1、Electronic copy available at: http:/ Collective Monitoring and Investment Illiquidity in Leveraged Buyout from the Private Equity Fund Hong-Jen Carlos CHIU Department of International Business College of Management, National Taiwan University E-Mail: hongjenmanagement.ntu.edu.tw instead, it has a mo
2、derating effect on choice of club deals through its interaction with the location of reference point for risk aversion. Finally, both fund size and fund sequence have U-shaped relations to the choice of club deals, while deal value of buyouts is related positively to the choice of club deals. Key Wo
3、rds: Buyout Fund, Investment Illiquidity, Collective Monitoring Electronic copy available at: http:/ This paper addresses the issue on how investment illiquidity affects the choice of monitoring mechanisms for investment in private-equity buyouts. Collectively, investors employ institutional constra
4、ints to screen out fund managers who could misuse discretionary rights to engage buyout deals. This symmetric approach follows Lerner instead, it has a moderating effect on choice of club deals through its interaction with the location of reference point for risk aversion. Finally, both fund size an
5、d fund sequence have U-shaped relations to the choice of club deals, while deal value of buyouts is related positively to the choice of club deals. Recent tremendous capital flows into buyout funds raised by private equity firms (PEFs) propelled frantic growth in takeover transactions (Acharya, et a
6、l., 2007). Accordingly, regulatory authorities have started to monitor the anti-competitive practices of PEFs collective bidding for the same target, known as “club deals” (Financial Services Authority, 2006). A club deal is launched by a group of PEFs that pool their assets together, make a joint b
7、id for a buyout target, and monitor the buyout processes collectively (Mergers Williamson, 1985). To address such discretion issue, we develop a model that attempts to link GPs managerial discretion, differences in cognitive architecture between the GP and LP, and investment illiquidity. Lerner Lern
8、er Wighton Tversky Wright, et al. 2000). Changes of the rent-seekers wealth may fall in the loss domain if managerial discretion turns fruitless, but rent-seekers expect to be free of behavioral and cognitive constraints (Barron, 2007) due to their perceived supervisory failure. Rent Seeking and App
9、ropriation The second constraint faced by GPs in buyout deals is behavioral. Rent-seeking behavior is inevitable when shirking at work in the joint-production system is hard to identified (Alchian Litchtenberg Phalippou returns persist across follow-on funds of the same PEF because of GPs may be abl
10、e to invest in better investments (i.e., proprietary deal flow). (Kaplan Kahneman, 2003; Lerner as a result, LPs who exercise governance roles in the partnership could endanger their limited liability status. Our modeling takes account of the impact of legal provisions on LPs cognitive architecture
11、(Kahneman, 2003) of governing effectively managerial discretion of the GP. Such cognitive constraints grant the GP with the incentive to take discretionary actions that may deteriorate private benefits of the LP. The basic idea behind our modeling is that club deals are employed to discipline GPs ma
12、nagerial discretion for buyout decision-making. GPs from partnering funds are supposed to exercise joint control over the buyout decisions. This paper assumes that GPs differ in their likelihood of making selfish discretion for buyouts, and hence in their likelihood of appropriating benefits accrued
13、 to the LPs. GPs with a higher propensity of selfish discretion would find collective monitoring undesirable, and hence would be less willing to participate in club deals. Moreover, it is assumed that LPs don not know which GPs are more inclined to selfish discretion ex ante, but GPs 9understand the
14、ir own objective functions conditioned on cognitive, behavioral, and illiquidity constraints. GPs willingness to accept collective monitoring is beneficial for the LP, because the fundraising process is of repeated game in nature. LPs with equity positions in the PEF usually take part in successive
15、fundraising, due mainly to the long-horizon nature of their financial positions. For instance, college endowment foundations seek long-term returns on investments by allocating their capital into assets with great potential of value growth (Lerner, 2000). If an LPs stake in the PEF that demonstrates
16、 superior performance, then this investor need not search for new investment outlets. Superior performance can be either internal rate of return (IRR) or public market equivalent (PME): IRR stands for an internal self-reported performance is still subject to indecent managerial discretion; PME bench
17、marks market returns such as S the fair GP (who occurs with probability 1-q) may also profit from her discretion with probability 2 1. We assume that ex ante LPs do not know the type of the GP, but GPs know the likelihood of profiting from their own managerial discretion. Misuse of managerial discre
18、tion indicates that the GP could appropriate a share of profits from the assets under her management, which incurs a loss of c to all LPs of the fund. The interest rate in the market is normalized to be zero. This model presents our baseline case of buyout investment at two stages. At stage 1, the L
19、P makes the first-time investment in the buyout fund, and his type is unknown. At stage 2, the GP faces a likelihood of profiting from her managerial discretion i; both parties learn the GPs true quality of managing her buyout fund; the LP makes further investment in the next buyout fund of the same
20、 GP, or switches to other investment alternatives. The premium of the capital invested at stage 2 will be called M2,if the LP switches to a new buyout fund, I2 if the LP keep investing in the follow-on fund of the same GP. Analytical Arguments The LP intends to maximize his investment returns (net o
21、f all fees paid to or rent appropriated by the GP) from buyout funds at two stages. The LP has to choose whether or not he will impose a preference for club deal at stage one. Thus, it is necessary to compute net profits from the buyouts with and without collective monitoring (i.e., the club deal) r
22、estrictions. 11Part 1: No Collective Monitoring Restriction If the LP puts no restriction, he will invest in the buyout funds raised by both type of GPs, selfish or fair. At stage two, the premium of the capital invested by the LP will depend on whether or not he is of a committed or an elusive type
23、. Only if the LP turns out to be a committed type, the incumbent GP is willing to offer this premium of the capital invested: The LP must search and then invest in a new buyout fund, if either the incumbent GP reveals intention to profit from managerial discretion or if the LP turns out to be an elu
24、sive type. The market for buyout funds can not differentiate between these two cases and will charge a lemons (i.e., below market-average) premium in both cases. The premium of capital invested for the LP becomes At stage one, the LP faces a premium of the capital invested independent of his type be
25、cause it is unknown: Hence, the LPs overall profits are (Vc p I + B) + (p(1- 1) q + (1-2)(1- q) (B + (Vc I) + (p1 q +2(1- q) (B + Vc - I q 1 + (1-q) 2) p + (1-p) ) (q 1 + (1-q) 2) p + (1 p)B). (4) We interpret each bracketed term in equation (4) as follows. The first term is the expected profit plus
26、 private benefits at stage one. The second term is the profit plus private benefits if the LP turns out to be committed (profitability p) and the incumbent GP does not profit from selfish discretion profitability (1- 1) q + (1-2)(1- q). The third term describes the profits if the LP is committed but
27、 the incumbent GP misuses I Vc p N1= (3)I Vc I2= (1)MN2= I (q 1 + (1-q) 2) p + (1-p) (q 1 + (1-q) 2) p Vc (2)12her managerial discretion probability 1 q +2(1- q), forcing the LP to switch to a new buyout fund at stage two. The last term is the payoff if the LP turns out to be elusive and has to swit
28、ch to a new buyout fund. He will receive the private benefits only because the buyout investment will be worth nothing. Part 2: With Collective Monitoring Restriction We model when the LP imposes collective monitoring restrictions at stage one, as incurring a monitoring cost c whenever the GP tries
29、to misuse her managerial discretion. The GPs with low probability of profiting from selfish discretion will be more inclined to pursue club deals in buyouts. Again, the premium of capital invested at stage two will depend on the LPs type. If the LP is a committed type and the GP does not face a coll
30、ective monitoring restriction, the premium of capital invested is This is parallel to the case with no restriction, but the probability of GPs profiting from selfish discretion is higher now, because the LP has screened out the selfish GPs. There are two cases when the LP decides to switch to a new
31、buyout fund: either he is an elusive type or the GP reveals her intention of misusing managerial discretion. In this case, the premium of the capital invested is The premium of capital invested in the new buyout fund is now much higher than in the case with no restriction. The market knows that the
32、GP has a low profitability of profiting from managerial discretion, and thus puts more weights on the likelihood that the LP is an elusive type. If the fair GP has a very low likelihood of misusing her managerial discretion (2 I (1-p)/(Vc I) p), now it becomes impossible for the LP to switch its inv
33、estment to a new buyout fund. The market will assume that the LP must be of an elusive type, if the fair GP declines capital infusion of the incumbent investor in next round of fundraising. Moreover, we analyze the case in which the LP is unable to find a new buyout fund to invest. At stage one, the
34、 premium of capital invested is equal to the case with no restriction: MR2= I 2p + (1-p) 2p Vc (6)I Vc I2= (5)13Now, the LPs overall profits are (Vc p I + B c ) + (p 2(1 - 2)(B + (Vc I) + (p 2(0) + (0) (8) Our interpretation of each term is parallel to that with no restriction. The first term is the
35、 expected profit plus private benefits at stage 1, minus monitoring cost c incurred by the LP to restrict selfish discretion of the GP. The LP persuades the GP to pursue club deals in buyouts, where cost c is paid to install collective monitoring mechanisms for curbing selfish discretion held by the
36、 GP. The second term is the profit plus the private benefits if the LP turns out to be committed (probability p) and the GP does not misuse her discretion (probability (1 -2). Because collective monitoring restrictions screen out GPs with a high likelihood of selfish discretion, the probability that
37、 the LP keeps investing in the follow-on fund is higher than otherwise. In contrast, the third and fourth terms show the costs of collective monitoring restrictions. The LPs profits are zero if he is a committed type, but the GP profits from her discretion (probability p 2). The LP also gives up his
38、 private benefits because he finds nowhere to invest in buyout funds. Part III: Justification of the Net Benefit of Collective Monitoring The difference between profit with restriction and that without restriction is (1 p)I B) ( 2 c) (p 2(B + Vc I) (9) We interpret each term in equation (9) as follo
39、ws. The first term reflects the benefits of working with the fair GP. If the LP turns out to be committed, then he benefits from facing a reduced probability of selfish discretion. The second term is the premium of commitment from the LP. The fair GP still has chance to profit from her discretion wi
40、th probability 2, so she will need to have incurred a monitoring cost c. The third term reflects the worsening of the lemons problem in the new buyout funds caused by the collective monitoring restriction. We further discuss the necessity of placing collective monitoring restrictions. Only 2 enters
41、equations (8) and (9) because the benefits of imposing collective monitoring restrictions arise from only encountering fair GPs. Also, when private benefits of equity partnership with a buyout fund are small (B 0) and when the fair GP rarely misuses her managerial discretion, monitoring cost c becom
42、es small. As a I Vc p N1= (7) 14result, the benefit of collective monitoring restrictions also increases. By screening for fair GPs, such restrictions reduce the adverse selection that the LP will face when making next investments at stage two. Our model emphasizes that selfish discretion in the buy
43、out fund has its behavioral-economic foundation in the GPs cognitive architecture. In a buyout deal, GPs intend to make opportunistic decisions for self-interest, but also cooperated with other counterparts. The economic performance of such disruptive cooperation constrained by rents seeking and app
44、ropriation should be only satisfying (i.e., suboptimal). Overall, each GP makes self-serving loss-averse decisions for its own individual efficiency, which was psychologically anchored in the risk-seeking cognitive architecture (Kahneman, 2003). Each GP could have biased perception of profiting from
45、 managerial discretion. Since perception systems were reference- dependent, misused discretion would exacerbate if prior indecent discretionary practices had been proven cognitively feasible. This is particularly important for those GPs who are convinced that a positive change in wealth worth misusi
46、ng their own managerial discretion, so as to appropriate rent inherent in the buyout investment. HYPOTHESES Based on literature review and the model presented above, we develop seven hypotheses. These hypotheses is concerned with the relations between collective monitoring restrictions imposed by th
47、e LP, managerial discretion possessed by the GP, and other related aspects of buyout funds. In this research, the choice of club deals serves as the proxy for collective monitoring restrictions imposed by the LP. As our model suggests, GPs may be selfish in terms of profiting from their discretionar
48、y rights in the buyout decision-making. To screen out such GPs, the LP implements such restrictions by requesting GPs to participate in club deals, which could benefit from collective monitoring for the buyout deal from partnering funds. H1(a): On average, performance of all types of PEFs is related
49、 positively to the choice of club deals. H1(b): On average, persistent performance of all types of PEFs is also related positively to the choice of club deals. H1(c): Performance of buyout funds is positively related to the choice of club deals. H1(d): Improved performance of other types of PEFs is related positively to the choice of club deals. 15The first set of hypotheses is on the relation between the choice of cl
