, the advantageous flexible structure turns out to be counterproductive for

standardised and process orientated data processing. However it is important to concede

that the maturity of the asset class does not nearly reach the level of other asset classes.

This clearly has a major impact on how far technology can be used effectively since the

effective use of EDI requires an equally advanced use of technology for the entire

industry. Additionally one interviewee maintained that accounting information and

reporting information are different in nature and therefore should also be separated

technically, i.e. in a different data base with different data models.

“You have to differentiate between systems which are an integral part of your business

process and systems which capture data.” (G)

The reason for separation is due to the different tasks of the OLTP and OLAP.

Whereas the former should make sure that information flows are integrated and


42

coherent, the latter should allow the flexibility to query information according to the

informational needs, without any limitation imposed by the system45.

4.3.2 Monitoring Factors and Particularities of the PE industry

When asked about the particularity of the PE industry, most of the interviewees

confirmed that many people who are not engaged in PE do not recognize sufficiently

the differences between PE and public equity investments. In particular the long term

orientation of this asset class and the uniqueness of each investment make it necessary

to have different ways of evaluating investments.

“The nature of PE is not systematic, it is not systemic investment. What you do in

public markets is take everything away which is actually driving the company. This

then leads just to a statistical exercise and methodology. In PE you have not got a

market, everybody is looking to fundamentals.” (B)

What drives a company is, however, multi-dimensional and therefore difficult to

grasp and represent systematically, i.e. each company has its own unique success

factors.

“The real characteristic which impedes standardisation is the idea the every company

is different, which is true but it doesn’t mean that standardisation is a bad idea in some

way”. (G)

This implies that standards and systems need to provide a high degree of flexibility in

monitoring management in order to accommodate different characteristics.

45 Typical relational databases are designed for on-line transactional processing (OLTP) and do not meet the requirements for effective on-line analytical processing (OLAP). As a result, data warehouses are designed differently from traditional relational databases. Warehouses are Time Referenced, Subject-Oriented, Non-volatile (read only) and Integrated. OLTP databases are designed to maintain atomicity, consistency and integrity. Since a data warehouse is not updated, these constraints are relaxed. (Source: Oracle http://www.orafaq.com/faqwh.htm#WHvsMART).


43

“It is the flexibility that really matters. Because you deal with so many different people

the ability to respond to these is absolutely crucial” (G)

Therefore one interviewee concluded that what matters in this industry is the potential

to adapt to processes and procedures.

In order to ascertain whether an investment in PE was successful or not the

investment manager has consider these factors individually. Consequently this makes

comparisons more difficult than in the public market where the underlying investment

itself almost irrelevant since it can substituted easily. This characteristic makes it rather

complex to standardize information for monitoring management which in turn makes

automated processing difficult.


In this section the interviewees were asked to give their views on improving the

interaction between LP and GP by means of technical or organisational changes. The

first question dealt with the introduction of an electronic interchange standard. The

interviewees were asked what they thought about a commonly accepted data exchange

protocol for PE. The example of XBRL was taken since it is the most promising XML-

based technology for data exchange in Banking and Finance46. Most of the interviewees

agreed that ideally, the industry should define a sub-set of this standard which

represents the requirements for PE. Together with a global methodology for PE, for

example, reporting standards which are currently under development, such as GIPS47 or

46 XBRL (Extensible Business Reporting Language) is an electronic format for simplifying the flow of financial statements, performance reports, accounting records, and other financial information between software programs. The goal is to provide a platform to publish financial information in a format which can be easily viewed and used. XBRL enhances the usability and transparency of financial information reported under existing accounting standards, simplifies disclosure and allows companies to communicate financial information more readily via the Internet (XBRL 2002). The major advantages include the effective access and analysis of financial information and the improvement of communications between stakeholders in the PE investment process. Not surprisingly, most of the interviewees had no information about XBRL since it is quite technically driven. 47 Global Performance Investment Standards , Investment Performance Council (IPC) subcommittee


44

ILPA48 data exchange between the portfolio company, GP and LP data could be

exchanged and stored automatically in the respective system along the entire PE

investment process.

Even though all the interviewees agreed that such a technical standard is highly

desirable, in practice some major problems might arise which will at least retard the

introduction of this technology, if nothing more. Firstly, there is an interface issue.

Each LP and GP needs a system which is compatible with this EDI standard.

“What you actually want is something which sweeps the data just through. At the

moment however I think it is difficult to achieve” (B)

Secondly, the level of technical sophistication is very varied in this industry. Whereas

institutional investors have their own home grown solutions, larger PE conglomerates

Fund-of-Funds tend to use ready-made packages. Smaller PE conglomerates very often

still use Excel spreadsheets or they are in the process of changing to an integrated

solution.

“The problem is that institutions are involved with their own system, develop their own

system and bringing in their own packages. You have an interface issue. (A)

Thirdly, standardisation might imply that networking and analysis skills become

relatively less significant. Thus the established PE houses are not very keen to improve

the overall transparency in this asset class. Consequently the drive to improved

standards and EDI might be hampered by the reluctance of established players, which

explains the general inertia in this asset class. Conversely however, a minority of

interviewees consider the introduction of EDI as synergetic, which is another example

showing how varied the views in this asset class are:

“The whole point of EDI is that you can focus on personal interaction” (G)

48 Institution Limited Partner Association


45

All the interviewees agreed that the personal interaction between LP and GP is

actually the real value adding in the monitoring process. During board meetings or

company presentations, but even more during face-to-face meetings with the CEO or

CFO, almost all participants agreed that the most relevant information can be retrieved

which allows them to build up as far as possible an objective or “real” picture of the

investments. It was largely considered that the information provided by reports is

valuable in identifying problems, raising questions and preparing for one-to-one

meetings. This however takes up to 40%-80% of the investment manager’s time but

adds only limited value to the investment process.

“Time spend reading through reports, using spreadsheets, building spreadsheets while

important is not the best use of the executives’ time. If we can reduce the time that it

takes them to manage the information flow around portfolio companies it frees them up

to do more for the actual understanding [of] what is going on and look for more deals”

(G)

4.3.4 Introduction of Potential Improvements and Automated Reporting

In the current state of PE, one might see some parallel development with other

electronic financial networks in their early days, such as S.W.I.F.T. 49 It is almost self-

evident that these approaches from the public markets can be applied to PE in a similar

fashion. One idea might be to establish a transfer agency which would act as go-

between the LP and GP and GP and the portfolio company. Potential benefits might be

the reduction of complexity due to a hub and spoke architecture (i.e. a reduction in

connectivity links) and the possible provision of enriched information such as ratios or

deviations. When questioned about the idea of a transfer agency, the interviewees gave

mixed responses. About half of the interviewees rejected the idea merely because they

considered the provision of investment data to a third party to be too sensitive an issue.

49 These financial networks make use of EDI for various transactions between financial institutions such as fund transfer or settlement information. They provide its members with low-cost, competitive financial processing and communication services and thus make greater automation of the end-to-end financial transaction processes possible. A great element of the success lies in their financial standards setting.


46

Around 30%, in contrast considered this as a feasible and interesting idea and some

even evinced some concrete interest. The remaining interviewees had no opinion. The

same result appeared when asked about potential outsourcing of back-office

functionality. There was consensus that since the frequency of reporting in PE is

significantly lower, the establishment of a go-between can only become attractive if

additional services such as certain enrichment or analysis capability are included50.

The answers to the question of who would be an adequate service provider for such

an agency varied quite significantly. The idea that a PE association could provide such

a service was not considered favourably due to the lack of business orientation,

although the neutrality was considered to be a big advantage.

“Associations are not formal enough. You need a company which is doing this. If you

need outsourcing, associations never manage well and there are not profit centres”. (C)

Most of the investment managers interviewed considered that a professional back-

office outsourcing provider would be the best organisation to provide such a solution51.

The last section concerned the introduction of improved automation in PE monitoring

management. When questioned about the best way to introduce EDI and an improved

monitoring methodology, around 80% of all interviewees believed that successful

introduction could only be achieved if developments are accompanied by guidance on

an association level. The most successful approach was thought to be that sub-

committees could work out widely accepted and improved methodologies and technical

standards for EDI such as an XBRL sub-set for PE. The idea that the software vendors

could provide solutions on their own was widely believed to be unfeasible. One-to-one

50 Such services might include portfolio analysis and risk exposure determination (e.g. by an analysis of the sector or style exposure of the fund). 51 It is important to note that some of the interviewees thought that the relevant advantageousness of such a transfer agency would be diminished if the interface problem is reduced by the introduction of a sophisticated PE data exchange format which would enable different PE software to communicate with each other directly and without any conversion.


47

customization between LP and GP was rejected due to its enormous cost in the absence

of a common standard for EDI52.

Concerning the introduction, some investment managers had an idea about future

developments in the PE industry. Questioned about the proliferation of EDI software or

PE management software with EDI capability, one interviewee thought that for larger

Fund-of-Funds players in particular the monitoring issue will become difficult to

manage. This would lead to a quite significant demand for integrated platforms and

EDI solutions.

“I think there will be probably quite a market out there among the institutional

investors. But for about 2-3 years, once they realize that they cannot handle their

portfolios anymore.” (A)

The problem however is that LPs come from various backgrounds such as banks,

insurance houses, semi-government organisations and PE conglomerates.

“A major problem is that the investors are such a mixed bunch such as institutional

investor, high net worth individuals, banks, insurance companies, Fund-of-Funds

etc.“ (B)

Not only are the requirements and interests are quite different. What also hampers

cooperation is the markedly competitive view between the peer fund-of- funds.

“You will never get a competitor and us [to] agree on what we [the Limited Partners as

a whole] want. We are competitors. That is like getting Coke and Pepsi agreeing on the

same label” (C).

52 It is important to consider that more and more GPs provide extranet pages for their LP, which gives them the information which was normally in the past supplied in paper-based format. One could argue that this is a form of semi -automation in which the human being (the investment manager) is in the role of adaptor (interface) for information exchange. This has becomes increasingly popular among investment managers and is considered to be a very cost effective approach to information management for this industry. It does however merely ease the access and availability of information and does not address the methodological issues.


48

Thus it might be quite complex to reconcile the different opinions and requirements

of the LPs. This is a drawback in the process of improving standards which the GPs

exploit in order to push their interest.

“There is no coherent body which is representing the LPs. It is likely to work with the

sophisticated investors, but with the smaller you have a real issue.” (B)

Currently, however, the situation of LPs is favourable due to the economic situation.

“The LP haven’t gone together to tell the GP what to do. You have to bring the groups

together and talk with one voice. In 1999 and 2000 the GP had the power, now the LPs

have the power” (C).

Therefore it is a good time for LPs to influence the GPs to disclose information in a

way which fulfils the requirements of the LPs to a higher degree and to introduce

common reporting and EDI standards. A prerequisite for this is, however, that LPs

agree on common requirements on a global basis in order to create significant

bargaining power. With the next economic boom the power of the LPs might be

diminished again and the assertion of demands might become more difficult.


49

5 Conclusions and Recommendations

In order to increase the attractiveness and advance the maturity of this asset class,

further transparency and efficiency of the investment process is necessary which take

account of its specific characteristics. The attempt to aim for the exactly same standards

as those in place for public market is not congruent with the fundamental assumptions

in this asset class53.

Therefore the explanatory power of investment information for monitoring purposes

in PE is different from that of the public market. However, this does not imply that

some of the more advanced developments in the public market cannot be applied to

improve the competitiveness of PE. Nevertheless, an improved transparency should not

aim at the degree of transparency in the public market since if it were the same the

attractiveness to invest into this asset class would be significantly reduced: the

attractiveness of this asset class for successful investment managers is to achieve

returns which are significantly higher that in the public market, i.e. the relative quality

of fund management skills should allow a disproportionately high pay-back. Without

this, there would be no significant incentive to invest in PE.

It is important for this diverse asset class to be associated with great differences in

investors and investment vehicles. Since the investor base has become even more

diverse recently, the need for an established internationally recognised benchmarking

and reporting system has become imperative (European Pension and Investment News,

2002). Thus it is necessary to accommodate the huge differences among the investors in

this asset class. Since the differences are quite substantial, the best way might be to

53 Since PE investments are long term orientated and liquid the change of an investment decision cannot easily be rescinded. The timing of cash distribution during the fund’s life is uncertain and the liquidity risk difficult to measure. Banc (2002) points out that the investment style is more active and due to higher confidentially the task of assessing the performance of different private equity investments is more complex than that of quoted investment in which a common benchmark can be used. Firstly, this is since in public market, the individual investment is not relevant since it is easily substitutable. Secondly, since there is a constant valuation of the investments it is possible to reduce the investment decision problem to just two dimensions: risk and return. In PE these prerequisites do not hold true and therefore the investment decision making cannot be simplified in this way. This implies that PE investments are more resource-intense to monitor since the informational cost is very high. Additionally real returns on the investment can only be confidently determined after the closure of the fund and the peculiarity of each investment makes comparisons difficult.


50

identify differences and clearly divide PE into distinct sub-groups in order to advance

certain developments.

For automation advances, LP should increase the cooperation of LPs and derive

common requirements for this sub-group. There are some developments in this

direction, such as the formation of the ILPA54; however, without a significant global

representation, major advances will be difficult to achieve. Therefore in order to

advance PE on a global basis the associations should consider how inter-cooperation of

national associations can be attained.

Secondly, in order to advance automation, methodological issues need to be resolved

as a prerequisite. A greater consistency of guidelines for both manager and investor is

necessary since distinctions, definitions and investments vehicles have evolved over

time e.g. Fund-of-Funds investing has attracted new sorts of investors with specific

investment needs. LPs must establish what their consensus requirements are. If the GP

have different entities to serve, it increases the cost of doing business for them.

Additionally no agreement among the recipients of what kind of data is expected and in

which format, gives the GPs the chance to only disclose information which is in their

interest to disclose. Consequently, the monitoring quality of all LP’s will only be

sufficient if it can be filled with informal information, but this puts larger institutions at

a disadvantage, since the management of a great number of various engagements can

only be efficient with a certain degree of automation.

Thirdly, it is important that PE executives appreciate technical aspects, such as the

necessity to invest in OLTP and OLAP technology in order to benefit from the

advances in effectiveness and efficiency by means of an advanced information

management – a mere recognition that they must move beyond a scattered Excel

infrastructure is not sufficient55.

54 Institutional Limited Partner Association, predominately representing LPs in the US. 55 It is important for management to be aware that information management should not be relinquished entirely to technical staff. Information Technology is there to address business tasks and processes and needs to be driven clearly by business needs. In order to represent these needs accordingly, the involvement and sufficient appreciation of senior management are necessary.


51

Fourthly, it should be recognized that major improvements are long term in nature

since they very much depend on intra- industry cooperation. The industry structure is

conditioned by the nature of the asset class i.e. change will only take place very

gradually. This is because the framework of PE investment is static. If the investment

contract is closed, changes are difficult to make i.e. a potential change in reporting

might just be possible if a new investment is concluded.

In the short run, however, organisations can very well improve their automation by

means of open, flexible platforms which represent the specific informational needs of

the individual PE house. By the implementation of OLAP databases information

management can alleviate the information deficiency which results from the non-

standardised information flow from various sources such as paper-based reports,

information in flat files, Excel spreadsheets etc.

On a company level the players need to automate and improve their internal processes

first, before industry-wide automation can really take off. Currently most of the larger,

established players understand that efficient PE organisations need to have some sort of

IT support throughout the investment process. Thus more and more PE investment

houses are investing in packages which are now available and therefore the prospects

for integration of the information look quite promising already. In order to have a

sustainable organisation, it is important that PE players should have integrated

information systems which are open to potential technological standards and these may

soon emerge for PE. XBRL/XML has a huge potential and might represent the future

technical standard. Such developments primarily driven by the more sophisticated

public markets should actively be pursued for PE as well. In order to make the

necessary advances in the future, it is nevertheless necessary that the industry should

start switching the points today, i.e. forming sub-committees which will determine the

necessary measures for advances in this asset class. However, only if major players

participate in this process proactively will improvements leading to the maturity of this

asset class be achieved.


52

A clear limitation of this research is the curtailed view of a Fund-of-Funds perspective

and a sample which may not represent international differences adequately. In this

study the LP’s view was emphasised and this may give only a limited view of the entire

problem. Future research might look into this problem from the GP’s point of view,

using a sample which includes additional countries and thus consequently makes up for

the deficiencies mentioned. Another study might look at the data emanating from

strategic management, which might bring in Porter’s 5 Forces and therefore add

additional knowledge of the various players in the market place and their impact on the

maturing of the asset class. Additionally, advances in IT may soon make it necessary to

take additional aspects into consideration.


53

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A p p e n d i x


58

Appendix

The Private Equity industry

Figure 1: Return Private Equity vs. MSCI World

Figure 2: US Private Equity Performance

Source: Venture Economics

US Private Equity Performance Benchmarks US Limited Partnerships Formed 1969-1999

Investment Horizon Returns Net to Investors as of 9/30/2000

Sample 3 Mo 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr

Early/Seed Stage 8.4 187.8 92.2 71.0 34.9 24.5

Balanced Venture 5.2 170 61.1 46.9 26.8 17.9

Later Stage Venture 4.6 65.5 35.4 36.1 25.6 18.9

All Venture 6.4 142.9 64.7 52.2 29.5 20.3

All Buyouts 2.2 21.6 18.0 17.4 16.6 19.5

Mezzanine 15.5 17.2 13.8 13.0 12.7 12.2

All Private Equity 3.8 56.7 34.0 29.6 22.1 20.0


59

Figure 3: Alternative Investments Source: Bance (2002)

Figure 4: J-Curve effect of Private Equity investments Source: Bance (2002)


60

Figure 5: Percentage of VC Investments to GDP Source: http://www.neweconomyindex.org/section3_page08.html


61

Reporting standards in the PE industry

GIPS (AIMR)

The Global Investment Performance Standards (GIPS) provide a framework for the

presentation of the performance of an investment firm. “GIPS are a voluntary set of

standards based on the fundamental principles of full disclosure and fair representation

of performance results” (Bacon 2002). For asset managers, the compatibility of their

investments has become a key issue, for it was difficult to produce comparable

performance information without a standard. Nobody (i.e. neither the portfolio manager

nor the investor) knew, especially when comparing different investments how his or her

investments stood in relation to other people’s. The globalization of financial markets

made it necessary to develop globally established standards, to which AIMR responded

by developing GIPS. The result of the introduction of GIPS is that there now is a

coherent way of measuring performance. Performance measurement provides the

investment information which is crucial for effective monitoring and control of any

asset management organisation. The development of GIPS compliance identifies

outliers and inconsistencies in the investments undertaken and provides the basis for

additional attribution and risk analysis. “Firms that don't comply with GIPS will be at a

considerable competitive disadvantage in the future” (Bacon 2002). Already firms

which are not GIPS-compliant attract some suspicion why not and whether there is

something to hide. In order to comply with GIPS, it is necessary to use information

technology effectively, since without automation it is difficult to comply with GIPS.

Even though it is only a recommendation, AMIR has suggested that a firm’s claim to be

calculating and presenting performance history in compliance with GIPS should be

verified by an external, independent body. Unlike an investment in a publicly traded

mutual fund, for example, in which there is a well-defined pricing mechanism, it is

difficult to find an objective valuation of the holdings of a PE fund. As is clear, the

AMIR GIPS standards are well advanced and address a number deficiencies which also

apply to PE. Therefore AMIR’s Investment Performance Council (IPC) decided in

2001 to establish a subcommittee in cooperation with regional venture capital

associations (NVCA/USA, BVCA/UK, ECVA/Continental Europe) in order to

determine how to best introduce a set of guidelines for consistent global performance


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measurement and valuation which will serve as a framework and provide guidance to

the process of disclosure and making information transparent throughout the

international PE industry. The draft proposal will be offered to the IPC to make new

provisions on VC and PE for incorporation into GIPS (AMIR 2000).

EVCA

The European PE and Venture Capital Association (EVCA) represents the European PE

sector. The organisation has over 950 members throughout Europe and the role

embraces the provision of information services for members, creating network

opportunities and promoting PE and venture capital to institutional investors. In

addition, one of its major tasks is to develop and promote a set of standards and

guidelines for this asset class. The EVCA Reporting Guidelines were published in 2000

with the objective of providing a greater degree of transparency to PE investors. The

guidelines seek to define a common way to improve the quality and consistency of

reporting to investors and thus help to promote PE to become a more attractive asset

class to them (EVCA 2000c). The purpose of the EVCA reporting guidelines is to

supplement the statutory accounts. There are two levels of reporting, one deeper than

the other, covering a company’s annual meeting, timing, fund performance, portfolio

reporting, stock distribution and capital account. The annual meeting and timing

suggest timelines for disclosure. More importantly, the level one fund performance

section defines which and how performance-related information should be disclosed. It

covers information about the fund structure, return calculation, commitments and draw-

downs, management fees and related party transactions, including any leverage of fund.

Level two includes graphical representation, return breakdown and additional

elucidation statements commenting on the shown figures, together with graphs.

Additionally an overview of the PE environment in which the investment is situated

should be provided. Concerning level one portfolio reporting, general information

about the portfolio companies and the investment should be provided, such as the total

amount invested, a brief description, statement of the fund’s role in the investment (lead,

co-lead etc), percentage of ownership and board representation. Additionally, the report

should include the valuation at the time of the investment (according to EVCA’s


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Valuation guidelines which are separately published) and specific information of the

investment (incl. significant events). For level two statements of budgets/forecasts and

their deviations from the actual (such as turnover, gross profit, EBIT etc), there should

be further assessment of the company’s status compared with expectations, exit plans,

syndicated deals and a year by year comparison of the evolution of the investments.

The level one capital account should give details of the changes in an investor’s equity

and capital contributions over a given period. Level two gives additional details about

commitment, contributions and values in at different dates for the purpose of

comparison.

BVCA

In the UK, the British Venture Capital Association (BVCA) represents the British PE

and Venture Capital industry. The organisation represents 298 corporate members who

are PE companies active in making equity investments, primarily in unquoted

companies. The BVCA guidelines are not nearly as detailed as the EVCA reporting

guidelines. The guidelines are more generally formulated, with the aim of conveying

common practice rather than obeying strict instructions on reporting. For instance the

guidelines propose to “show as much detail to investors as possible without risking

damage to those investments and within the practical limitations of preparing accounts”.

Thus, the BVCA guidelines leave much more room for a company to design its own

variety of reporting framework. The BVCA suggest reporting principles and procedures

for valuation, portfolio movement summary, realisation details, and information on the

specific investments. Specifically, as regards valuation the BVCA’s fundamental

principle is that all valuations should represent a fair valuation of the investment from

the investor’s point of view. Different valuation rules apply according to the category in

which the investment falls: Early stage investments should be valued at cost less any

provision; for those in the development stage it can be decided which of the following

valuation principles would meet the situation best: cost less provision, third party

valuation, earnings multiple or net assets. The choice of method is a matter of

judgement. Not surprisingly, for quoted investment the mid-market price quotation

should be used. Concerning the portfolio valuation movement summary, it should in


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general provide an analysis of the change in the valuation of the portfolio, in particular

a breakdown in movements due to investments, realisation and in/decreases in value.

For realisations, more detailed information should be disclosed and compared with the

original cost and with at least four previous periods. Information on GP fees is

considered to be beyond the scope of the guidelines. Specific investments are defined

as any investment amounting to 5% or more by value of the portfolio. Additional

details such as name, incorporation details, business description, investment

information (such as turnover, EBIT, Profit after/after tax, extraordinary items,

dividends, net assets etc) should be disclosed separately. Additionally, information

should be provided concerning the share capital owned, cost of investment, valuation

thereof and income received, comparing them to the position in the previous year.

NVCA

In the US the valuation principles were not driven at an association level (NVCA:

National Venture Capital Association) but by pressure from practitioners to develop a

standardised set of valuation guidelines. A designated committee was chosen from

advisors, investors and fund managers in 1989 with the goal of generating guidelines

for industry-wide adoption (Venture Economics, 2000). The guidelines were not

formally adopted by any association, however, to the development of a de facto

valuation standard for venture capital in the US which is called the “United States

Recommended Valuation Guidelines (“NVCA Valuation Guidelines”). They are

considered to be standard industry practices (Venture Economics 2000). These

valuation guidelines consist of 10 industry practices for quoted and unquoted

investments which propose rules for the method of valuation used, the disclosure and

treatment of investment deterioration, point of revaluation, illiquidity consideration and

adjustments and option valuation. Concerning reporting disclosure and presentation, no

guidelines are available as an industry standard for the US. The current guidelines are

merely recommendations rather than de facto standards which have emerged from the

widespread custom and practice within the industry i.e. they provide only a very basic

framework. The guidelines presented are derived from the requirements of the various

players and what they may practically expect as part of an investment report and these


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guidelines are supposed to cover the requirements of the various players in PE. Since

the participants in PE are very diverse (e.g. professional investors, captives, corporate

investor, PE conglomerates etc.) it is implied that using such a general approach to

reporting dilutes the aim of providing a standard in order to improve overall

transparency. Different PE firms place emphasis on different criteria and for some this

is regarded as a distinguishing characteristic and competitive advantage in the

marketplace (EVCA 2000c). However standardisation in terms of valuation and

information disclosure is an issue which has drawn the attention of various players in

the marketplace. For instance BVCA has set up a committee to produce valuation

guidelines with international acceptance (EVCJ 2002). EVCA itself is currently

reviewing its valuation guidelines and is trying to integrate the feedback and reactions

of its members. In the US, a new PE Industry Standard Board has been set up 56.

In detail, in fact, there seem to be quite significant differences - for instance the EVCA

valuation guidelines also consider a mark-to-market valuation. Thus, in contrast to the

above view, Kevin Kester of PERA (Public Employees’ Retirement Association),

which provides retirement benefits for the employees of more than 379 government

agencies and public entities in the state of Colorado, emphasizes that “in the absence of

standardised means of reporting performance data, it becomes a challenge to manage a

portfolio of assets and make future decisions on the portfolio” (in Bhaktavatsalam,

2002). From this one can see that this industry is far from consensus in terms of

reporting and disclosure, in contrast to the mutual fund industry, where standards are

now commonly accepted by all players in the market. The reason for this can be seen in

the nature of PE itself. Temple (1999, 4), for instance, differentiates between 11 players

in the PE market place of whom 5 are different types of investors who have all quite

different needs and approaches to monitoring and reporting. Temple differentiates

between professional investors, captives, PE conglomerates, corporate investors and

angles. The differences result from the different objectives and investment

56 However, the views on information disclosure represent a broad range of diverse players and thus it is not surprising that there is a significant range in perceptions of the current situation, from the following: “We find that the US standard industry practices and the formal BVCA and EVCA guidelines are fairly congruent with each other and allow for comparable measurement to be made” (Venture Economics, 2000) to “There ‘s no consistency from one partner to another in the way in which they report that information and how they present the financial results for their funs or the performance of their underlying portfolio companies” (Burns 2002).


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environments to which players are exposed. For instance, a professional PE investor

tends to manage investment closer to the factual characteristics of PE (i.e. long-term

view, difficulty of measuring returns and illiquidity), while captives (insurance

companies or banks with VC/PE arms) tend to supplement their investment by PE in

order to achieve diversification and return effects in their overall portfolio. These firms,

however, operate from their banking or insurance context, which implies that these

players demand reporting and monitoring procedures which will resemble established

procedures, since these institutions instead of a specific PE view have the view of PE as

one asset class being invested in. Consequently, the requirements in respect to content,

frequency and degree of automation should closely correlate with the internal

organisational information needs. Corporate investors very often undertake strategic

investments, where the emphasis lies on technology transfer or know-how generation

rather than primarily on a return objective. Logically, the factors being monitored are

obviously more technological than financial in nature. There are even differences

between professional investors and those in PE conglomerates. There is a tendency

among financial institutions (e.g. pension funds) to be reluctant to invest directly in PE

firms. Rather, they invest in PE funds or even in fund-of- funds, since the establishing of

PE expertise is costly and difficult. At the same time, PE conglomerates specialise in

different aspects of PE, such as buyouts or venture capital. Thus, the view of the former

is more from a portfolio level, while the latter is more concerned about the individual

company. Individual investors in the form of an “angel” have their own motivation for

the investment (such as the support of an excellent business idea, i.e. an ideal

motivation), and such investments are normally limited in size. It is obvious that this

diverse structure of the market makes it very difficult to agree on standards for

reporting and monitoring. since certain factors are meaningful only to a specific group

of investors.


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Reflection of Standards Hypothesis

Standards for reporting and monitoring purposes are common conventions for

representing investment-specific data. At first sight, incoherent data can be

consolidated in ways which represent the current and the potential future situation of an

investment in an objective and perspicuous way. Standards for PE represent financial

meaning efficiently and avoid unnecessary ambiguity. However a convention which fits

the general may be inefficient for the specific, i.e. when informational standards

highlight certain aspects they may inhibit others. For instance, a reporting standard

from a captive’s point of view might emphasise regulatory needs which the banks or

insurance companies have to fulfil and might not include information which is more

relevant for smaller players (e.g. planned draw-downs).

Concerning standardisation, Landis (1991) showed in his study the following general

hypotheses about standards

1. Standardisation is often not the best way to achieve compatibility.

Landis describes two misconceptions about standardisation. One is that standardisation

and compatibility are the same. Standardisation is a particular way of making products

go together. Standardised products go together because they have been designed in

conformance with a common technical specification – the standard” (Landis, 1991).

However, standards are not the only way to create compatibility. Gateways and

adaptors can be used as go-betweens on a technical level. But also, transitions can be

introduced in questions of financial methodology. For instance, every company listed

on the NYSE also needs to disclose according to US GAAP. Normally this is done by

reconciliation statements. To some extent, there is a clear trend to gateways now in the

PE industry. Many GPs offer internet/extranet pages for its investors carrying the

fund’s investment data and reporting. In this case the human interaction between two

systems is the go-between. However, as a prerequisite, specific methodologies need to

be defined beforehand in order to reconcile the two systems and this can be very costly


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and cumbersome. The underlying issue is the lack of common methodologies in PE.

The other misconception is whether standardisation can be achieved freely, i.e. cheaply,

without any trade-off. Standards often result in a “lowest common denominator”

solution, i.e. they cover only the most obvious commonalities and requirements from all

participants. For PE this is difficult to achieve, since the industry structure is very

diverse and thus there many opposing interests to accommodate. Clearly, what makes

PE a very special case is the fact that many players in the industry see the opaque and

dissimilar market structure as offering an opportunity to stand out from their

competitors, which consequently makes it more difficult to standardise methodologies

and reporting for monitoring purposes.

2. A dominant firm will oppose and weak firms will favour multi- firm standardisation

This hypothesis cannot be applied directly to PE reporting standards and methodology,

since, firstly, there is no one dominant PE firm in this scattered marketplace. Secondly,

PE firms can by the use of their informal networks and relationships obtain inside

information which is not commonly available, no matter what size the company is.

There is no relationship between market power due to mere size and the ability to

produce superior returns. The crucial point in this industry is produce higher returns

derived from qualitatively better information and investment expertise, which is more

or less irrespective of company size. In this context it is more appropriate to look to the

industry structure and ask which participants will benefit and which will lose out.

Not being directly applicable to PE participants is not the same as not being applicable

to PE software vendors, which apparently has great significance from the standpoint of

technical standards. The software industry in PE, however, is currently so little

advanced that standards for data exchange issues are currently not on agendas of

software vendors. In addition, there is no global dominant vendor in the PE software

industry. Thus power struggles about standards within the PE software industry have

not actually started yet. However, since the PE software industry is as scatted as the PE

industry itself, neither can yet promote the establishment of potential standards.


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3. Multi- firm standardisation will only be achieved if it is competitively neutral but

multi- firm standardisation also increases price competition and reduces the

industry’s profits.

As mentioned earlier, improved methodologies and standards in PE will bring each

individual investment closer to the industry average i.e. the deviations in distribution

will be reduced. Clearly this has two effects: the first is that PE will become more

similar to other classes of asset and the second is that the investor will be able to

determine track records of investment companies more accurately. Obviously improved

transparency favours the investors, since it potentially reduces investment risks.

However, it will have an adverse effect on PE funds due to the increased competition.

Therefore it is not surprising that whereas LPs are in favour of improved reporting

standards, GPs seem to be quite happy to maintain the status quo. However, most

successful PE fund managers, who benefit from improved standards in so far as their

superior expertise can be exhibited to better advantage, tend not to promote improved

reporting standards enthusiastically, since lower potential returns disproportionately

reduce the implicit rewards of their superior managerial knowledge.

Contradicting other research areas in PE such as valuation, monitoring as a research

issue has been, relatively speaking almost neglected. Exceptions are Robbie, Wright

and Chiplin (1998), who examined monitoring policies, information and actions and

Lerner (1995), whose research covered uncertainty, asymmetric information, the nature

of a firm’s assets and financial conditions. Practitioners, however, paid more attention

to these informational needs. A study of the Manchester Business School and KPMG

revealed that the senior management considered communication, speed of response and

good information as their critical success factors as far as PE portfolio management and

monitoring were concerned. By inference, it might be concluded that a major amount of

potential improvement could be addressed by the use of sophisticated information

technology. But efficient monitoring by the use of sophisticated information technology

makes sense only if standards for monitoring and electronic data interchange (EDI)

exist. In other segments of the financial industry, such as transacting payments,

standards for data interchange are well established.


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Questionnaire

This questionnaire focuses on the technical aspects of investment monitoring and consists of three sections: Section 1. Requirements of an improved monitoring Section 2. Current situation in your organisation and/or your judgement of the industry Section 3. Possible solutions for an improved monitoring and standardization Section 1. Requirements of an improved monitoring What are the requirements for an improved automated monitoring and reporting? Concerning:

??Content => What? ??Volume => How much data? E.g. Dataset daily, monthly, yearly ??Granularity => How detailed? E.g. Breakdown of details ??Frequency => How often? E.g. Data delivery daily, monthly, yearly ??Speed of response => How quickly? E.g. within minutes, hours, days ??Data quality => How accurate? E.g. 1 error in 10, 100, 1000,

differentiation of severity ??Access => Ease of enquiry? E.g. user interface, SQL database queries ??Presentation => How represented? E.g. in spreadsheet format, in report

form etc ??Other___________________________

- Which factors do you consider as critical (critical success factors) from above?

Please rank.

b) Monitoring Factors

- What are the requirements for improved and automated monitoring factors (i.e.

factors which fulfil your information needs for monitoring) from your point of view?

- What kind of information would you require for a monitoring attribution, i.e.

breakdown of monitoring information for an improved transparency?

- How do you think differ the information requirements of different players (e.g. institutional investors, captives, conglomerates etc.)?


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c) Interaction between LP and GP and Standards

- What are your requirements for an improved interaction between LP and GP i.e. where would you like to use ??Personal interaction (phone, visits, presentations)? ??Paper based reports? ??Excel spreadsheets? ??Electronic Data Exchange (EDI)? ??Other (e.g. informal)


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Section 2. Current situation in your organisation and/or your judgement of the industry

What is the status quo of monitoring and reporting in this asset class?

a) Monitoring Policies and Processes

- What is the current approach (the process) of monitoring within your organisation?

?? Monitoring procedures?

?? (Internal) Documentation? (e.g. defined fund objectives, clear investment classification (style, fund stage))

?? (External) Reporting? Frequency, report content and level of detail, used data

??How do you deal with difficulty of data availability?

??Do you have a back/middle office for data input?

- How many people are working there? - What is the skill set required? - What are your experiences?

b) Monitoring Factors - Which factors do you monitor (i.e. factors which fulfil your information needs

for monitoring)? - How do you ensure that different investments can be compared with each

other? - Do you have a formalized policy to review / adjust / correct reported data

(such as the NAV) based on plausibility / cross checking?


- How would you describe the interaction between LP and GP? Passive, reactive, proactive // formal, informal

- What kind of information at the GP is maybe not passed explicitly to LP and

what does this imply for the monitoring?


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(Background of this question: if certain information is acquired by informal (tacit) means, which however is necessary for monitoring, it is important that for an improved automation (data exchange) this information is somehow represented)

- Is the interaction more ad hoc (i.e. specific queries) or comprehensively and

planned (e.g. monthly reports) or both? - Do you use any technical standards for communication (e.g. EVCA Reporting

Guidelines in standardised Excel spreadsheets)?


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Section 3. Possible solutions for an improved monitoring and standardization

How could such improvements look like? What need to be considered for an improved and automated monitoring and reporting concerning the development of industry standards? a) Monitoring Policies and Processes

??Which goal do you think would be dominant towards expectations of an

improved monitoring by electronic means?

- Improvements in information / data management (effectiveness). - Improvements in cost reduction (efficiency).

b) Monitoring Factors

- Which particularities of the PE industry should be considered for a standardised

and improved monitoring from your point of view (i.e. which characteristics of the industry possibly impedes?)

- How do you think could transparency be improved to ensure that investments

with different characteristics can be compared with each other? E.g. Different accounting standards etc.

?? (Internal) Documentation? E.g. conversion from tacit => explicit knowledge Workgroup database in which notes, contact details, minutes are stored in an integrated approach. Partly, information can possibly used for reporting.

?? (External) Reporting? E.g. different requirement for different countries (e.g. like country specific GIPS)


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??Improvement of interaction by means of EDI / IT / own protocol for private

equity?

- Transmission of data to independent or commercial unit “clearing agent” (publicly/anonymously) or via 1:1 interactions between GP and LP?

- Interfaces: For instance based on XML like Swift or FIX protocol?

Usage of specific software or internet page for data entry? Integration into current systems?

??What in your opinion is the major obstacle for possible standards? (E.g. cost

sharing)

- From the Limited Partner point of view? - From the General Partner point of view?

d) Technology and introduction

??What kind of technological platforms do you think are necessary for such automation? - Current scattered technology (such as Excel spreadsheets) can be used.

The problem is primarily an organisational one. - An integrated platform (such as an Oracle database) is necessary. The

usage of adequate underlying IT is necessary for both effective and efficient automation.

- The major problem is the interface between the parties. Without a well

defined standard, effectiveness and efficiency cannot be improved

??Do you think outsourcing of data interchange/automation is feasible?

- Because of internal policies we would never outsource the handling of investment data (if that is the case: what are the KO criteria that forbid outsourcing)

- We would consider outsourcing part of the data handling (example: input of data for underlying portfolio companies)

- We would like to outsource data input and cleaning to outside parties


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??How could the introduction of improved automation look like?

- Standards for automation are defined on PE association level (EVCA) and voluntary candidates GP and LP test this concept

- Software vendors should develop feasible solutions - One-to-One customization between GP and LP where feasible - Other_____________________________________

the information deficiency problem of private equity fund-of

Economy & Finance