<GPAC 2009>
Private Equity Funds, are they the
financial doctors?
International Finance 1 Team
Seoul National University
Table of Contents
I. Introduction
1. Introduction of the research
2. The Definition and Characteristics of Private Equity Funds
3. Existing Literature and the focus of the research
II. Design and Process of the Research
1. Research Samples
2. Methodology of the experiment
3. Result of the test and analysis of data
III. Conclusion
1. Implication
2. Limitation of the study and guideline for the further study
I. Introduction
1. Introduction of the research
Throughout the financial crisis and its aftermath, many firms are restructuring and trying to
attract foreign capital. In this situation, much interest is moving towards foreign private equity
funds. The National Pension Service and the Korea Development bank, two organizations that
control most of Korea’s money, have already made an agreement with major global private
equity funds Kohlberg Kravis Roberts & Co (KKR) and Blackstone to make a joint fund to
aggressively restructure the firms of Korea. Also the Korean Government has unveiled
intentions to make a ‘financial stabilization PEF’, a fund that does not move with the intentions
to take over the company, and rather tries to participate as a financial investor. These
movements are just a small part of the large interest that is focused on private equity funds by
global and domestic investors.
Even before the financial crisis of 2007, private equity funds were actively operating usually in
the United States and the United Kingdom and were expanding into many other countries as
well. In the 2000s, many U.S. private equity funds, with the purpose of investing in faltering
firms, became larger than ever with investments from many institutional investors from all over
the globe. For instance, in 2004, Goldman Sachs managed an 8.5 billion dollar financing, and
Blackstone Group financed 11 billion dollars from American and European institutional investors.
Also, in 2004, before the financial crisis, Mergers and Acquisitions done by private equity funds
were quickly expanding, having increased by 64% from the previous year reaching 304 billion
dollars.
Most of this comes from the abundant liquidity that was throughout the international financial
market before 2007, with the institutional investors that were pursuing high returns. With the
high liquidity, stocks and bonds provided insufficient returns to some, and those that could not
be satisfied sought ways to obtain high returns. Especially, in the U.S. and the U.K., the method
of acquiring faltering firms or spin-off firms, restructuring them to expand the value of the firm,
and selling them through an IPO or to other businesses and funds was one of those ways that
earned the investor high profits. The targets were spread out in many areas, from
telecommunication, information technology, medical machinery, media, retail, to financial
services. Also, as the funds grew, the synergy effect between the acquired firms was a benefit
that was pursued.
The investment that was focused in the U.S. and the U.K. expanded into other countries as
well, especially rising nations such as China and India. As the fainacial stability, accounting
measures and corporate governance has improved in these rising countries, many private
equity funds have increased their investments in the area for profits and to establish investment
positions. In 2005, the Blackstone Group established a branch in India with a plan to invest 1
billion dollars, and to further increase their investments in the future to build an Asia investment
fund. The Carlyle group announced that they were going to invest 1 billion dollars in China for 3
years starting from 2006, and Apax Partners also said that they were installing a branch in Hong
Kong to invest in Asian companies of various industries.
After the financial crisis that hit the world in the latter half of 2007, the dangers have started to
dissolve and many new opportunities of investment are showing up throughout the world. This
situation brings again more interest to the role of private equity funds. In Korea, the activities of
domestic private equity funds are arising as well. After the ‘Indirect Investment Asset
Management Law’ was passed in 1998, many firms that had liquidity issues were sold to funds
like Lone star and Carlyle, which marked the start of private equity fund investments in Korea.
From 1998 to 2000, many blue-chip companies were sold to foreign funds, such as the
acquisition of Hanmi Bank by JPMorgan Partners, Jaeil Bank and Hanaro communicaitons by
Newbridge capital, and so on. Also Lone star, which tried to sell the Foreign Exchange Bank
right after acquiring it, earning a bad reputation of ‘MukTwi’, is a global PEF as well. But the
situation changed as domestic private equity funds started to sprout up in the Korean M&A
market. MBK Partners, the largest PEF in Korea, KTB securities, etc. are the Korean funds that
are changing the market. In May of this year, when KKR was trying to acquire OB Beer, one
could see that the domestic funds had grown to the level of being able to compete with the
global funds. The number of funds has grown as well, with 84 private equity funds and about 40
General Partners registered with the Financial Supervisory Service in May of 2009. In the
following months, with the major restructurings that are expected, the activities of private equity
funds are also expected to increase as well. With this comes interest on the question regarding
the role of private equity funds and their effects and influence to the market. There are 2
different opinions on private equity funds. One is that they buy in a firm in distress, do massive
restructuring, and sell off assets just for the profit of a small number of investors. On the other
hand, some say that these funds save firms that are on the brink of bankruptcy, which in the
long run is beneficial to the economy and provides more jobs to the market. This research
focuses on how firms that were acquired and disposed by private equity funds performed
afterwards, to find an answer to this question.
2. The Definition and Characteristics of Private Equity Funds
Private Equity Funds (PEF) are funds that generally gather investments from a small number
of investors to invest in stocks, bonds, etc. PEF usually acquires a whole firm or a dominating
share to participate in the management of the firm. Using various methods to increase the value
of the firm, the funds then sells the firm and obtains high returns after a substantial period of
time. The table below is a comparison of securities firm and private equity funds.
Securities firm
PEF
Public Subscription
Private offering
Investment
Marginal profits depending on market
Profits through increasing the value of
objective
price
the firm
Investment
Public companies
Public and Private companies
Short-term
Long-term
Depends on the stock price
Depends on the amount of value
Financing
method
target
Investment
period
Returns
increased
Table 1: Jabong Kim, 2007, <The current situation and major problems of domestic PEF>,
Federation of Korean Industries, p.16
Private Equity Funds can be classified into Buy-out funds, Venture Capital Funds, Venture
Funds, Fund of funds, Real Estate funds, and Mezzanine funds. This is not a classification that
is legally defined, but rather one that is based on investment targets and strategies. 1
(1) Buy-out fund
These types of fund seek high returns by finding firms that have undervalued assets, acquire
them to increase the value, and then sell the shares of the firm either directly of through an
Initial Public Offering, if it is a private firm. Examples would be the Blackstone group, KKR, the
Carlye group, etc. The PEF that is in Korea is defined as this concept.2
(2) Venture Capital Fund
This type of fund invests in firms that are relatively new and is expected to show high growth or
has a substantial level of technology. These funds invest during the establishing level or before
the public offering by buying shares and realize their profits later on.
(3) Venture Fund
These funds buy securities or real estates of faltering firms to sell them when the prices rise.
The difference in the price is the funds returns, and because it usually invests in failing firms,
1
Kyungwon Kim(2006), <Policy support for the revitalization of Private Equity Funds>,
National Assembly Legislation Office, p.6
2
Indirect Investment Asset Management Law
they take in high risks and are considered to be speculative. An example is the well known Lone
Star, which acquired the Korea Exchange Bank.
(4) Mezzanine Fund
This fund invests in securities that have the characteristics of both stocks and bonds, such as
convertible bonds and subscription rights bonds.
Private equity funds are commonly called Private Equity, LBO funds, and buy-out funds. This is
because Private Equity Funds are the most dominant type of private equity, and many private
equity funds are buy-out funds. But the terminology should be used with precaution.
Among these classifications, the type that will be considered in this research is the Buy-out
fund. This is because the purpose of the research is to observe the effect of PEF on the
acquired firm.
3. Existing Literature and the focus of the research
As the role of private equity funds have become larger than ever in the international finance
market, much research has been done on what private equity funds do, how they are different
from other investment firms, and how their performance has been.
The paper “ The cash flow, return and risk characteristics of private equity”(Alexander
Ljungqvist and Matthew Richardson, 2003) studies the cash flows and return, risks of private
equity and analyzes its characteristics. The study of the cash flows show that private equity
usually yields a 5~8% return higher than the stock market. Also when the investment was
assumed to have a beta of over 1, the results with this risk factor showed that the investment of
the private equity fund has a present value that is 23.8% higher than the amount of invested
capital. The paper explains that this extra return is compensation for the illiquidity of the
investment that lasts over 10 years.
A research on the average return of private equity funds from 1980 to 1997 was conducted in
the paper “Private Equity Performance: Returns, Persistence and Capital Flows”(Steve Kaplan
and Antoinette Schoar, 2003). The results showed that the average return excluding fees were
quite close to that of the return of the S&P 500. This tendency was constant throughout the
whole sample, but the performance was better in funds that were larger and had more
experienced management. These factors can bring in more investing capital to private equity
funds, but the paper explains that the relation between experience and performance is concave,
and that the increase of performance gradually decreases. Finally, the paper explains that
private equity funds that were established when the economy is bullish usually does not yield
good returns and that those funds usually fail to build follow-up funds. This implies that private
equity is somewhat influenced by the economic ‘boom and bust’ cycle.
In the paper “ What Drives Private Equity Fund Performance?”(Ludovic Phalippou and
Maurizio Zollo, 2005), 5 major factors of fund performance are discussed. These 5 factors are
the yield of the corporate bond during the investment, the overall stock performance of the total
market during the investment, the length of the investment, the size of the private equity, and
the experience of the fund managers. This implies that the belief that the private equity
performance is independent of the total stock market is wrong and that institutional investors
that invest trying to obtain extra return through this belief are unreasonable. This belief is
refuted by the research results that show the performance of private equity funds move along
with the performance of the stock market. The reason for this is thought to be the bad
performance of small and inexperienced funds.
Most of the existing studies focus on the American and European cases, and looks at the
performance of private equity funds, with different opinions at times. But although there are
many studies that look into the private equity funds, there are no studies that actually look at
how the firms that were acquired have been changed. Therefore it seems adequate to look at
how these acquired firms have performed afterwards, to see how private equity funds influence
the economy.
This research samples firms that have been acquired and sold by private equity funds to see
how the performance of these firms have changed after the management has been taken over
by the funds. To prevent bias, the samples are from the top 10 global private equity funds, and
the firms and their stock performances are observed for 5 years after the exit, compared to the
stock index during the same period. Although a significant statistical result was hard to obtain
because of the small number of samples, we were able to find significant results by looking at a
few representative cases.
II. Design and Process of the Research
1. Research Samples
To evaluate the efficiency and performance improvement of firms acquired by the PEF, w
e chose samples which were owned by the PEF for the certain period of time and sold.
The criteria that we cared about were the PEF, holding period, exit point, exit process.
In the perspective of the PEF, we selected top 10 PEFs with the biggest raised capital a
mong top 50 PEFs announced by Private Equity International. Prior researches studied a
bout the whole PEF itself or the institutional investor which invest in the PEF. However, t
his research focused not on the fund itself but on the acquired firm so it is not proper to
research in the perspective of the fund or the investor itself. To see that the performanc
e of the PEF is either due to the improvement in efficiency and managerial process or ar
bitrage gain using the business cycle, we selected the PEF with proper amount of size a
nd performance. We believe that it can exclude the bias coming from the size and mana
gerial ability.
To observe the business performance improvement we set the holding period of over 24
months. The best case is the long-term holding period but some of firms acquired by the
PEF are sold after the short period of holding time. According to the prior studies, firms
with less than 2 years of holding period are only 8% and the median of holding period i
s 9 years. In the case of these firms, they are not matched well with the original purpos
e and business model of the PEF. Therefore we excluded firms with less than 2 years of
holding period. Especially, we set the holding period of over 2 years to see the effect of
influence in management over the reasonable period of time.
Exit time was selected to be after 1 January 2000 to have the timeliness of this research.
Exit procedures are basically either by Trading Sales (TS) or Secondary Buyout (SBO).
SBO means that the other PEF acquires the target firm from the original PEF. This case
was excluded since it cannot explain well the effect of managerial change by the first P
EF which acquired that firm.
The size of acquisition fund was set to be over 5 million Euros or 5 million U.S dollars.
Small size deals are not qualified since purpose of these is not acquiring the manageme
nt ownership and it does not coincide with the business model of the PEF. And basically
the public company was the target. We used stock price as the performance measure a
nd private companies do not provide the objective barometer when using the dealing amo
unt. However it is opposed to the basic strategy of the PEF since lots of them acquire th
e whole shares of the target firms making them privatized. Dealings targeting public comp
anies are 6.4% of all samples, and we focused on those segments.
We extracted samples based on these conditions. The source of those samples is the M
ergemarket.com. Prior studies mainly sourced samples from ThomsonFinancial’s Venture E
conomics Service and VentureOne. However these two sources do not provide performan
ce of the target firm but the performance of the PEF itself. In other words, we need sam
ples focusing more on individual firms’ perspectives. The Mergemarket.com has the datab
ase of big deals among companies globally, which provides proper data for our research.
After selecting samples from this source, we used Bloomberg to get the specific data we
need.
2. Methodology of the experiment
This research studied how much performances were driven by looking at prices and indices
based on certain assumptions.
The basic assumption is about the barometers. We set the stock prices as the primary
barometers. We base it on the principle that firms make profits to maximize value of
shareholders and this is reflected on the stock prices thoroughly. In other words, the stock price
is a barometer of the value, which reflects the both efficiency and effectiveness of management.
According to the ‘Efficient Market Hypothesis’ the stock price is reflecting the given information
which includes the current status of the firm.
The PEF often do not disclose information when they acquire firms. There are lots of cases that
the amount of investment and acquired share numbers are veiled. However, the business
model of the PEF is basically acquiring the whole or major shares of the target firm and
executing the influence on the management. Therefore, we assumed that the performance
improvement is partially driven by the influence in the management by the PEF. There can be
an objection that the target firm’s business was going well but undervalued in the market. So the
PEF saw chance in the M&A resulting in performance improvement which can be seen as effect
of the participation by PEF.
Observation period for the sample firms was set to be 5 years after the PEF exited from the firm.
The performance was monitored annually from the moment. The PEF tries lots of method to
improve management and maximize shareholders’ value after acquiring the target firm.
However, there should be prejudice while the PEF is ruling the firm. The stock price of the target
firm does not only reflect the value of itself. Rather, the essential value of the firm can be
estimated after the PEF sold the company and the company was run by new structures.
Therefore, the observation period was set to be after the exit of the PEF. However, since more
than 5 years can capture irrelevant observations out of the PEF effect, the observation period
was set to be till 5 years.
Based on these observations, this research looked for the acquired firm’s performance and its
comparison with the index. To see that we monitored stock movement and its comparison with
the index for five years after the PEF exited out from the target firm. The reason for looking at
stock index is to allow for the economic situation over that period. Stock price is not only
affected by the firm itself but also by the whole market sentiment. In other words, even though
the stock price decreased, if the amount is relatively small compared with the index, we can
conclude that the performance of the firm is relatively good. The reverse is still effective.
To monitor the stock price movement, we used geometric average and Public Market
Equivalent(PME) barometers. The geometric average was used to see the annual stock return.
This is because geometric average enables to estimate the stock return of the point of time and
comparison with other returns. PME compares the investment performance of the firm with the
performance of the index. Basically the stock price and the index at the moment of exit were set
be 100 and they were monitored annually. PME was calculated by dividing the stock price
barometer with the index barometer. If the result is more than 1, it means that the individual firm
did better than the market. If the result is less than 1, it means that the individual firm did poorer
than the market. It is meaningful since it shows the relative performance of the firm compared
with the market. For example, if one company invested 10 billion won in other company and got
12 billion won after one year, it earned return of 20%. It seems high figure. However, if the
company took 15 billion won from the 10 billion won investment in index for the same period of
time, it cannot be said the investment in the company was smart choice. Of course there is a
flaw of ignoring the fact that investment in the individual firm is more risky since it includes both
the systematic and unsystematic risks. However, to adjust those factors, more subjective
measures will be included. Therefore they were excluded in the test.
3. Result of the test and analysis of data
Based on the conditions stated above, we finalized this result
<Table 1>
Stock
Number
price
of
Year after Exit
Annual stock Index average
average
PME average
Observation
return
(Year 0 = 100)
(Year 0 = 100)
1
11
91.74301261
9.244933228
94.58805495
0.934984644
2
9
166.8348711
14.13492611
93.81918327
1.563100586
3
5
211.5006615
14.62840126
119.7066401
1.638484965
4
3
180.5091195
4.44868524
114.819963
1.375139717
5
2
119.1988065
3.505429588
90.54475727
1.39757844
<표 2>
Annual stock
Number
of
기준치
대비 return
기준치 대비 주가 PME standard
Year after Exit
Observation 주가 표준편차
standard
지수 표준편차
deviation
deviation
1
11
54.85551364
72.07545224
17.27826222
0.472003917
2
9
200.6108273
73.2379271
43.44598218
1.335056852
3
5
217.2652422
53.41849443
54.38257189
1.619528592
4
3
212.3177932
45.42558494
27.29932063
1.534348173
5
2
114.8358292
29.8411311
10.2926948
1.427146987
Stock price at the point of exit was given 100 and sample firms’ stock prices were calculated
compared with that standard afterwards. And the annual stock return was calculated based on
those. Stock index which includes the target firm was set to be 100 at the point of exit and the
same process was introduced. Finally PME was calculated with the method stated in the
methodology of experiment.
These samples gave the whole sample average and standard deviation. One thing noticeable is
that there are sample number differences at the respective year of observation period. Actually
there are 2 companies for year 1~2, 4 companies for year 2~3, 2 companies for year 3~4, 1
company for year 4~5, 11 companies for more than year 5 after the exit.
This result shows us two perspectives of profitability and volatility. When we see the profitability,
the most important observation is that both stock price averages and PME averages decline
after 1 year from the exit, and they rebound rapidly and maintain high level after 2 years. Annual
stock returns also show that relatively small gain in the first year from the exit and declines after
reaching the peak during 2 or 3 years after exit.
We see reasons for this phenomenon in two parts. The first one is that after exit of the PEF, the
firm is reevaluated in the market resulting in decline of price. For example, abundant resources
which were available under the ownership of the PEF do not exist anymore driving a little price
decrease. Or it can be simple correction due to the increased stock selling of the PEF when
they exit the firm. Actually in lots of cases, profits from the exit deals are not disclosed so price
drops due to the time requirement of adjusting this effect.
Secondly, we can look for the reason by considering the characteristics of samples and
economic crisis. Certain sample firms which were observed after 1 year are sold recently.
Nordex AG and Transics International NV were sold respectively on 31 July 2008 and 9 June
2008. These firms might have been sold due to the financial crisis and it is obvious that they
could not perform well in the market too. Especially the reason the PME barometers also lags is
that the exit was not executed at the best time. It can be said the exit was executed early in the
needs of urgent pay back or because the target firm was in trouble managing risks resulting in
crucial damage to the firm value.
However generally speaking, firms which experienced managerial participation from the PEF
performed well above the market index. Looking that the phenomenon still exists after the exit of
the PEF, we can conclude that it is due to the increase of value of the firm. Common strategies
which the PEF uses in managerial participation are squeezing cash reserves, increasing debt
ratio, focusing on managerial efficiency and maximizing shareholder values. If these changes
are maintained, they can have competitive advantages and perform well compared with other
firms which do not have these policies.
In the perspective of volatility, it is observed that the volatility is very big. Especially there are
some observations that show above average standard deviation. However, it is due to the big
volatility of individual firms and the weights are given equally to them. In other words, large
volatility of small firms drove this effect. Since sample size is not big enough, there should be
more samples to meaningful observation on the volatility.
III. Conclusion
1. Implication
The reason for starting this study was significant growth of PEF recently. The PEF, an unfamiliar
investment method even around the Asian financial crisis, were founded in Korea and are
growing rapidly. This study has a meaning since there are not so many studies which worked on
the PEF issues. In Korea, people still consider the PEF, especially foreign PEF as a ruthless
investment entity which aims only for achieving profit. People often mention the term ‘diversion
of national wealth’ and worry that M&A trial of PEF will damage economy of the country.
However, it is hard to conclude since there are not enough studies on it.
On the other hand, some people believe that the PEF benefit the company which was acquired
while increasing the value of the firm. Therefore they insist that PEF should be encouraged
more. Recent deregulation trend in Korea is focusing on encouraging development of Korean
PEF.
However, in the cases of prior studies, they focus more on the investment performance of the
PEF themselves. It was also because the PEF was practicing new business model and
strategies. It led to the relatively scarce studies on companies acquired by the PEF and the
effect. And this study was worked on to solve this curiosity.
Even thought there were not so many sample firms, based on our observation we could
conclude that acquired firms showed better performance than stock index after exit of the PEF.
Looking at the good performance result even after the exit of PEF, the firm can be said to
experience value increase by the acquiring PEF. In other words, participation in management
by the PEF improves the efficiency of management and increase the value of the firm despite
they do not always succeed.
Therefore, this trend of encouraging the PEF can be acknowledged in its value creating
capability making the future prospect of this market more promising.
2. Limitation of the study and guideline for the further study
The biggest problem of this study is that size of samples was not big enough to conclude
something in statistical study. Most of the PEF privatize public companies after buying all
shares of the target firm or acquiring it. Therefore, it was difficult to find reliable stock prices and
announcements for lots of firms, which ended up being excluded from the final sample. This
lack of information gives limitation of not only insufficient sample size but also difficulty in
observing the performance of firms.
The further study definitely should focus on capturing the right information when studying
acquired firms. It should be difficult since the PEF often do not disclose the information about
the firm. The further study also can work on the effect on the acquired firm in the field of finance,
accounting etc.