Fund Investors’ Monitoring


Chapter 3 investigates the post-investment relationship between private equity fund investors and their fund managers. More specifically, it analyzes the monitoring of private equity fund managers by their respective fund investors. So far, this issue has been largely neglected by academic researchers.275 Due to the increasing role that private equity investments play in the overall investment allocation of institutional investors, however, it is important to understand the nature and extent of the monitoring and the resulting information requirements.


Cash Flow Private Equity Fund Manager Fund Investor Secondary Market 
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  1. 275.
    A study of Robbie/Wright/Chiplin is an exemption. However, the authors mainly focus on the way how the fund investors gather information. See Robbie/ Wright/ Chiplin (1997). Two books recently published by practitioners also address the management of private equity fund programs. See Grabenwarter/Weidig (2005a) and Meyer/Mathonet (2005).Google Scholar
  2. 276.
    See Fried/ Hisrich (1989), p. 268.Google Scholar
  3. 277.
    See Bader (1996), p. 300; Hagenmüller (2004), p. 44.Google Scholar
  4. 278.
    See Meyer/ Mathonet (2005), p. 272.Google Scholar
  5. 279.
    See Meyer/ Mathonet (2005), p. 64.Google Scholar
  6. 282.
    See Barnes/ Menzies (2005), p. 212. Based on their experience, the authors state that senior executives at private equity investors were unlikely to complete mailed questionnaires and often pass them to more junior colleagues.Google Scholar
  7. 283.
    See Private Equity Intelligence (2006), p. 54.Google Scholar
  8. 285.
    See EVCA (2006c). The data only serves as an indication as it is not directly comparable. EVCA reports data provided by private equity funds that are their members. Their respective investors are not only European-based. The respondents in this study, however, are European investors who invest globally.Google Scholar
  9. 286.
    See EVCA (2006c). As only members of the EVCA have been surveyed, this is probably a conservative estimation.Google Scholar
  10. 287.
    See EVCA (2006c). Venture capital includes seed, start-up and expansion capital.Google Scholar
  11. 288.
    See EVCA (2006c). 9% of the investors were not identifiable.Google Scholar
  12. 290.
    See Easterby-Smith/ Thorpe/ Lowe (2002), p. 130, for a distinction of qualitative and quantitative research.Google Scholar
  13. 291.
    See Easterby-Smith/ Thorpe/ Lowe (2002), p. 86.Google Scholar
  14. 292.
    See Easterby-Smith/ Thorpe/ Lowe (2002), p. 86. Furthermore, non-verbal clues which are present in the inflection of the voice or facial expressions and which provide additional insight could be identified.Google Scholar
  15. 294.
    See Hagenmüller (2004), p. 44.Google Scholar
  16. 295.
    See Grabenwarter/ Weidig (2005a), p. 84.Google Scholar
  17. 296.
    See Grabenwarter/ Weidig (2005a), p. 84. There are few occasions where investors really restructure funds.Google Scholar
  18. 297.
    See for this and the following Meyer/ Mathonet (2005), p. 276.Google Scholar
  19. 298.
    See McKinsey (2003), p. 26.Google Scholar
  20. 301.
    See Kaserer/ Wagner/ Achleitner (2003), p. 261. It is typically rather impossible to transact the investments at any point in time and/or only with incurring substantial transaction costs, e.g. high costs of searching potential buyers and sellers. See Kaserer/Wagner/Achleitner (2003), p. 260. This is true for the fund itself as well as for the underlying portfolio companies.Google Scholar
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  22. 305.
    See Kemmerer/ Weidig (2005), p. 88.Google Scholar
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    See Burgel (2000), p. 33. A study of German private equity companies finds that 98% of the participants use the IRR to measure their performance. See Haarmann Hemmelrath/Universitaet Leipzig (2002), p. 8.Google Scholar
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    See Kaserer/ Diller (2004c), p. 37; Grabenwarter/Weidig (2005a), p. 23; Brealey/Myers (2005), p. 91.Google Scholar
  25. 308.
    See Troche (2004), p. 30.Google Scholar
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    See for more details Defusco et al. (2001), pp. 81 et seq; Rouvinez (2003b), p. 34; Kaserer/Diller (2004b), p. 37.Google Scholar
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    See zu Knyphausen/ Kittlaus/ Seeliger (2003), p. 549. Limited partners cannot influence either the call of committed capital by or the timing of any distributions from their general partners.Google Scholar
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    See Rouvinez (2003b), p. 35. Chapter discusses the difficulties of fund valuations.Google Scholar
  29. 312.
    In cases in which over time a mix of positive and negative cash flows occurs may be more than one internal rate of return. See Gottschalg/ Zollo/ Loos (2004), p. 37.Google Scholar
  30. 313.
    See Gottschalg/ Phalippou/ Zollo (2004), p. 9.Google Scholar
  31. 314.
    Even if another private equity fund is raising capital at the time when the distribution occurs, the investment in the new fund is rarely immediate. See Gottschalg/ Phalippou/ Zollo (2004), p. 9.Google Scholar
  32. 315.
    See Kaserer/ Diller (2004b), p. 38. To overcome these problems HIELSCHER/ZELGER/BEYER suggest a modified IRR that discounts the investment of committed capital at money-market rate and the distributed cash before the exit at a rate that depends on investors risk attitudes and investment opportunities. See Hielscher/Zelger/Beyer (2003), p. 500.Google Scholar
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    See Burgel (2000), p. 33. Gull (1999) and Hagenmüller (2004), p. 119 provide sample calculations.Google Scholar
  34. 318.
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  35. 319.
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  36. 320.
    See for the following Troche (2004), pp. 28–29; Hagenmüller (2004), pp. 117–118.Google Scholar
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    See for a discussion of several measures Anonymous author (2002), pp. 32 et seq.Google Scholar
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    See Frei/ Studer (2004), p. 30. The authors analyze the relation between the IRR of a fund and the payback period for a sample of more than 500 U.S. and European private equity funds.Google Scholar
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    See Burgel (2000), p. 34.Google Scholar
  42. 326.
    Based on Burgel (2000), p. 35; Meyer/Mathonet (2005), p. 12.Google Scholar
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  44. 328.
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  45. 330.
    See Fort Washington (2006); Achleitner/Müller (2005), p. 69. In fact, the conservative valuation policy had been proposed or required by many private equity and venture capital industry associations for many years. For more details see chapter 4.3.4.Google Scholar
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    See Bane (2005), p. 6; Meyer/Mathonet (2005), p. 154. There are typically only few other net assets or liabilities of private equity partnerships. See Böhler (2004b), p. 204.Google Scholar
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    See Kaserer/ Wagner/ Achleitner (2003), p. 263. For example during fundraising for subsequent funds, general partners may write up investments in order to be able to show a better track record.Google Scholar
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  58. 346.
    See Guennoc (2006), p. 122. The net asset value method implicitly assumes a break-up of the fund whereas in reality the fund is still hold.Google Scholar
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    See Meyer/ Mathonet (2005), p. 154. CLARK/KOJIMA add that also the legal arrangements in the partnership agreements and the alignment of interest between general and limited partners contribute to the value of the fund perceived by fund investors. See Clark/Kojima (2003), p. 84.Google Scholar
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  61. 349.
    For high-quality and successful (low-quality) fund managers the fair value of the existing portfolio may underestimate (overestimate) the total value to be created. See Meyer/ Mathonet (2005), p. 154.Google Scholar
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  63. 351.
    See Meyer/ Mathonet (2005), pp. 180 et seq. They call their approach Grading-based Economic Model (GEM).Google Scholar
  64. 352.
    A major challenge is the determination of an appropriate discount rate for private equity fund investments as standard approaches, e.g. the capital asset pricing model (CAPM), fail due to the unavailability of necessary data. Meyer/Mathonet conclude that different rates should be used, depending on the context. For valuation purposes they suggest a discount rate at the level of the public market plus a risk premium of 100-300 basis points. See for a detailed discussion of the private equity fund discount rate Meyer/ Mathonet (2005), pp. 253 et seq.Google Scholar
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    See Kinsch/ Petit-Jouvet (2006).Google Scholar
  66. 354.
    Based on the discussion in Kinsch/ Petit-Jouvet (2006); Meyer/Mathonet (2005), pp. 154 et seq; Kojima (2005), p. 42.Google Scholar
  67. 355.
    Meyer/Mathonet correctly do not use the calendar age, but a proxy based on the actual drawdowns. See Meyer/ Mathonet (2005), p. 186.Google Scholar
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    See Ljungqvist/ Richardson (2003), p. 1; Kaplan/Schoar (2005), p. 1811. According to Cochrane, the problem of a selection bias is especially a problem when analyzing exited individual private equity investments. These investments are far more likely to go public when they are successful. See Cochrane (2005), pp. 4 et seq. Chen/Baierl/Kaplan argue that this is a minor problem when analyzing funds. Return data by private equity funds includes both successful and unsuccessful investments. See Chen/Baierl/Kaplan (2002), p. 85.Google Scholar
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    See Gompers/ Lerner (2000). 251.Google Scholar
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    See Gottschalg (2006), p. 203, who cites a study from HEC School of Management.Google Scholar
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    See Long/ Nickels (1995), p. 4. This methodology is adopted by Thomson Financial and EVCA for measuring and comparing industry returns. See Guennoc (2006), p. 123. Figure 13 shows current performance results for the industry.Google Scholar
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    See Grabenwarter/ Weidig (2005a), p. 24.Google Scholar
  81. 370.
    See Rouvinez (2003b), p. 35.Google Scholar
  82. 371.
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    See Rouvinez (2003a), p. 26.Google Scholar
  84. 373.
    See Rouvinez (2003b), p. 36. The negative value at the end of the measurement period even might cause the IRR to be undefined as there is no discount rate that brings the net present value to zero.Google Scholar
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  86. 375.
    See Grabenwarter/ Weidig (2005a), p. 25.Google Scholar
  87. 376.
    See Rouvinez (2003a), p. 28. In Figure 26, the scaling factor (=0.2281) can be derived by adding all shares bought (=11,600), subtracting the final number of index shares (=7,252) and divide the result by all shares sold (=19,065).Google Scholar
  88. 377.
    Own calculations based on the methodology presented in Rouvinez (2003a); Rouvinez (2003b). For the derivation of the scaling factor see Rouvinez (2003a), p. 24.Google Scholar
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    See Frei/ Studer (2006), p. 141. Although the PME+ scaling procedure mitigates a potential negative exposure and ensures a positive ending balance, it does not guarantee a constant positive exposure over the entire investment period. See Rouvinez (2003b), p. 37.Google Scholar
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    Different authors use different alternative reinvestment hypotheses to overcome the mentioned problem with the IRR. Ljungqvist/Richardson, for example, calculate ex post net present values of investments in a fund by discounting realized cash outflows at the risk-free rate of return and at the cost of capital for inflows. The net present values are then scaled by the present value of the investment, giving a so-called profitability index. See Ljungqvist/ Richardson (2003), p. 19.Google Scholar
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    See Kaserer/ Diller (2004c), pp. 40 et seq. for more details. Kaplan/Schoar use a similar approach modified only because their public market equivalent is the ratio of the discounted value of all cash outflows (using the total return of a public index) and the discounted value of all cash inflows.Google Scholar
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    See Kaserer/ Diller (2004c), p. 40.Google Scholar
  95. 385.
    See Kaserer/ Diller (2004c), p. 40. This can be calculated by dividing the terminal value of the private equity investment in t=10 (7,544,000) by the present value of all cash outflows in t=0 (1,160,029).Google Scholar
  96. 386.
    See Kaserer/ Diller (2004b), p. 40. The presented PME+ example assumes that the respective private equity fund is not fully liquidated. If the fund is fully liquidated, the net asset value is zero and SN equals zero. In these cases, Rouvinez’s scaling factor is the reciprocal value of Kaserer/Diller’s PME. Both approaches are quite similar, only different with respect to calculation and interpretation.Google Scholar
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  99. 389.
    See Kaplan/ Schoar (2005), p. 1797. If the private equity investments’ systematic risk is higher (lower) than the index, i.e. its beta is higher (lower) than 1 with respect to the index, the PME will overstate (understate) the true risk-adjusted returns to private equity.Google Scholar
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  101. 391.
    See Guennoc (2006), p. 125; Kaplan/Schoar (2005), p. 1797.Google Scholar
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    See Frei/ Studer (2003), p. 207. If the fund investors for example anticipate a decline in value before market participants, they may therefore not be able to act on such information. There are no quickly exercisable secondary transactions possible. On the opposite, if the fundamental outlook of a fund is promising, it may be impossible or very difficult to increase the exposure. See Frei/Studer (2003), p. 207Google Scholar
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    Typically, private equity funds themselves are not leveraged as the limited partnership agreement prevents the general partner from taking this additional risk. See Gompers/ Lerner (1996), p. 480.Google Scholar
  104. 396.
    See Financial Service Authority (2006b), p. 37. The leverage is typically measured with the debt/EBITDA ratio.Google Scholar
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    A detailed discussion of the negative but also positive aspects of excessive leverage is provided in Financial Service Authority (2006b), pp. 59 et seq.Google Scholar
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    A wide gap between top-and bottom-quartile fund managers is evidence for this. See Schmidt (2003), p. 256.Google Scholar
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    See Kaserer/ Wagner/ Achleitner (2003), p. 262. The internal rate of return does not allow the estimation of a standard deviation of returns, and a correlation of returns to other asset classes. See Buchner/Kaserer/Wagner (2006), p. 3.Google Scholar
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    See for example Gompers/ Lerner (1997), pp. 5 et seq. The authors suggest a marking to market valuation of the portfolio companies to overcome conservative valuation biases.Google Scholar
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    See Artus/ Teiletche (2004), p. 8. The authors conclude that in these cases, the risk of the fund investment is individually underestimated (via the standard deviation) or collectively with other assets (via the correlation).Google Scholar
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    See Helwing/ Hummel (2005), p. 43. The authors develop a scoring model based on institutional characteristics of private equity funds to measure risks.Google Scholar
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    If not all investments are realized, the valuation of the unrealized portfolio should be considered. The gross return according to EVCA Reporting Guidelines neither includes any fees paid by the portfolio company either to the fund or the fund managers, nor fees paid to lawyers, accountants or other advisors. See EVCA (2006b), p. 29.Google Scholar
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    See EVCA (2006b), p. 28.Google Scholar
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    The net present value of management fees and other charges over the life of a fund alone may sum up to around 12–15% of the committed capital. See Sormani (2006), p. 45; Feinendegen/Schmidt/Wahrenburg (2003), p. 1177.Google Scholar
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    After a specified investment period, most funds calculate the management fee based on the purchase costs of the remaining portfolio. This reflects the perceived level of activity necessary to manage the remaining portfolio. See Schell (2006), chap. 2, p. 31.Google Scholar
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    See Schell (2006), chap. 2, p. 27. A budgeted management fee shifts power towards limited partners and is typical for captive funds.Google Scholar
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    A controversial issue might be the treatment of placement fees which should cover the fundraising costs of the general partners. Fund investors normally do not accept that these fees should be reimbursed by the fund. See Schell (2006), chap. 2, p. 40.Google Scholar
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    In case the defaulting investor needs to sell the partnership, the co-investors in the fund often have a right of first refusal. See Grabenwarter/ Weidig (2005a), p. 153.Google Scholar
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    See Meyer/ Mathonet (2005), p. 273. In some jurisdictions, limited partners may even loose their status as limited partners or have to fear tax consequences when getting an influence on the dayto-day activity of the fund. See Grabenwarter/Weidig (2005a), p. 83.Google Scholar
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    This may be indicated by the potential size of the market for this strategy, its specialization, or the historical risk-return generated through these strategies. See Grabenwarter/ Weidig (2005a), pp. 44 et seq.Google Scholar
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    See Atkins/ Giannini (2003), p. 223. As fund investments are blind-pool investments and the fund investors normally have no influence on the portfolio company transaction, the selection of the fund management team is the most important element that a fund investor actively can control. See Grabenwarter/Weidig (2005a), p. 47.Google Scholar
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    Carried interest allocation mechanisms that are in favour of senior people who are actually no longer involved in the activities of the fund may lead to tensions in the team and, in extreme cases, to departures of team members. See Grabenwarter/ Weidig (2005a), p. 54.Google Scholar
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    This is called multiple arbitrage. See Fingerle (2005), p. 40.Google Scholar
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