Contracts and Returns in Private Equity Investments

Abstract

We analyze the relationship between contracts and returns in private equity (PE) investments. Contractual control in the form of covenants tends to be employed to identify good deals. Better quality …rms are more likely to have covenant-rich contracts, as they are less concerned by the constraints imposed by the covenants. PE investors appoint closer associates of the fund in deals that are performing poorly but tend to outsource board governance in better deals. Collectively, our evidence suggests that PE investors operate along two dimensions, choosing covenants and board seats di¤erently, based on the ex-ante quality of the company.

Due Diligence and Investee Performance

“…In terms of type of exits employed by PE investors, our data show that the most commonly used divestment route is represented by the trade sale (51%), followed by the secondary sale (27%), IPO (9%), and buyback by the entrepreneur or founder (4%). This evidence is consistent with Caselli et al (). Our sample also includes a portion of write‐offs (10%), mostly associated with the exits that occurred after the global financial crisis (post August 2007–2009 period; for details on the exit distribution over the 2000–2012 period, see Table A1, Panel E in the online Appendix).…”

“…In line with Richard et al () and Kabir and Roosenboom (), for each investee firm we track two operating performance indicators over the first 3 years from the investment date: the Return on Assets (ROA) and the operating profit margin (EBITDA to Sales ratio, hereafter EBITDA/Sales), as measures of operating profitability. These performance measures on a firm level are also consistent with Caselli et al () and Cao () . The key independent variable underlying our study is represented by the time spent on DD, considered as a proxy of the importance and effort given by the investor to that particular activity, in line with a recent tendency in the entrepreneurial field (e.g., Achleitner et al ., ; Wangerin, )…”

“…And because we look at a 3‐year horizon where many firms do not yet have an exit, we cannot examine IPOs. Moreover, as highlighted in Caselli et al (), ROA and EBITDA/SALES do not heavily depend on market conditions as IRR does (which is influenced by the entry and exit prices paid by the PE fund). The IPO exit is also a coarse measure of an investment outcome (i.e., ROA and EBIT/Sales can vary widely across different IPOs), despite its wide usage, as highlighted by Sorensen ().…”

“…Research in entrepreneurial finance has stressed the importance of DD, but primarily from a theoretical perspective (Yung, ). While empirical studies to date have emphasised the importance of investor characteristics, reputation and cultural differences among venture capital (VC) and private equity (PE) intermediaries (Casamatta and Haritchabalet, ; Caselli et al , ; Das et al , ; Masulis and Nahata, , Nahata, ; Nahata et al , ; Sevilir, ), no empirical studies have formally examined the economic value and impact of DD. Related research in corporate finance (Li and Prabhala, 2006) and entrepreneurial finance (Bengtsson and Hsu, ; Sorensen, ; Yung, ) has focused on selection models.…”

“…This definition, which differs from the one typically adopted in USA (see, e.g., Gompers and Lerner, ), excludes the funding of start‐up and early stage firms (venture capital investments) and includes: a) development or expansion financing, b) leveraged buyout (LBO) deals, and c) replacement and turnaround financing (see, e.g., Zambelli, ; ). Historically, the PE sector has dominated the Italian alternative financing industry, while early stage investments have always represented a minority (see AIFI Statistics Reports from 1999 onwards, Caselli et al ., ).…”