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10,1 The use of financial information
by private equity funds in
evaluating new investments
46
Jan Smolarski
The University of Texas Pan American, Edinburg, Texas, USA
Neil Wilner
University of North Texas, Denton, Texas, USA, and
Weifang Yang
The University of Texas Pan American, Edinburg, Texas, USA
Abstract
Purpose – The purpose of this paper is to examine the use of financial information and valuation
methods among private equity funds in Europe and India. The authors analyze differences in the choice
of valuation methods and how the use of financial information differs among funds in the UK,
Pan Europe and India.
Design/methodology/approach – A survey approach was utilized in collecting proprietary data
from European and Indian private equity funds. The data were classified according to fund type,
country grouping, size, risk profile, labor cost and industry structure and analyzed using MANOVA and
ANOVA.
Findings – The results show that the use of valuation models is relatively homogeneous across
countries and that the use of financial information appears to be driven to a large extent by fund type and
fund focus. The use of audited financial statements appears to increase as firms mature. Significant
differences were found in standard financial adjustments between the two fund types and between the
country groupings. Results based on labor cost are weakly significant whereas industry structure does
not appear to have an impact on how fund managers evaluate investments.
Research limitations/implications – The results indicate that fund managers adapt their
decision-making behavior according to investment type and risk. The authors argue that understanding
asymmetrical and structural issues may potentially improve investment decision-making processes.
The main conclusion for researchers is that buy-out and venture capital funds should not be combined as
one asset class. Since a survey approach was used, the study is subject to the belief that fund managers
do not internalize decisions well, which could reduce the effectiveness of the research design.
Originality/value – There are few studies in the areas covered by this paper due to the proprietary
nature of the private equity industry. The results are important because they help in understanding
how fund managers use decision aids such as financial statements and valuation techniques. A better
understanding of current practices will help fund managers and fund sponsors in devising improved
decision aids and processes, which ultimately may lead to fewer non-performing investments. This is
especially important in private equity since investment decisions are often irreversible and binary.
Keywords Venture capital, Equity capital, Financial reporting, Financial risk, Europe, India
Paper type Research paper
French and German funds were used as a proxy for the Pan-European group. France
and Germany are by far the two largest Pan-European private equity markets.
Omitting smaller European private equity markets provided an opportunity to control
for level of market maturity.
We divided the sample into BO and VC funds according to industry criteria[2], and
use rank sum tests for differences in responses between the sub-samples. In order to
verify non-response bias, we performed t-tests for differences in size for responding and
non-responding funds. The test was replicated using fund type. We also performed a
x 2-test for difference in the proportion of VC and BO funds between responding and
non-responding funds. The results show that there are no distributional differences
between respondents and non-respondents. Table II displays descriptive statistics
regarding the survey and respondents. Due to the lack of lower level fund detail, we were
4. Analysis of results
Table I provides summary information about the private equity markets in India,
France, Germany and the UK. Table II shows descriptive information about the
European private equity markets. Figure 1 and Tables III and V show the results
regarding the methods private equity funds use in valuing new investments, as well as
their use of financial information. Figure 1 and Table III display the results from VC and
BO funds and Table V shows the results from the country groupings. The results are
analyzed using MANOVA because it tests for population group differences on several
56
50 2.0
25
0 1.0
IRR NPV Payback EVA Sales based Earnings Real
based options
VC percentage BO percentage VC mean rank BO mean rank
Notes: The figure displays the responses to a question asking firms to rank how often they used each
valuation method; the possible ranks are 0 – never, 1 – seldom, 2 – often and 3 – always; the left-hand
Figure 1. scale refers to the bars in the figure and displays the percentage of firms that indicated that they used a
Valuation methods method at least seldom (rank above 0); the right-hand scale refers to the lines in the figure and displays
the mean rank calculated from firms that responded that they used a method at least seldom
more suitable when earnings are stable. In Table III, we note a difference in the use
of earnings-based factor models and IRR. BO funds use IRR and factor-based earnings
valuation models to a greater extent. This is in line with our expectations since VC funds
focus on early stage financing whereas BO funds focus on mature investments. Earnings
may be non-existent or volatile in earlier stage companies making these models
less suitable for VC funds. Similarly, IRR is more suitable for larger investments. We
hypothesize that there are three primary reasons for this result. First, the assumptions
underlying IRR may frequently be violated in valuing cash flows of small firms, making
the model unsuitable in these cases. Second, the magnitude of the IRR is important for
BO funds, suggesting that BO funds are interested in the actual return rather than using
IRR as a benchmark. In VC funds, the IRR may be used as a hurdle rate to a larger extent.
Third, the nature of VC investments may make the model impractical. BO funds would
make greater use of earnings-based models according to this reasoning. We previously
discussed this contention. This reasoning is empirically supported at the 0.01 level.
We also find that VC funds use accounting-based valuation techniques and real options
to a greater extent than BO funds although the means are low (accounting-based
valuation techniques: 1.217 and 1.086 for VC and BO funds, respectively). Our findings
are contrary to H1A except for IRR and factor-based earnings models. We detect a
convergence in the use of valuation techniques, in comparison with earlier studies,
except in the case where structural issues play a role in the due diligence process. The use
of IRR and factor-based earnings models supports H1A.
Table III, Panel B reports responses to questions concerning adjustments made to
financial forecasts in the VC and BO groupings. Respondents use revenue adjustments,
cost adjustments and audited financial statements quite often. The differences between
Pan Pan
UK Europe UK India Europe India
n Mean n Mean Diff. Sig. n Mean n Mean Diff. Sig. n Mean n Mean Diff. Sig.
Indian funds
57
RAF the VC and BO groups are pronounced, except for the use of industry averages to verify
10,1 reasonableness. Supporting H2D, we find that VC funds adjust the firms’ financial
projections more often when evaluating investment performance. The results are
significant at the 0.01 level, except for cost adjustment where the result is significant at
the 0.05 level. VC funds are more likely to make standard financial adjustments
suggesting that management either produces less realistic forecasts or that it is more
58 difficult for VC funds to verify the projections realism. We also find that BO funds use
audited financial statements to a greater extent than VC funds. The result, supporting
H3A, is significant at the 0.01 level. We speculate that this is due to the availability of
meaningful financial data and audited financial statements for larger investments. The
relatively large transactions cost in producing meaningful financial data and audited
financial statements may prevent their use in small or start-up/early stage investments.
Panel A of Table V reports the responses to questions regarding valuation methods
based on country groupings (H1B)[6]. It shows that IRR is the method used most often.
Its’ use is as extensive as expected. The popularity of IRR is followed by valuation
methods based on earnings (e.g. price-to-earnings ratio), NPV valuations and valuation
methods based on revenue (e.g. price-to-sales method). EVA and real option methods are
used infrequently as was the case in Table III. The results, when comparing valuation
methods used by UK and Pan-European funds, reveal few differences and do not support
H1B. Interestingly, differences which support H1B were noted between UK and Indian
funds with Indian funds using DCF techniques to a greater extent. Indian funds also
use real options to a greater extent as compared to UK funds. Our findings suggest that
Indian funds differ from their UK and Pan-European counterparts in putting emphasis
on different valuation methods.
Panel B of Table V reports responses to questions concerning adjustments and the use
of audited financial statements (H2A-H2C and H3B). On average, the respondents make
extensive use of adjustments to revenue forecasts and cost projections. The use of audited
financial statements is also high[7]. We noted no major differences between UK and
Pan-European funds. We therefore reject H3B. Both UK and Pan-European funds use
audited financial statements to a large extent. The results show differences in three of the
five categories when comparing Indian and UK funds. UK funds increase firms’ cost
projections in evaluating the investment performance to a greater extent than Indian
funds. The emphasis on cost adjustment may be the result of a high cost structure in the
UK. The results may also be attributable to differences in the level of maturity between the
UK and the Indian private equity markets, as well as cultural and behavioral factors.
Another potential explanation is the greater focus on high-technology investments by
Indian venture capitalists, which implies a greater focus on revenue growth. UK funds give
more time to meet pre-determined goals. Indian VC funds use industry data to check the
reasonableness of the forecast to a larger extent as compared to UK funds. A comparison of
the Pan-European and Indian funds reveals similar results, except in the case of extending
additional time to meet pre-agreed goals. Cultural differences in the corporate governance
systems in Asia may also play a role. Our results support hypotheses H2A-H2C.
Pan-European funds do use audited financial statements to a greater, though
statistically insignificant extent, than UK funds (the means were 2.78 for Pan-European
funds and 2.62 for UK funds). French accounting regulations dictate that all firms use the
same set of accounting standards. This makes financial statements very standardized
and easily verified from a legal point of view. Germany’s accounting system is also
based on legal requirements although firms do not necessarily use the same accounting Evaluating new
principles to the extent that French firms do. Almost all firm financial statements in investments
France and Germany are audited and, in most instances, are available to funds. This
availability is not necessarily the case in the UK where most financial statements are
also audited. We argue that the implementation of uniform accounting standards and
harmonization of financial regulations are decreasing structural and cultural differences
across Europe. It also appears that Indian funds are using audited financial statements 59
with high frequency in assessing investment opportunities. This may be the result of
significant problems with asymmetric information. Finally, previous research indicates
that cultural aspects play a role in determining the preparation and use of financial
statements (Salter and Niswander, 1995).
The results reported in Tables III and V indicate that fund orientation may play a
role in how firms use financial information to analyze potential investments. This also
supports the argument that fund focus plays a role in how funds analyze investments.
We therefore test two additional hypotheses:
H4A. There will be a difference in the use of valuation techniques among high- and
low-risk funds.
H4B. There will be a difference in the use financial information among high and
low-risk funds.
We examine historical investments made by each fund and analyze available descriptive
information to classify funds into high and low risk. Funds are classified in the high-risk
category if they primarily invest in startup, early stage or expansion. Funds are
considered low risk if they primarily invest in late stage, pre-IPO and BOs. This
classification introduces selection bias since larger funds tend to invest in the low-risk
category. To analyze the impact of size on our results, we also classify funds into small
and large using the same cutoff as discussed previously. Classifying funds into large and
small is a proxy for investment size. We test the following hypotheses:
H4C. There will be a difference in the use of valuation techniques among small and
large funds.
H4D. There will be a difference in the use of financial information among small and
large funds.
Consistent with our previous methodology, we use both MANOVA and ANOVA to
analyze the data. Panel A of Table VI reports the results for the high/low-risk
classification. The use of valuation techniques is consistent with our previous tests.
Low-risk funds use IRR and earnings-based factor models to a greater extent when
compared to high-risk funds. This result lends further support to the argument that the
use of valuation techniques is fairly uniform across all funds. Panel B of Table VI reports
the differences in how firms use financial information in the investment evaluation
process. The results are highly significant, except for variable (d), reasonableness check.
Fund managers in high-risk funds lower firms’ revenue projections to a larger extent
compared to low-risk funds. High-risk fund managers compensate for the higher risk by
lower revenue projections due to significant and expected revenue volatility. It is
important to note that this type of fund manager behavior results in lower downside risk
while preserving the upside potential. We also find that high-risk funds increase cost
RAF
No. HR No. LR Mean
10,1 HR mean LR mean diff. Sig.
projections to a larger extent. The result for the variable cost projection is not as strong
as the variable revenue adjustment. Fund managers are also more likely to give a
high-risk investment more time to reach the firms’ goals and objectives. Finally, the use
of audited financial statements is significantly higher for low-risk funds. We attribute
this result to:
.
the almost universal availability of audited financial statements;
.
transaction cost theory; and
.
past history.
UK India
n Mean n Mean Diff. F Sig.
5. Conclusion
In this study, we attempted to analyze differences in the use of valuation methods and
the use of financial information among VC and BO funds. Our initial results lead us to
investigate the role of risk and fund orientation. We analyzed the same questions
grouping the sample into three geographical categories: the UK, Pan-European and
India. The results show that there are differences in the use of valuation methods but that
these differences as not as large as previously reported. Our findings suggest that the
use of valuation models is relatively homogeneous across countries. The use of financial
information in the evaluation process appears to be driven by fund type and fund focus.
Our results suggest that future research should focus on VC and BO funds separately.
Labor costs were only weakly related to how fund managers use financial information
and unrelated to the use of audited financial statements. We find no support for the
argument that country specific industry structures affect how funds evaluate
investments.
There are several limitations associated with this study. First, it suffers from
common problems associated with survey research. Zacharias and Meyer (1998)
suggest that funds managers are poor at internalizing decisions resulting in reduced
effectiveness of survey research. Second, we used a Pan-European sample as a Evaluating new
proxy for a non-Anglo Saxon legal and economic system. Third, we were unable to investments
conduct interviews to follow-up survey answers. Fourth, we do not test for interaction
effects.
Notes 65
1. In comparing VC and BO funds, we used a larger sample consisting of funds in several
different European countries (Table II). Owing to the small sample size, we were unable to
divide the Indian sample into VC and BO funds.
2. Classification into BO and VC funds was accomplished by analyzing the investment
activities of each responding fund. In analyzing the initial results of our study, we further
divided the sample into high and low risk. We also classified funds into small versus large
funds using standard ECVA classification where a fund is considered small if its capital
under management is less than e250 million. We discuss the results later in the paper. Our
sample excludes specialized BO funds such as distressed asset and mezzanine funds.
3. UK funds may differ in the management of the pre-investment process compared to funds in
other European practices since they operate in the Anglo-Saxon legal system. Therefore, as a
robustness test, we included a UK dummy in all regressions (not reported). This approach
did not change our results, and we did not find that UK funds differed systematically from
other firms. Thus, our results are not driven by a “UK effect”.
4. Additional explanatory variables are warranted, but lack of data limit us to those presented. In
effect, we cannot control for other, potentially important, variables such as fund managers
compensation programs, or more detailed data on the inherent riskiness of funds’ investee
firms.
5. Initially, we analyzed the sample using Mann-Whitney tests. In addition, ordered LOGIT
regressions, LOGIT regressions and OLS regressions were used where applicable. However,
the repeated tests decreased the statistical power and increased possibility of a type I error.
Therefore, we report the results from the MANOVA and two-way ANOVA tests.
6. Since extant literature show differences in the use of valuation methods, we grouped all
European funds into random categories without taking into account fund type, size and risk.
We then compared the results of the various groups. A group was defined as having at least
two countries. The results are consistent with our main finding that there are few country
differences. Only one group comparison resulted in significant differences at the 10 percent
level. We found differences between group 1 (Denmark, Switzerland and the UK) and group 3
(Austria, France, Luxembourg, Poland, Portugal and Spain). There is no theoretical basis for
finding differences in random groupings so we do not comment further.
7. We observe that not all funds use auditing financial statements when evaluating potential
BO investments. This may seem odd at first. However, not all BO transactions include the
entire firm. Some transactions may be for assets only and some involve a previously
integrated division of a firm.
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