UNIVERSITY OF EDINBURGH

What matters the most to Limited Partners?

by

Chung Ang Taing

Dissertation presented for Honours Degree in International Business

2013/2014

Dissertation Advisor:

Mehdi Safavi

Abstract

otivated by the disparity of private equity investments across developed and

emerging markets, this paper is interested in identifying the most important

country-specific and firm-specific determinants of capital allocation decisions.

Building on the existing literature, this abductive research differentiates its contribution by

directly surveying limited partners through questionnaires. This research is conducted at a global

scale with a diverse sample of 76 limited partners. A series of Wilcoxon Signed Rank tests is

employed to establish the rank positions of the tested determinants. This paper successfully

identifies the most important country-specific and firm-specific determinants.

At the country- level, while investors are attracted by the expected returns of private equity

investments in emerging markets, issues related to securing their claims such as investor

protection, bribing and corruption and regulation on repatriation of capital also rank highly

among investors. Investors also have strong concerns about local entrepreneurial management

quality and skills. Public funding and subsidies are not effective in attracting investments. Such

findings urge policymakers to re-evaluate their efforts, and more emphasis should be placed on

facilitating the enforcement of investors’ claims. At the firm-level, investors concur that the

integrity and transparency practices of general partners are the most important determinants.

Likewise, investors desire general partners who possess the right match of expertise and strategy.

Key findings suggest the possibility of firm-level corporate governance as an alternative

mechanism to compensate for the shortcomings of legal protection. Investors believe that general

partners could bring about significant improvements to compensate for the lack of local

entrepreneurial management quality and skills.

Keywords: Private Equity, Limited Partners, General Partners, Emerging Markets, Determinants.

M

Acknowledgement

I am obliged to my supervisor Mr. Mehdi Safavi for his advice, guidance and support during the

period I am writing this dissertation. I also would like to thank him for providing me with other

career development opportunities. I am sincerely thankful to Professor Jake Ansell and Professor

Jo Danbolt for spending their valuable time to provide feedbacks and conduct expert tests on the

questionnaire used for this research.

Without the supports from limited partner community, this dissertation would not be completed.

I would like to express my deepest gratitude to many investment and business executives for

participating in this research, further redistributing questionnaires and providing valuable

feedbacks. Many thanks go to two anonymous warriors who had allowed me to conducted phone

interviews with them. I am enchanted by the dedication to education within the limited partner

community.

I am grateful to a few very good friends of mine including Angela Mi, Marie Chia and Martin

Lam for their valuable comments and encouragements. Last but not least, special thanks are due

to Benjamin Lau for providing technical support and valuable feedback and for proofreading this

dissertation.

Table of Contents Chapter One: Introduction ...............................................................................................................1

Chapter Two: Literature Review .....................................................................................................3

2.1. Introduction ............................................................................................................................. 3

2.2. Country-specific determinants................................................................................................... 3

2.2.1. Capital market ................................................................................................................... 3

2.2.2. Economy ........................................................................................................................... 4

2.2.3. Investor protection and legal environment ........................................................................... 5

2.2.4. Human and social capital environment ................................................................................ 6

2.2.5. Taxation ............................................................................................................................ 8

2.2.6. Entrepreneurial activities .................................................................................................... 8

2.3. Firm-specific determinants........................................................................................................ 9

2.3.1. Individual capability .......................................................................................................... 9

2.3.2. Incentive structure............................................................................................................ 10

2.3.3. Firm-level corporate governance ....................................................................................... 11

2.3.4. Strategic focus ................................................................................................................. 12

2.4 Conclusion and gaps in the literature ........................................................................................ 13

Chapter Three: Research Setting ...................................................................................................15

3.1. Rationale and approach of identifying the target population ...................................................... 15

3.2 Description of census .............................................................................................................. 16

3.2.1 Fund origin....................................................................................................................... 16

3.2.2 Type of LPs...................................................................................................................... 16

3.2.3 Fund size .......................................................................................................................... 17

Chapter Four: Research Design .....................................................................................................18

4.1 Methodology .......................................................................................................................... 18

4.2 Methods ................................................................................................................................. 19

4.2.1 Structure of the questionnaire ............................................................................................ 19

4.2.2 Process of constructing the questionnaire............................................................................ 20

4.2.3 Sampling and treatment to the mailing list .......................................................................... 21

4.3 Analysis ................................................................................................................................. 22

Chapter Five: Data analysis ...........................................................................................................23

5.1 Description of collected data and identification of potential bias................................................. 23

5.1.1 Fund origin of the responding LPs ..................................................................................... 23

5.1.2 Type of responding LPs..................................................................................................... 24

5.1.3 Fund size and commitment to private equity investment of responding LPs .......................... 24

5.2 The most important country-specific determinants, and appreciation of key drivers of capital

allocation in EMs.......................................................................................................................... 26

5.3 The most important firm-specific determinants of capital allocation in EMs ................................ 29

5.4 The most important determinants – reconciling firm-specific factors with country-specific factors 31

5.5 Sample bias and reliability test ................................................................................................. 33

Chapter Six: Discussion.................................................................................................................35

6.1 The most important country-specific determinants..................................................................... 35

6.1.1 The expected return in PE investment in EMs ..................................................................... 35

6.1.2 Property right and investor protection................................................................................. 36

6.1.3 Bribing and corruption ...................................................................................................... 36

6.1.4 The regulation on repatriation of capital ............................................................................. 37

6.1.5 The entrepreneurial management quality and skills ............................................................. 37

6.1.6 Public funding and subsidiaries .......................................................................................... 37

6.2 The shortcomings of country-level endowments in emerging markets ......................................... 38

6.3 The most important firm-specific determinants ......................................................................... 38

6.3.1 The integrity of GPs .......................................................................................................... 38

6.3.2 The transparency practice of the GPs.................................................................................. 39

6.3.3 The matching between GPs’ expertise and strategy ............................................................. 39

6.3.4 Track record ..................................................................................................................... 40

6.3.5 Accessibility to deal flows ................................................................................................. 40

6.3.6 Size of cumulative AUM, popularity of the funds and co-investment programmes ................ 40

6.4 Reconciliation of firm-specific determinants with country-specific determinants ......................... 41

6.5 Research Implications ............................................................................................................. 42

6.5.1 Theoretical contribution .................................................................................................... 42

6.5.1 Implication to policy makers of EMs .................................................................................. 42

6.5.2 Implication to GPs ............................................................................................................ 43

6.6. Conclusion ............................................................................................................................ 43

Bibliography ..................................................................................................................................45

Appendices ....................................................................................................................................50

List of Tables

Table 1: Geographic distribution of fund origin .................................................................................. 16

Table 2: Demographic distribution of LPs type................................................................................... 17

Table 3: Description of fund size ....................................................................................................... 17

Table 4: Geographic distribution of the responding LPs ...................................................................... 24

Table 5: Distribution of responding LPs by type of investors ............................................................... 24

Table 6: Distribution of the responding LPs by size ............................................................................ 25

Table 7: Distribution of the responding LPs by commitment to PE investments .................................... 25

Table 8: Kruskal Wallis test on level of commitment into PE, grouped by fund size .............................. 26

Table 9: The most important country-specific determinants ................................................................. 28

Table 10: The most important firm-specific determinants .................................................................... 30

Table 11: Reconciling the most important firm-specific determinants with country-specific determinants

....................................................................................................................................................... 32

List of Figures

Figure 1: Overview of workflow ....................................................................................................... 18

Figure 2: Nominations of the importance of country-specific factors.................................................... 27

Figure 3: Appreciation (effectiveness) of the key drivers of country-specific factors ............................. 29

Figure 4: Nominations of the importance of firm-specific factors......................................................... 30

Figure 5: Nominations of the importance of (top-five) firm-specific and country-specific determinants.. 32

List of Acronym

Emerging Market [EM]

Private Equity [PE]

General Partner [GP]

Limited Partner [LP]

Initial Public Offering [IPO]

Asset Under Management [AUM]

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Chapter One: Introduction

According to The World Bank (2011), by 2025, more than half of global economic growth will

be accounted for by the six major emerging economies - China, Brazil, India, Indonesia, South

Korea, and Russia. It is also projected that emerging markets [EMs] will grow on average by 4.7%

per year (about twice the rate of developed economies) between 2011 and 2025. The urgent need

to finance capital in EMs is evident. In EMs where capital markets are less developed, private

equity [PE] should play a critical role in financing such growth. However, in 2012, investments

in EMs only accounted for 8.8% of global PE investments (Klownoski, 2013). The PE

penetration1 (0.14%) in EMs is also significantly lower than the U.S. (0.98%) and the U.K

(0.75%).

On the other hand, there is a strong consensus in the academic and professional literature that PE

investments bring about superior returns to investors. Financing at the individual-company level

also translates to significant economic development. It has been shown that PE involvement in

investee companies increases the efficiency and economic benefits of innovation efforts (Learner

et al., 2011). It enhances the level of productivity in individual companies as well as in the

economy as a whole (Ernst and Young, 2012). PE investments also foster stronger

competitiveness at the macroeconomic level (Samila and Sorenson, 2011).

Therefore, it is important to understand why does the supply of capital seem unable to match up

with the strong demand of capital in EMs? While some EMs such as China, Brazil and India

have increasingly received a tremendous influx of capital, the PE activity in other EMs is low.

Why is there such a significant difference across EMs? These prompt us to identify the most

important determinants of capital allocation decisions in PE investments in EMs – what matters

the most to LPs? Certainly, there are many aspects of consideration when LPs make capital

allocation decisions. But the two main fundamental decisions to be made are the choice of

countries/regions and the choice of a general partner [GP]. Two main bodies of literature explore

the determinants of PE investments. The first body of literature looks at the various factors that

might attract or hinder PE investments in a country. The second body of literature looks at firm-

specific factors as key determinants of capital allocation decision. However, these two main

bodies of literature mainly derive their findings through surveying GPs or running multivariate

analysis on secondary data. This research is an abductive research that aims to differentiate its

1 Private equity penetration refers to a ratio of private equity investment to gross domestic product.

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contribution by addressing directly the source of capital, i.e. the international LPs who are

investing or interested in PE investments in EMs.

The remaining of this paper is structured as follows: First, the two main bodies of literature will

be reviewed. Gaps in the literature and research questions will also be identified at the end of the

section. Then, a description and rationale of the chosen research setting and design will be

provided. Next, comprehensive analysis will be performed to identify the most important

determinants. Finally, a discussion of research findings and implications will be provided, and

the entire paper will be concluded with suggestions of future research areas.

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Chapter Two: Literature Review

2.1. Introduction

Two main bodies of literature will be reviewed in this chapter. At the country level, the first

group of literature explores various institutional and environmental factors as key determinants

of capital allocation decisions in PE investment in EMs. These factors will be explored with

different themes, namely: capital market, economy, taxation, investor protection and legal

environment, social and human capital environment, and entrepreneurial activities. At the firm

level, the second group of literature explores various firm-specific determinants of allocation

decisions for a PE fund. These determinants will be grouped into four subcategories, namely:

GPs’ individual capability, incentive structure, firm-level corporate governance, and strategic

focus. The extensive literature encompasses different disciplines, including finance,

entrepreneurial finance, international business, economics, and law.

2.2. Country-specific determinants

2.2.1. Capital market

The various pieces of literature have a strongly harmonised view that financial markets are

important for the development of private equity markets. Black and Gilson (1998) point out the

important link between an active stock market and a strong PE market. The potential for exit

through an initial public offering [IPO] allows entrepreneurs and GPs to contract implicitly over

future control of the targeted company. Such exit potential is critical to the development of a

private equity market. Where the entrepreneur hold a call option on the firm and has strong

financial incentive to exit through IPO sales, 2 Jeng and Well (2000) find that the volume of IPOs

fosters strong demand for venture capital funds. On the supply side of capital, Jeng and Wells

(2000) quantitatively evaluated the determinants of private equity fundraising across 21 countries.

Echoing Black and Gilson (1999), both studies find the strength of IPO markets (measured by

the number of venture-back IPOs) is a key determinant of capital commitment to private equity

fundraising. 3 Wurgler (2000) concludes that developed financial markets appear to improve

2 A Venture Economics (1998) study found that the exits through IPO provide an average return of 195 per cent on initial investment, with an average 4.2 years holding period. Compared to the next best exit alternative through trade sales, yield a return of just 40 per cent over an average 3.7 years holding period. 3 However, as noted by Gompers and Lerner (2004), it is inconsistent with the experience of Singapore and Israel, whose private equity industries experienced dramatic growth without having strong domestic public equity market.

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efficiency in capital allocation. Kaplan and Schoar (2005) further confirmed the strong relation

between stock market cycles and PE fundraising activity.

PE investment is essentially illiquid (Sahlman 1990) (Lerner and Schoar 2004), which further

emphasizes the importance of liquidity and deal flows in private equity market. Balboa and Marti

(2003) empirically find that the market liquidity accessed by the amount of investment and

divestment of the previous year has a positive and significant impact on fundraising. One major

deficiency of this research is its data of the divestment volume, which is based on cost price. The

data provide no disclosure of the return obtained. In spite of this, its findings are highly

applicable to EMs where the information on returns are limited or unavailable. As a result, the

amount of investment becomes an important determinant for investors. However, Chemla (2005)

argues for the importance of the depth of the market (transaction size). Investment opportunities

in one particular region become attractive to investors, if only deal flows, transaction sizes, and

expected payoffs exceed certain hurdles that allow investors to cover their management fees and

expected premium.

The transaction size and availability of deal flows in one region could be related to the

accessibility of debt financing. Greene and Villanueva (1998) argue that the availability of debt

financing is crucial for start-ups in entering the market and further expanding their business.

However, Gompers and Lener (2004) find that the availability of debt financing is not a key

determinant of investing commitment for private equity firms. Together, the literature reveals an

interesting fact, that start-ups and private equity firms perceive the importance of debt financing

unequally.

The literature assesses the implications of various factors in a capital market on investing

commitment in the PE industry. However, there is little to no recognition of the degree of

acceptance of the PE market and the role of various agents and supporting institutions in their

work. This paper will also explore a linear relationship between the size of the economy and

private equity activity implied in their work.

2.2.2. Economy

Acs and Audretsch (1994) explored the influence of macroeconomic conditions on start-ups

through examining cross-sectional data of 117 industries over six different periods between 1976

and 1986. Their model demonstrates a positive relationship between the macroeconomic growth

rate and the number of new start-ups. Gompers and Lerner (1998) and Aylward (1998) provide

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supporting evidence for this relationship - an increase in growth rate of gross domestic product

[GDP] has a positive effect on the demand for private equity funding, and hence fundraising.

However, surprisingly, Jeng and Wells (2000) find that the GDP growth rate is not a significant

determinant of private equity investing. Likewise, Acs and Audretsch (1994) find that the

entrepreneurial activities of new start-ups are promoted by low cost of capital and a high

unemployment rate. Such relationships implicitly suggest a low interest rate environment is

associated with higher fundraising. However, Bygrave and Timmons (1985) and Gompers and

Lerner (1998) find no impact of interest rate on fundraising. In short, the impact of economic

activities on private equity investing and fundraising is unclear.

2.2.3. Investor protection and legal environment

Leeds and Sunderland (2003) emphasized that investor protection and the legal environment as

key determinants of performance and investment activities in EMs. They point out that the

underperformance of PE funds that entered EMs in the nineties was mainly due to shortcomings

in investor protection.

Desai et al. (2003) and Friedman et al. (2000) specifically studied the implications of investor

protection and the legal environment on the demand side of private equity, i.e. entrepreneurial

activities. Desai et al. (2003) find that greater fairness and greater protection of property rights

would increase the entry rate of enterprises into the market, enable a smooth transition and

reduce the exit rate. These effects are more profound in EMs and less so in more developed ones.

Friedman et al. (2000) quantitatively showed that start-up firms’ investment decision and

reinvestment of profit are affected by the perceived security of property rights. This coincides

with two different sets of cross-country tests conducted by Knack and Keefer (1995) and

Svensson (1998). They demonstrate that investor protection has a significant impact on private

investments and growth.

Cumming and Johan (2007), La Porta et al. (1997, 1998 & 2002) and Lener and Schoar (2005)

study the implication of investor protection and the legal environment on the supply side of

private equity, i.e., the investors’ financing incentives. Cumming and Johan (2007) emphasised

regulatory harmonization as a key determinant to increasing institutional investors’ allocation to

the asset class. La Porta et al. (1997 & 1998) found that the legal environment (measured by both

legal rules and their enforcement) would strongly determine the size (market valuation) and

breadth (scope of funding) of a country’s capital market and local enterprises’ ability to receive

external funding. Later reinforced by La Porta et al (2002) and Lerner and Schoar (2005), they

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empirically and independently test this finding. On one hand, La Porta et al. (2002) test the

concept using 539 large firms from 27 wealthy economies. The sample selection is biased as

only wealthy economies are included. Yet the problems of property rights and investor

protection are more profound in developing nations. The use of large firms also makes it more

difficult to assess the benefits of investor protection, since large firms have access to alternative

mechanisms (reputation-building, listing on international exchanges and foreign shareholdings)

for limiting the expropriation problem. On the other hand, Lerner and Schoar (2005) analyse 210

transactions from a wide variety of private equity groups primarily in developing countries.

Integrating both studies, a well-rounded and empirically tested conclusion provides confirmation

to La Porta et al. (1997). Both studies also show that deficiencies in the legal environment might

severely distort the contracting process by forcing PE firms to rely on large ownership to achieve

the desired level of control. Consequently, investors face constraints in diversifying their

portfolio and entrepreneurs have weaker incentives to perform since they are forced to give up

large cash flows and control rights early on.

Cumming et al. (2006 & 2010) also look at the implications of investor protection and the legal

environment on business operations of PE firms. They found that the quality of a country’s legal

environment has a very strong connection with facilitating private equity backed exits, even

stronger than the size of a country’s stock market (Cumming et al., 2006). They go one step

further and show that legal origin and accounting standards (as proxies for investor protection)

could significantly influence the quality of investment governance in the PE industry (Cumming

et al., 2010). They conclude that better laws and law enforcements facilitate deal origination,

deal screening, investors’ board representation and the use of desired types of securities.

2.2.4. Human and social capital environment

Within the human and social capital environment, various factors have been considered to be key

determinants in the private equity industry and the decision to allocate capital. In a simplified

manner, the extant literature on corruption and labour market rigidities will be reviewed.

Much of the literature studied the effects of corruption on investments and economic growth.

The inconsistent viewpoints have prompted a particularly fervent debate on this topic. Shleifer

and Vishny (1993) claim corruption makes investments and economic growth sluggish. As

pointed out in the case of foreign investment in the post-communist Russia, where foreign

investors preferred not to invest due to high cost associated with bribing and other corrupt

practice. Murphy et al. (1991) addressed this issue implicitly by looking at the general human

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capital allocation of a country in relation to its entrepreneurial activities. They provide evidence

that countries where talented people are involved in rent-seeking activities more than innovating

and producing tend to grow slower. In contrast, Leff (1964) suggests that corruption might

actually be beneficial for investments through two mechanisms, i.e. to avoid bureaucratic

inefficiency and to provide personal incentive. Probably, the East Asian Puzzle 4 might lend

some supports to Leff (1994). In response to the controversial nature of this debate, Maoro (1995)

and Keefer and Knack (1995) find empirical evidence for the negative impact of corruption on

investments and economic growth. Stone et al. (1996) and Paul (1995) provide evidence of high

transactions costs accompanying corrupt practices.

Labour market rigidities might negatively affect the attractiveness of the PE industry. Bozkaya

(2009) suggests that labour market rigidities are likely to impact PE firms in two ways. First,

heavy dismissal costs might demotivate PE firms, (especially the early-stage venture capitalists)

that operate in high growth and rapidly restructuring sectors. Indeed, Jeng and Wells (2000) used

multivariate analyses and empirically found that strict employment regulations have a strong

negative impact on early-stage venture capital investments across countries but not later-stage

transactions. Second, labour market rigidities can pose a great restriction on PE firms’ ability to

reallocate resource across portfolio companies. It is essential for PE firms to aggressively

reallocate their resources from the underperforming businesses to winning ones. Strict

employment regulations increase the costs of such adjustments. The impact of labour market

rigidities could hurt entrepreneurial activities, which implicitly affects the demand for capital.

Black and Gilson (1999) believe that restrictions on layoffs impose costs on start-up businesses

and thus discourage their initial formation.5 For example, as in the case of Germany where there

is strong employment protection; or in Japan, where there are little formal employment

protections but the strong embedded culture of career for a lifetime have hindered employees to

create their own ventures.

Overall, the literature reveals that corruption has strong and negative implications on investments.

Labour market rigidities also have a strong and negative impact on the operation of PE firms and

4 Transparency International (1996) ranks China, Vietnam, and Thailand among the most corrupt countries and yet. These countries have continued to grow substantially, and more importantly, to attract considerable flow of private investment. The phenomenon is called the East Asian Puzzle by the academia. 5 Start-up businesses are generally subjected to volatile business risk, hence during the initial stage, they would involve extensive restructuring and searching for the right talents.

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the demand for capital. Both factors are important to the capital allocation decision of PE

investments in EMs.

2.2.5. Taxation

Gompers and Lerner (1999) emphasised the role of capital gains tax on private equity activities.

Poterba (1989) explores the role of capital gains tax on both the demand and supply side of

private equity. Its findings indicate that a decrease in tax rate is associated with an increase in

capital commitment to private equity funds. This relationship is mainly driven by an increase in

demand of private equity, i.e. an increase in entrepreneurial activities, and not so much by an

increase in supply. In fact, Gompers and Lerner (1999) confirmed this demand-side effect

through their observations that a decrease in tax rate would increase the capital committed by

both tax-exempt and tax-sensitive investors. If this relationship is due to supply-side effect, they

should have observed a disproportionate increase of capital commitment by tax-sensitive

investors. Bruce (2002), Cullen and Gordon (2002) and Bruce and Gurley (2005) provide

evidence that taxes influence entrepreneurial activities, and hence the innovation activities in an

economy. The difference between personal income tax rate and corporate tax rate tends to

positively induce greater self-employment. Through a comprehensive study across 85 developed

and developing countries, Djankov et al. (2008) conclude that the corporate tax rate tends to

negatively affect entrepreneurial activities, aggregate investments and foreign direct investments.

Overall, taxes have a significant impact on private equity activities in one country, and it mainly

influence the demand-side of private equity.

2.2.6. Entrepreneurial activities

Gompers and Lerner (1998) examined both the demand-side and supply-side forces that affect

fundraising of independent private equity firms from 1972 through 1994. They found that

demand-side factors, i.e. those that affect entrepreneurial activities, are more important than

supply-side factors. Industrial and academic R&D expenditures are the demand-side factors that

appear to have a significant impact on fundraising. Subsequently, through a simple demand-and-

supply economic model, Gompers and Lerner (2002) suggested that an increase in demand in the

long run, measured by volume of funds invested, will lead to an increase in supply, measured by

volume of funds raised. Hence, the demand for the risk capital for funding entrepreneurial

activities will incentivize investors to supply capital. Supported by Schertler (2003), they

claimed that human capital endowment, as measured by number of employees in R&D fields and

number of patents, has a positive and significant impact on private equity activities. Interestingly,

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Baughn and Neupert (2003) argued that national cultures shape institutional practices and

policies, which in turn will affect the development of entrepreneurial activities. It is also possible

to predict the environmental conditions that favour entrepreneurship in different nations through

the understanding of culture and economic conditions. Understanding the essence of such

cultures also allows LPs to assess the level of acceptance of PE activities in different nations. All

of the literature discussed suggested that entrepreneurial activity is an important determinant of

private equity activity in one market.

2.3. Firm-specific determinants

2.3.1. Individual capability

As discussed earlier, a wide range of literature explores the determinants of PE activities at a

country- level. Balboa and Marti (2000) mainly differentiate their contribution by looking at

variables that directly relate to the PE process at the firm-level, i.e. by focusing on the capability

of GPs. The findings are achieved from studying panel data of GPs who operate in European

Union countries, during the nineties (at that time, PE was still a developing industry). Within the

EMs context, Balboa and Marti (2000) found that the higher the amounts invested earlier by GPs,

the easier it was to raise new funds. Besides considering the amount divested and past

performance, investors are interested in the GP’s ability to access and close a satisfactory

number of deals.

Kaplan and Schoar (2005) found that GP’s ability to raise capital into new funds is positively

related to GP’s past performance. They also found that performance tends to improve with fund

size and GP’s experience. By using the profit sharing scheme as a reflection of performance, this

explanation is supported by Gomper and Lerner (1999). They found that the profit sharing

scheme for GPs is generally higher for older and larger GPs. In addition, those GPs tend to

perform well. Gomper and Lerner (1999) further argued that GPs should capitalize on their

experience and past performance to increase their compensation by raising more funds. However,

it is puzzling that there is a concave relationship between performance and funds raised. This

means that with the same proportionate increase in performance, the top performer grows

proportionally less than the average performer in terms of funds raised. Based on the LPs’ claims

that those top performers were always oversubscribed, Gomper and Lerner (1999) deduce that it

might be the GP’s choice to stay smaller. They suggest there must be an incentive for GPs to stay

oversubscribed to appear as top performers. Such attempts might be applicable in the context of

early funds in EMs, where GPs could leverage the popularity of existing oversubscribed funds to

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attract investors to commit capital in their new EMs funds. The findings of this paper will

validate this phenomenon.

Gompers and Lerner (2004) claimed that better GPs would foster good corporate governance and

establish relationships with LPs who could provide more value-added activities. Hsu (2004)

argues that better GPs have the ability to access better deal terms than average GPs. He

empirically tested the benefit of GPs’ reputation as an economic good, and found that offers

made by GPs with high reputation are three times more likely to be accepted.

Overall, the literature depicts GPs’ capabilities as being important determinants of the capital

allocation decision. Such capabilities could be assessed by the amount of investment and

divestment, track records, GPs’ experience, accessibility to deal flows, and reputational capital.

Indeed, the empirical evidence produced by the literature suggests that GPs’ superior

performances are positively associated with these measures.

2.3.2. Incentive structure

As discussed, track record and reputation are important determinants of investors’ capital

commitment. However, in EMs where the private equity industry is at its earliest stage, local

GPs have no established track record and reputation to leverage from. Based on the predictions

in a signalling model of compensation, Gompers and Lerner (1999) suggested that inexperienced

GPs should signal their capabilities by having higher pay-for-performance sensitivities and lower

base compensation. Out of some of the venture capitalists being studied, the base compensation

in their contract might be even negative. Rationally, GPs with higher capabilities are more

willing to take risk than GPs with lower capabilities. Ironically, Gompers and Lerner (1999) find

no evidence of a relationship between incentive compensation and performance. It seems that

GPs’ incentives to perform are secondary in contributing to good performance of their

investments. Another effective way to signal to investors of GPs’ capabilities is through equity

participation. The industry standard of equity participation is from 1% to 2% of total fund size.

However, some prestigious private equity firms, who are willing to take more risk, might have

up to 5% of equity participation. Overall, regardless of the effectiveness of the proposed

incentive structure, investors consider it as a powerful signal of capabilities. Hence, the ince ntive

structure is a key determinant of capital allocation.

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2.3.3. Firm-level corporate governance

Legal rules and legal enforcements only provide basic protection when dispute occur. If a

country’s legal protection is insufficient, it is safe to assume that investors will have to rely on

firm-level corporate governance as alternative mechanisms to mitigate risk. 6 Love (2010)

mentioned that additional provisions or mechanisms include increasing transparency, selecting

self-governing and well- functioning boards of representatives, and imposing various disciplinary

mechanisms to prevent expropriation.

At the fund managers- investors level, agency risk is largely lessened through the use of unique

incentive structure, limited partnership structure and other strict contractual provisions. Despite

all these mechanisms, the ex-post danger of agency risk might still exit. Cumming and Walz

(2010) empirically find that PE funds have the tendency to overstate the value of their

investments in order to attract new investors into their subsequent funds. The problem is even

more severe in countries where the accounting rules are less stringent and the law enforcement is

relatively weak. As a result, investors rank the quality of disclosure by private equity funds as

one of the most important hurdles in PE investment (Cumming and Johan, 2009). At the fund

managers-portfolio company level, the agency problem remains a major concern to investors.

The discussion of the specific problems is beyond the scope of this paper.

The importance of corporate governance is further emphasized when exploring the relationship

between corporate governance and performance. A group of literature including Black (2001),

Black et al. (2006), Chong and Lopez-de-Silanes (2007), Bauer et al. (2003), Klapper and Love

(2004), Durnev and Kim (2005) and Epps and Cereola (2008) explore this relationship within

both the developed markets EMs contexts. Independently, they all find this relationship to be

fairly strong and positive. Some of the literature suggests that in countries where legal protection

is weak, firm-level corporate governance matters more for firm valuation.

However, another group of literature questions the positive relationship between corporate

governance and performance. For example, Pham et al. (2011) studied this relationship in

Australia and Firth et al. (2002) studied it in the case of China and both found it to be

insignificant. Surprisingly, Aman and Nguyen (2008) found a negative relationship in Japan,

suggesting poorly governed firms tend to significantly outperform better-governed firms in term

6 Easterbrook and Fischel (1991) and Black and Gilson (1998) address the flexibility in making adjustment to the country-level protections.

12

of market returns. While all these studies are statistically proven to be significant a nd robust,

each of it only provides a time-series analysis in one particular country.

The support of this paper is tending toward the positive relationship between firm-level

governance and performance, since the research for this position was conducted in a more

comprehensive manner using multivariate analysis across countries (spanning across both

developed and emerging markets) and over long period of time. Overall, the important takeaway

here is that investors rely on firm-level corporate governance to safeguard their capital,

especially in EMs where legal protection is insufficient. F irm-level corporate governance is an

important hurdle when considering capital allocation in EMs.

2.3.4. Strategic focus

Investment in private equity is highly illiquid and investors have little freedom to influence their

investments once the capital is committed. In some instances, especially during downturns,

investors might find the GPs’ management style and investment strategies very frustrating.

Hence, at ex-ante, investors would only entrust their capital with a fund manager if only they

share the same investment foresights; or investors find the investment strategies credible.

Gao (2011) claimed that GPs’ strategies to manage individual investments and portfolio

composition are likely to relate to their degree of involvement in the management of portfolio

companies and expertise. Elango et al. (1995) and Acharya et al. (2010) address these issues

separately. Elango et al. (1995) found that the level of involvement of private equity firms differ

with their stage of specialization. Acharya et al. (2010) found evidence that there are

combinations of strategies and expertise that correlate with abnormal return. GPs who are ex-

consultants and ex- industry managers tend to have expertise in the operation, and are associated

with outperforming deals focused on operational improvement. GPs who are ex-bankers and ex-

accountants tend to have expertise in finance, and are associated with outperforming deals

focused on mergers and acquisitions activities.

At the portfolio-composition level, Gao (2011) addresses three types of investment strategies,

namely, specialisation, diversification and complementary networks investments. Private equity

firms could be specialized in term of industry, stage of development and geography. Gupta and

Sapienza (1992) and De Clercq et al. (2001) illustrated that the advantages of specialisation are

associated with the reduction of information asymmetries and uncertainties, added expertise,

knowledge and know-how experience, and understanding complexities specifically embodied in

13

one particular industry or development stage. Gao (2011) and Cressy et al. (2007) found a

strong association between abnormal performance and industry specialization. However, Cressy

et al. (2007) find stage specialization might only help in spurring growth but not profitability.

Sharpe (1963) described the advantages of diversification in his portfolio theory. Interestingly,

while Knill (2009) found some benefits associated with stage or industry diversification, at the

same time, he also finds such strategies might cause a delay in exiting the portfolio company.

Gao (2011) also investigated if private equity firms follow a strategy in exploiting

complementarities and synergies among different portfolio companies. Gao (2011) looked at the

investments in information technology and communications classified through a method of

“software stack7”. He found that the diversified portfolio in this narrowly defined industry had

positive abnormal returns, suggesting the benefit of the complementary-network strategy.

At the individual- investment level, Barber and Goold (2007) emphasis the usefulness of the

basic strategy of value adding and transforming. Other strategies including value strategy,

aggressive debt strategy and merger and acquisition investments are also investigated. Value

strategy refers to the investment in underperformed businesses or units of businesses at a

substantially undervalued price. After introduced various structuring such as cash flow and

margin improvement, the investments is expected to exit at a higher multiple. Aggressive debt

strategy is used to capture the benefits of financing and tax shield.

Overall, GPs’ investment strategies are important determinants of capital commitments by

investors. The specialization strategy seems to generate better performance than diversification.

This is also consistent with Acharya et al (2010)’s findings, suggesting that fund managers could

better utilize their expertise in specialized industries or business areas. Complementarities could

be found in portfolio companies if they are located in the same narrowly define network.

2.4 Conclusion and gaps in the literature

This chapter presented two main bodies of literature, i.e. country-specific and firm-specific

determinants of capital allocation decision. However, each group only looked at a small selection

of named factors. In comparable term, the literature does not clearly distinguish which of the

determinants is the most important one (except Groh et al., 2008). To provide practicable and

7 This concept was introduced earlier by Gao (2006). This concept defines the software industry into different layers. The application of this concept is premised by the idea that each software firm could utilize services provided by other members in the network without knowing how these services were implemented.

14

meaningful conclusions to policy makers and GPs, there is a need to fill this gap. Two main

research questions emerge and they are set to be explored within the EMs context.

(1) What are the most important country-specific determinants of capital allocation decision in

PE investments in EMs.

(2) What are the most important firm-specific determinants of capital allocation decision in PE

investments in EMs.

Furthermore, while LPs consider both country-specific and firm-specific criteria when allocating

capital, none of the literature explores the interactions between these two groups of determinants.

The last research question is motivated by an interest in exploring such interactions.

(3) What are the firm-specific determinants that would sufficiently compensate for the

shortcomings of the country-specific disadvantages in EMs.

Building on the existing literature, this paper seeks to answer the established research questions

through conducting primary research with LPs. The fo llowing two chapters provide detailed

explanations of the research setting and research design on how this research will be carried out.

15

Chapter Three: Research Setting

In this chapter, the rationale and approach of identifying the target population for this research

will be discussed. Some geographic and demographic descriptions of the target population, such

as fund origin, fund size and type of LPs will also be provided. This chapter sets the foundation

for the representativeness check done later in the analysis section.

3.1. Rationale and approach of identifying the target population

The literature reviewed earlier only looked at a selection of regions or capital markets. The

majority of the studies run cross-sectional analysis on secondary data collected from various

agencies. Some of them attempted to conduct primary research through surveying GPs. This

research follows the rationale of Groh et al. (2008), arguing that ultimately it is LPs that make

capital allocation decision both at the country level and fund level. Hence, it is most appropriate

to formulate research findings based on LPs’ opinion on capital allocation decision. As

secondary data on such opinion is scarcely available, primary research is chosen to solicit

opinion from LPs through a questionnaire. This research is highly differentiated from others

studies in many ways. First, it directly assesses the source of capital, i.e. the LPs. Second, rather

than focusing the research population on several countries or regions, the research in this paper

attempts to solicit opinion of LPs at a world-wild scale.

This research aims to assess the opinion of LPs on capital allocation decisions into PE

investments in EMs. Hence, the target population is limited to the LPs (or potential LPs) who are

investing or interested in PE investments in EMs. However, due to the inseparability of

information of such LPs from those who are not interested in EMs, the objective is to cover as

many LPs as possible. While Groh et al. (2008) claim to cover the majority of LPs population by

sourcing 1,079 LPs from three different databases, in comparison, a list of 3,647 LPs8 from the

Dow Jones LP Source database was attained for this research. Certain efforts were employed to

deliberately enhance the size of the research audience, first, by manually sourcing contact details

from several sovereign wealth funds, pension funds and private equity association websites. This

attempt would pose little danger of selection bias or overrepresentation, since all the association

websites claim to contain companies that have diverse fund size, origin and investment activities

across different EMs. Second, a snowballing technique was used by asking the recipients of the

questionnaire to further forward it within their networks of LPs. The potential danger of 8 The number indicated here is a unique number of LP, but not the actual number of mailing address available.

16

capturing opinion from non-targeted research audience is mitigated by explicitly indicating in the

invitation, as well as in the cover page of the questionnaire, the description of target population.

3.2 Description of census

Since this is an abductive research, the objective is to cover LPs across a wide range of

demographic and geographical characteristic such as different fund size, origin, markets of

interest, level of private equity commitment and types of funds. However, due to limited access

to the Dow Jones LP Source database, neither the information of LPs’ private equity

commitment nor the information of emerging markets of their interest is attainable. Also due to

the incomplete records in this database, a number of mailing addresses does not match with the

number of LPs. However, for the best representation of the LP population, the description of the

entire 3,647 LPs in the Dow Jones LP Source database is provided here.

3.2.1 Fund origin

The majority of the LPs are originated from the U.S. and Canada followed by Europe, Asia and

the rest of the world. LPs from the U.S. and Canada accounted for more than half of the total

depository in the database. Together with Europe, they account for almo st 90% of the depository.

Table 1 provides a summary of the distribution.

Table 1: Geographic distribution of fund origin

3.2.2 Type of LPs

The Dow Jones LP source database provides detailed description of the type of LPs. They were

classified into 17 specific types of investors. For simplification, the closest types of investors

were combined together to a more manageable number of 14 groups as shown in Table 2. Such

details and specific descriptions of investor types make representative check feasible. Pension

Fund is the biggest group, accounting for one fifth of the database depository. One major

deficiency of this data is the unmentioned Fund of Funds group that could be classified in the

Private Investment Firm, Other and/or Unknown group.

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Table 2: Demographic distribution of LPs type

3.2.3 Fund size

LPs are also classified into four different groups based on their fund size. The small to medium

(100 million to 999 million dollars) and medium to big (1 billion to 9 billion dollars) are the two

biggest groups in this database. Together they account for 27.31% of the depository.

Unfortunately, the unknown record of 60.49% is extremely high. Table 3 provide a summary of

fund size description.

Table 3: Description of fund size

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Chapter Four: Research Design

In this chapter, the rationale and merit of the chosen methodology, methods and analysis will be

provided. In the research methods section, more details on the questionnaire’s structure, the

process of constructing it and treatments to the mailing list will be provided. Figure 1 provides

an overview of workflow in carrying out this research.

Figure 1: Overview of workflow

4.1 Methodology

The literature has produced an overwhelming amount of findings related to the determinants of

PE activities in EMs. Each study tends to produce sensible and significant findings in their own

fashion, whether deductive or inductive. However, it is not clear which determinants are the most

significant criteria. This research is an abductive research that aims to build on the existing

literature, and verify, calibrate, and generate highly differentiated findings from it. The main

objective is to identify the most important country-specific and firm-specific determinants. These

findings will lead to exploring the interaction between the two groups of determinants when

investors making capital allocation decision.

To identify the most important determinants, a ranking procedure is required. Hence, it is clear

that a quantitative research is the most appropriate methodology since it provides the most

objective measure. Although this paper subscribes to a post-positivism view9 , a pragmatist

9 Balnaves and Caputi (2001), Post-positivism accepts the criticism presented by the subjectivists that we cannot observe the world in a total and absolute reality. However, post-positivists believe in the possibility of there being an objective reality. In this research, while the opinions of LPs are somewhat subjective to their own preference and experience, but collectively their opinions shape their own capital allocation decisions and hence the overall market condition.

19

approach10 to research is employed. To answer the research questions, many opinion-based

answers are required from LPs. It seems that qualitative research would provide better

explanatory power. However, existing studies already offer many good explanations of the

theories about relationships and causalities between certain determinants and investments. The

main task here is not to explore alternative explanations. Instead, for practical purposes, the

focus is on helping policymakers and practitioners to identify the most important determinants in

the current investment climate through using quantitative research. Hence, they can benefit from

academic literature in the most effective way. To ensure the explanatory power and depth of this

research, much effort was put into the design of the questionnaire, which shall be discussed in

the next section.

4.2 Methods

To comply with the requirements of the research setting outlined earlier, an electronic

questionnaire appears to be the best choice in attaining opinions from LPs at a worldwide scale.

Google Forms, a web-based software, was used to send questionnaires and collect responses.

The merit of an electronic questionnaire is judged based on its effectiveness in collecting

answers. In a practical sense, this method is quick and effective in distributing questionnaires

and collecting responses. It can obtain responses from LPs at a global scale, which might not be

possible if face-to-face or phone interview methods were chosen instead. In term of its

effectiveness in yielding answers, a questionnaire is sufficient to assess the level of importance

of each determinant. However, this method limits potential discussion that might lead to

unexpected results. To ensure that all the important issues are covered, other efforts are

employed within the process of constructing the questionnaire.

4.2.1 Structure of the questionnaire11

To answer the research questions, opinion-based answers of the LPs’ assessment on each

country-specific and firm-level factor are required. Factual information about the LPs such as

fund size, origin, level of commitment and preference of EMs are also required for further

analysis of patterns and findings. The questionnaire was structured around three main sections.

The first section is the cover page which explains the purpose and the aims of this study. This

10 Balnaves and Caputi (2001), Pragmatist approach simply suggests that each philosophy view or research approach should be best viewed in term of their practical uses and outcomes. The merit of a research approach is judged by its usefulness in answering the questions. 11 Due to space limitations, the actual questionnaire is not provided but available upon request.

20

section allows the research audience to have a brief idea of what is expected from them and what

kind of questions will be asked. It also contains a statement of their right of anonymity and

choice of participation. More importantly, this section serves as a filter to rule out those not

targeted. The second section contains all the factual questions. The third section contains all the

opinion-based questions which are further categorized into two main sub sections on country-

specific and firm-specific factors that affect the capital allocation decision into PE investments in

EMs. Following Groh et al. (2008), within the subsection on country-specific factors, six themes

of questions are included, namely economy, capital market, investor protection and legal

environment, taxation policies, social environment and entrepreneurial opportunities. In the

subsection on firm-specific factors, four themes of questions are covered, namely capabilities of

a general partner, incentive structure, firm- level corporate governance and general partner’s

strategic focus.

All of the opinion-based questions require metric responses. Participants were asked to indicate

their assessments of the level of importance of each factor on a six-point Likert scale. The

ordinal responses range from “not at all important” to “very important”. To ensure that all

important determinants are included, the respondents were asked to use key words to indicate

any missing factors.

4.2.2 Process of constructing the questionnaire

The first four steps in Figure 1 regard constructing the questionnaire. Please note that these four

steps are not entirely sequential, and refinements are made back and forth across different stages.

The majority of the literature only focuses on a few factors. The questionnaire-constructing

process is started off by consulting Groh et al. (2008), Jeng and Well (2000) and Balboa and

Marti (2003) which covered the most factors. In Groh et al. (2008)’s study alone, almost the

entire list of country-specific factors studied by the literature is surveyed. Jeng and Well (2000)’s

and Balboa and Marti (2003)’s regression analysis also contains an extensive list of variables. To

ensure the most important country-specific and firm-specific factors are covered, other studies

are also carefully reviewed in detail.

After the initial refinement steps, two informal phone interviews with practitioners in the private

equity industry were conducted. These interviews were not executed for the purpose of data

collection as part of any sorts of qualitative research, but merely for further exhausting the list of

factors in the questionnaire. Due to the interviewee’s right of anonymity, they would only be

21

identified in this paper by their initials. KB 12 and RM 13 provided significant contribution,

especially in identifying the firm-specific factors, where literature coverage is relatively much

scarcer than the country-specific factors.

To ensure the reliability and validity of the questionnaire as suggested by Easterby-Smith et al.

(1991), two professors at the University of Edinburgh were approached to help in conducting

expert tests. Reliability refers to the degree of stability of the questionnaire. Ideally, it should

yield the same result if it was administered to the same individuals at two different occasions.

While LPs’ opinions could have changed according to the changes in investment climate, the

questionnaire should yield temporal stability within a short timeframe. Validity refers to the

extent to which a test measures what it is supposed to measure. The two experts are Professor

Jake Ansell14 and Professor Jo Danbolt15. With help from these two experts, the validity and

reliability of the questionnaire was significantly improved. At least to a certain extent, construct

validity and content validity were enhanced. Construct validity refers to the degree of

appropriateness to which the questionnaire indeed measures the intended construct. Content

validity refers to the extent that the questionnaire covers a representative set of factors to be

measured. While it is difficult to measure the extent of reliability, the inclusion of explanations

and help text greatly improved it.

4.2.3 Sampling and treatment to the mailing list

As discussed earlier in section 3.1 on target population, the entire data from the Dow Jones LP

source database was used. While this census is far from a complete list of all LPs, at least, it

provides the best representation to the LP population. The following rules were used to sort the

entire mailing list in the Dow Jones LP Source database. First, all personal emails were identified.

Second, all corporate emails that addressed to different personnel were identified. Third, the

remaining corporate emails of non-repeated companies name were included. Following these

12 KB – a finance professor in one of the most prestige business school in the United States. His primary focus is on venture capital and private equity research. He also sits on the investment board of committee at the university’s endowment and other private equity firms. 13 RM – a principle at one of the most prominent international investment advisor firm. He is primarily responsible for fund of funds investment program of the European private equity and venture capital. He also focused on the coverage in emerging Europe, Russia and Africa. 14 Professor Jake Ansell – a professor of risk management and head of marketing research group at the University of Edinburgh. He is a consultant in statistics who has research interests in economic statistics and indices, expert systems, risk management and assessment, reliability and so on. 15 Professor Jo Danbolt – a member of the University of Edinburgh’s school research committee and research champion for finance. He taught a wide range of finance subjects and has research interest in shareholder wealth effects of mergers and acquisitions, capital structure determinants and corporate governance and firm value and so on.

22

rules, a unique list of 3,475 non-duplicated emails was attained. Unfortunately, the numbers of

corresponding LPs were reduced from the total of 3,647 in this census to only 2,437. With great

consideration of the risk of over representation from some companies, multiple recipients per

company are allowed. The argument for this decision is that multiple recipients are attributed to

different fund managers or business representatives who are managing different emerging

markets. Hence, their answers are formulated based on different background and experience.

4.3 Analysis

The IBM SPSS Statistics 20 was used to conduct the statistical analyses. To assess the level of

importance of each factor compared to other factors, a simple ranking based on the mean of

Likert scores of each factor is used. To confirm the ranking, I followed Groh et al. (2008)’s

method to perform several pair-wise Wilcoxon Signed Rank tests to determine if there is a

significant different between the ranked factors. This test does not assume the normality of

distribution of responses; hence it is non-parametric in nature. The Wilcoxon Signed Rank test

considers the means and standardizations of the tested pair, and detects if the difference of the

means are indeed statistically significant. Three rounds of ranking were performed. First, all the

individual countries-specific factors were ranked to establish the top five most important

determinants. Second, all the firm-specific factors were ranked to achieve the top five positions.

Third, the top-five determinants from each category were ranked together to directly answer the

main research question. In addition, other types of analysis such as Kruskal Wallis, Mann

Withney U test, frequencies table and reliability test were conducted. All of the non-parametric

tests that produce a p-value smaller than 0.05 are said to be significant.

23

Chapter Five: Data analysis

In this section, descriptions of the data collected and its status in comparison to the census will

be provided. An assessment of its representativeness and any potential bias is suggested. After

establishing an overall picture of the responding LPs, the three rounds of rankings as described

in the analysis section will be performed. To investigate the potential biases and ensure the

robustness of the findings, a series of comparison tests will be carried out. Finally, to check for

the internal consistency of the responses, a reliability test on the data collected will be done.

5.1 Description of collected data and identification of potential bias

From the 2,437 LPs addressed, 76 valuable responses were received. Considering this response

rate of 3.12% for an electronic questionnaire type of primary research, it is quite satisfying.

Compared to Groh (2008)’s response rate of 7% from 1,079 LPs, this repose rate seems much

less significant. However, in absolute term, the same number of responses is achieved.

5.1.1 Fund origin of the responding LPs

Geographic distribution of the respondents’ fund origins are: U.S. and Canada, Asia, Europe, and

the rest of the world. Table 4 is a frequencies table of the respondents’ fund origins. There is

only one missing datum from 76 responses. Due to the possibility that an LP fund’s origin could

belonging to more than one geographic group, the segmentation of respondents is not mutually

exclusive. According to the response rate of each reported geographic group, the LPs that have

fund origin in Europe (41.4%) dominate the data then followed by those in U.S. and Canada

(33.8%). Unfortunately, there is no way to find out the actual distribution of the entire LP

population. The comparison with the depository in the Dow Jones LP Source database offered

the best alternative to check for potential bias since it is the most complete database available.

Compared to the U.S. and Canada group (54.04%) in the depository, this group is significantly

underrepresented in the data collected. Unfortunately, it is not possible to make any adjustment

to the data. On the other hand, the Europe group is overrepresented compared to the same group

in the depository (34.77%). To address this bias, a series of Mann Withney U tests between the

Europe and non-Europe group was carried out to detect if there is a significant difference

between them. The test results will be presented in a subsequent section of this paper.

24

Table 4: Geographic distribution of the responding LPs

5.1.2 Type of responding LPs

The respondents are segmented into different types of investors as in Table 5. As expected, the

data is dominated by fund of fund (26.7%) and pension fund (16.2%) investors. The pension

funds investors are only slightly underrepresented (21.5% in the depository). This would not

meaningfully bias the findings. However, the fund of funds investors is unclassified in the Dow

Jones LP source database. To address any potential bias, a series of Mann Withney U tests on

fund of funds versus non fund of funds group will be carried out.

Table 5: Distribution of responding LPs by type of investors

5.1.3 Fund size and commitment to private equity investment of responding LPs

As reported in Table 6 and Table 7, the fund sizes of the responding LPs are relatively

heterogeneous, while the commitments to PE are not. Two distinct groups of investors are

highly-specialized investors who commit 80% of capital or more in PE investments (44.7%) and

diversified investors who commit less than 20% into the asset class (42.1%). This distribution is

similar to what Groh et al. (2008) find in their data set which further reinforces the

representativeness of this research. These kinds of distribution lead to an investigation of the

relationship between the level of commitment and fund size. It is suspected that the level of

commitment into PE investment decreases as the fund size increases. There is a possibility that

25

smaller-specialized funds are simply investment vehicles that received funding from larger-

diversified funds. Hence, a Kruskal Wallis test is performed to investigate whether the level of

commitment differs with fund size. The hypotheses H0: µi = µk suggests there is no significant

difference in term of level of commitment to PE across different fund size. The alternative

hypotheses H1: µi ≠ µk suggests there is a significant difference.

Table 6: Distribution of the responding LPs by size

Table 7: Distribution of the responding LPs by commitment to PE investments

The result of the Kruskal Wallis test with mean rank and test statistics are reported in Table 8.

The test statistic suggests that H0 has to be rejected. Hence, there is a significant difference in

levels of commitment across different groups of fund sizes, but not in the expected manner.

Surprisingly, the smallest and largest investors (have a mean rank of 33.94 and 29.23

respectively) have a smaller mean rank than the medium fund size investors (those fa ll in $100m

- $999m and $1000m - $9,999m, have a mean rank of 47.11 and 38.94 respectively). The

medium size investors are more specialized in PE investments. The proportion of variability in

the ranked level of commitment accounted by the fund size was 11.88%,16 indicating a fairly

strong relationship between fund size and level of commitment.

16 Eta square = Chi-square / (Number of observation – 1)

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Table 8: Kruskal Wallis test on level of commitment into PE, grouped by fund size

Summarizing these statistics, it can be reported that a unique dataset of LPs who are investing (or

interested) in EMs’ PE asset class is achieved. This dataset covers a diverse sample of LPs in

term of type of investors, fund size, geographic distributions and level of commitment. A series

of Mann Withney U tests will also be carried out to detect the difference in responses between

large (larger than $1 billion) and small investors (smaller than $1 billion), and between

specialized investors (more than 80% of commitment in PE) and diversified investors (less than

80% of commitment).

5.2 The most important country-specific determinants, and appreciation of key drivers of

capital allocation in EMs

The questionnaire asked LPs to indicate the level of importance of various country-specific

factors as discussed in the literature review section. The individual factors are grouped into six

main drivers for private equity investments in emerging markets, i.e. economy, taxation policies,

capital market, investor protection and legal environment, social environment and

entrepreneurial opportunities. Figure 2 presents all the individual factors being considered and

their means. These factors are presented in their corresponding categories. The bars indicate the

range within 95% confident interval where the means are expected to fall in. 17 Figure 2 reveals

that, on average, the expected returns of PE investments in EMs, and property rights and investor

protection, are ranked the most important criteria. Figure 2 also clearly indicates that public

funding is ranked as the least important factor.

17 The 95% confident interval is used instead of an interval based on +/- standard deviation here, because it is a stricter measurement. It is not to say that the normality of distribution is assumed. A series of non-parametric test is used to determine the rankings.

27

Figure 2: Nominations of the importance of country-specific factors

Firgure.2. presents that, within a 95% confident interval, the sample means are quite close to

each other. Hence, it is not clear which factors dominate others as the most important

determinants in capital allocation decision. Therefore, a series of pair-wise Wilcoxon Signed

Rank tests are used to determine the rankings of the top five most important factors (based on

mean nominations). These are expected returns of PE investments in EMs (5.47), property rights

and investor protection (5.36), bribing and corruption (5.23), regulations on repatriation of

capital (5.19) and entrepreneurial management quality and skills (5.08). These Wilcoxon Signed

Ranks tests are non-parametric in nature with the hypothesis: H0: µi = µk and H1: µi ≠ µk to

determine a ranking. View Appendix 1 for the test statistics of all the tested pairs. The result is

shown in Table 9.

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Table 9: The most important country-specific determinants

At significance level of 0.05, Table 9 reveals that the definition of absolute ranks based on

investors’ ratings is impossible. The expected returns of private equity investments in emerging

markets and property rights and investor protection are ranked either at the first, second or third

position. Both factors are clearly ranked before the forth criterion, i.e. the regulation on

repatriation of capital. Next is bribing and corruption (ranking at 1, 2, 3, 4 or 5). Then, the

regulation on repatriation of capital, and entrepreneurial management quality and skill follow

closely (broth are ranking at 3 or 4 or 5). While the rankings are rather sticky, only the expected

returns of PE investments in EMs, property rights and investor protection, and bribing and

corruption could possibly ranked as first or second. These three factors are viewed as the most

important determinants for capital allocation decisions.

The respondents were also asked to rate their level of appreciation (perceived effectiveness) of

the key drivers of the country-specific factors on a six-point Likert scale. One being the least

effective and six being the most effective. Figure 3 reveals the level of appreciation in LPs’

opinion. These findings have to be interpreted with caution, since the investment environments

and challenges within each EM are different. The comparison of the findings in Figure 3 with the

results in Table 9 clearly point out two obvious problems that emerging markets face in

attracting PE investments. First, while investors rank highly importance of bribing and

corruption and entrepreneurial management quality and skills, they perceive the social

environment provided in the EMs to be weak. Second, even though investors perceive investor

protection and the legal environment in EMs to be of moderate strength, they still rank highly the

importance of property rights and investor protection and regulation on repatriation of capital.

This indicates that investor protection and the legal environment is still relatively unstable in

investors’ perception and they do not take it for granted.

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Figure 3: Appreciation (effectiveness) of the key drivers of country-specific factors

5.3 The most important firm-specific determinants of capital allocation in EMs

The questionnaire asked LPs to indicate the level of importance of various firm-specific factors

as discussed in the literature review section. The individual factors are grouped into four main

drivers of a qualified GP, i.e. the capability of a GP, incentive structure, firm-level corporate

governance and GP’s strategic focus. Figure 4 reveals that, on average, investors highly concur

that integrity and transparency practices of GPs are the most important criteria, and then

followed by the match between GP’s expertise and investment strategy. Certainly, the majority

of investors are not impressed by the size of cumulative assets under management [AUM] and

the popularity of the fund (assessed by the actual fundraising amount in comparison with the

target amount), hence these factors are deemed to be the least important. The availability of co-

investment programmes to LPs is also ranked as one of the least significant factors.

30

Figure 4: Nominations of the importance of firm-specific factors

To confirm the rankings, a series of pair-wise Wilcoxon Signed Rank tests were carried out on

the top five most important factors (based on mean nominations), namely the integrity of GPs

(5.77), transparency practices of GPs (5.60), the match between GPs’ expertise and investment

strategy (5.53), track record (5.49) and accessibility of deal flows (5.31). The tests with the

hypothesis: H0: µi = µk and H1: µi ≠ µk are described in Appendix 2 and the result presented in

Table 10.

Table 10: The most important firm-specific determinants

31

Table 10 reveals that investors have a strong consensus that the integrity of GPs (ranking at 1)

and the transparency practices of GPs (ranking at 2, 3 or 4) are the most important determinants

of qualified GPs. Next is the match between GPs’ expertise and strategy focus (ranking at 2, 3 or

4), followed by the track record (ranking at 2, 3, 4 or 5) and accessibility of deal flows (4 or 5).

While the integrity of GPs is hard to assess, investors ranked it as the most important attribute.

This finding gives a direct corollary to the country-specific factors ranked as most important

such as property rights and investor protection and bribing. Investors appear to view firm-level

corporate governance as an alternative solution to poor investor protection and bribing issues in

the law in emerging markets. This statement is further investigated in the next section. The top

five of both country-specific and firm-specific factors are ranked together, to determine if indeed

some GPs’ attributes are viewed as effective compensations to the shortfalls of country-specific

factors by the LPs.

5.4 The most important determinants – reconciling firm-specific factors with country-specific factors

Figure 5 reveals that, on average, investors consider the integrity of GPs, the transparency

practices of GPs, the match between GPs’ expertise and investment strategy and track record to

be more important than other country-specific determinants. The ranges of the confident

intervals also suggest that investors have more consensuses on the level of importance of these

firm-specific determinants (i.e. smaller standard deviations) than the country-specific ones.

32

Figure 5: Nominations of the importance of (top-five) firm-specific and country-specific

determinants

To confirm the ranking, pair-wise Wilcoxon Signed Rank tests with the hypothesis: H0: µi = µk

and H1: µi ≠ µk were carried out. The test statistics is shown in Appendix 3 and the results is

shown in Table 11.

Table 11: Reconciling the most important firm-specific determinants with country-specific determinants

33

As expected, Table 11 reveals that only the integrity of GPs is ranked as the first. Hence,

investors think that the integrity of GPs is absolutely the most important factor. The absolute

ranks of other factors are impossible. This suggests that investors would consider all these

determinants to be closely important when making capital allocation decision.

5.5 Sample bias and reliability test

The heterogeneous set of LPs in the sample could be categorized into several homogenous sub-

samples. These sub-samples could be either European or not, fund of funds or not, large (larger

than $1 billion) or small (smaller than $1 billion) or highly specialized investors (more than 80%

of commitment to PE) or not. Mann Withney U tests are carried out to detect if there are any

differences between sub-samples regarding their key determinants of capital allocation decision.

First, based on the distribution of the origins of the responding LPs, European investors are

overrepresented compared to the depository. It is arguable that European investors might face

different challenges or follow a different approach to investing. Hence, they may perceive

different key determinants of their capital allocation decision compared to other LPs.

The European investors are distinguished from non-European investors. The Mann Withney U

tests with the hypothesis H0: µi = µk and H1: µi ≠ µk are performed. Only the top five of the

country-specific and firm-specific determinants are included in the tests. The results suggest

there is no significant difference between European and non-European investors regarding their

perception of key determinants of capital allocation decision. The test statistics are shown in

Appendix 4.

Second, the distribution of the fund of funds investors is not available in the depository, yet it is

the biggest group in the sample. To anticipate any potential bias, fund of funds are distinguished

from non-fund of funds investors, the Mann Withney U tests with the hypothesis H0: µi = µk and

H1: µi ≠ µk are performed. As before, the focus is on testing for different perceptions of the top

five most important determinants from both groups of factors. The test statistics in Appendix 5

show that fund of funds investors only differ in opinion from non-fund of funds investors

regarding the matching between GP’s expertise and investment strategy. The fund of funds

investors (mean rank of 44.41) have a marginally higher mean rank than non-fund of funds

investors (mean rank of 34.18) on this determinant. Hence, the overall high ranking of the

matching between GP’s expertise and investment strategy is driven by the opinion of fund of

funds investors. A possible explanation is that fund of funds act as agents for other types of

34

investors in allocating capital to PE firms, and hence the matching between GPs’ expertise and

investment strategy is naturally more important to them.

Third, the comparison by investors’ size is also impossible since such information for the

majority of LPs in the depository is unknown. The segmentations of investors by size in the

sample are rather heterogeneous. To address any potential bias, large investors are distinguished

from small investors. A series of Mann Whitney U tests with the hypothesis H0: µi = µk and H1:

µi ≠ µk are performed. The test statistics in Appendix 6 indicate that the two groups’ opinions on

property rights and investor protection, and regulation on repatriation of capital are different but

not very significant. Large investors have a marginally higher mean rank for both factors than

small investors. Since large investors generally have a higher exposure to investments than small

investors, it is natural for them to have a stronger concern about the return of their capital.

Consequently, large investors are more likely to rank these two factors more highly.

Last, the information on the level of commitment in PE is not available in the depository. It is

interesting to see whether there is any difference between specialized and diversified investors.

The Mann Withney U tests with the hypotheses H0: µi = µk and H1: µi ≠ µk are carried out. The

test statistics in Appendix 7 shows that there is no significant difference between the perceptions

of specialized and diversified investors on their key determinants of the capital allocation

decision.

A reliability test is conducted. This test calculates the Cronbach’s alpha, which is a measure to

assess the correlations among the test items. Hence, it is an internal consistency estimate of

reliability. Since the Cronbach’s alpha is not robust to missing data, list-wise deletion based on

all test items is ensured. Based on 88 test items, the reliability statistics in Appendix 8 indicate a

Cronbach’s alpha of 0.88. Following a general rule of thumb, a set of tests with Cronbach’s

alpha that is larger than 0.7 is considered to have good internal consistency.

Summarizing all these results, there are some minor differences in the capital allocation decis ion

of certain sub-samples. However, these differences are not significant to such an extent that will

meaningfully bias the general findings toward certain sub-groups of investors. The findings

generated from this research are also considered to have good reliability. In the next chapter,

these findings will be put into perspective and reconciled with the existing literature. From this

discussion, the important implications for policymakers and GPs will be explored.

35

Chapter Six: Discussion

This chapter will discuss the findings of the previous chapter, and their implications. There are

many ways to interpret these results that go beyond the scope of this paper. The discussion in

this chapter is focused on answering the research questions mentioned earlier. First this chapter

will discuss the country-specific and firm-specific determinants of capital allocation decisions in

PE investments in EMs that were identified to be the most important in the previous chapter.

Next, through abductive reasoning, these determinants of capital allocation were ranked together.

The findings enable two propositions that might then answer what, if any, are the firm-specific

determinants that would sufficiently compensate for the shortcomings of the country-specific

disadvantages. These propositions are:

Proposition (1) Integrity and transparency practices of the GPs act as effective mechanisms of

firm-level corporate governance that would sufficiently compensate for the shortcomings of

protection offered by legal and social environment in EMs.

Proposition (2) GPs’ with the right match of expertise and strategy would sufficiently

compensate for the lack of entrepreneurial skills and quality inherent in emerging markets.

6.1 The most important country-specific determinants

6.1.1 The expected return in PE investment in EMs

As shown in Table.9, investors identify the following country-specific factors as their key

determinants of capital allocation decision: expected returns of PE investments in EMs, property

rights and investor protection issues, bribing and corruption issues, regulation of repatriation of

capital, and entrepreneurial management quality and skills . Generally speaking, it is clear that

investors’ decisions to invest in EMs are driven by the expected returns of PE investments. PE

investments are extremely illiquid and risky, especially in EMs where the exit potential is

constrained by their underdeveloped capital markets. Once capital is committed, investors are

susceptible to investment losses and opportunity costs if the investments do not work as expected.

Hence, investors have to ensure that the expected returns justify the risks they are taking in the

first place. It is the most important prerequisite for investors to even consider allocating a portion

of their capital in EMs.

36

6.1.2 Property right and investor protection

Investors also rank the issues of property rights and investor protection as equally important

(both factors are ranked at 1, 2 or 3). Despite measuring a moderate increase in perceived

effectiveness of investor protection and the legal environment compared to a previous study by

Groh et al. (2008), investors do not take this issue for granted. Such cautious attitudes could be

attributed to the previous experiences of underperformance in the 1990s, which were caused by

poor investor protection in EMs (Leeds and Sunderland, 2003). The rationale for such a high

ranking is rather intuitive. Investors’ claims on private equity funds have to be secured. Similarly,

the private equity funds’ claims on portfolio companies also have to be secured as it would

directly affect investors’ payoffs. If investors are not confident of the protections offered by a

country’s legal environment, they are reluctant to invest in it. This high ranking of property

rights and investor protection is strongly supported by La Porta et al. (1997, 1998 and 2002). The

high ranking of these issues suggest that investors are greatly incentivized by the actual demand

of their capital. Quality of property rights and investor protection could fundamentally influence

the demand of risk capital, i.e. the entrepreneurial activities. This interpretation is supported by

Desai et al. (2003).

6.1.3 Bribing and corruption

Bribing and corruption issues (ranking at 1 or 2 or 3 or 4 or 5) were also ranked highly. This

further emphasises investor’s desire for securities and claims of their capital, as investors worry

of the additional unexpected transaction cost. In some severe cases, corruption could directly

disrupt the exercise of investors’ claims by influencing the possibility of the law being enforced.

Maoro (1995) and Paul (1995) lend strong support to such an explanation. However, within the

limited scope of the questionnaire, it is impossible to completely exclude the possibility that

investors rank this issue highly because of its perceived benefits as conceptualized by Leff

(1964). Despite such drawbacks, and not to ignore the benefits of bribing, the suggested

explanation is most likely to be the case. As supported by empirical studies (Stone et al., 1996

and Paul, 1995), investors are most likely to have strong concerns on this issue because of its

negative influence on their investments.

37

6.1.4 The regulation on repatriation of capital

Investors also rank regulation on repatriation of capital (ranking at 3 or 4 or 5) highly. While

investors are return driven, a combination of such high rankings on related issues on securing

their claims suggest that investors are more concerned with the return of their money than the

returns on their money. The nature of investing in the PE asset class is highly illiquid, possibly

spanning five to ten years. Within this period, the regulation on repatriation of capital and other

forms of capital controls could drastically change. At ex-ante, investors would decide to invest in

a country only if they find the regulations on capital controls in that particular country are

acceptable and expected to remain stable in the long run. Any delays of the repatriation of capital

would disrupt the redeployment of their capital. Investors might incur significant opportunity

cost if they are unable to supply their capital when it is most needed. This explanation is in line

with the findings of Dooley and Isard (1980) and Desai et al. (2006). As a reflection of this

disruption, Desai et al. (2006) find that investors in countries with strict capital controls tend to

face higher cost of capital. Investors also face significant costs associated with the actions to

avoid the impact of control on repatriation of capital. Hence, investors’ incentive to invest is

significantly reduced.

6.1.5 The entrepreneurial management quality and skills

LPs also place great emphasis on the entrepreneurial management quality and skills (ranking at 3

or 4 or 5). This suggests that LPs need to rely on talents to drive for abnormal returns. Despite

the expertise and business connections brought about by private equity funds, ultimately it is the

entrepreneurs who drive business growth. Hence, it makes sense that investors place significant

emphasis on entrepreneurial management quality and skills. This is also related to other issues

within the downstream chain of agents whom investors rely on to generate superior returns, such

as the integrity, incentive, capability and level of involvement of the agents.

6.1.6 Public funding and subsidiaries

It is worth highlighting that investors are not attracted by public funding and subsidiaries

provided by local governments. They rank this criterion as the least important factor with clear

absolute ranking. As Groh et al. (2008) said, “Private money does not follow public money.”

Investors are looking for a market with true growth potential and strong demand of their capital,

rather than an artificial capital risk market. To prove this view point, this research also indicates

that investors rank the economy growth rate and the entrepreneurial spirit and culture highly (test

38

results are not shown in this paper). Likewise, this finding is confirmed by Da Rin et al. (2005),

Armour and Cumming (2006) and tested by Groh (2008).

6.2 The shortcomings of country-level endowments in emerging markets

Within the current investment climate, as shown in Figure.3, the perceived strength of economic

activities and entrepreneurial opportunities offered by EMs is high among investors. While the

perceived strength of capital markets is moderate, the overall expectation of the return potential

coincides with investors’ opinions on the importance of this determinant. Unfortunately, while

bribing and corruption issues and entrepreneurial management quality and skills are ranked

highly, investors do not perceive the effectiveness of the human and social capital environment

in EMs to be high. Furthermore, despite the improvement in the perceived effectiveness of

investor protection and the legal environment, investors are still holding an extremely cautious

attitude toward this issue. This suggests investors still have fairly little confidence towards the

investor protections offered by EMs. Considering this at a country- level, these two problems

become the main obstacles that prevent investment in EMs. In the short term, these two problems

would not be resolved or assumed away by investors. The solutions might be found at the firm

level instead.

6.3 The most important firm-specific determinants

6.3.1 The integrity of GPs

As indicated in Table.10, investors identify the following firm-specific factors as key

determinants of capital allocation decision: the integrity of GPs, the transparency practices of

GPs, the match between GPs’ expertise and strategy, track record and the accessibility of deal

flows. Unsurprisingly, investors concur that the integrity of GPs is the most important

determinant with an absolute rank above other firm-specific criteria. The integrity of GPs is the

most powerful self-governing mechanism. This very quality would effectively resolve agency

problems at the fund manager-investor level and lessen its negative impact at the fund manager-

portfolio company level. The integrity of GPs is difficult or virtually impossible to assess, since

it has a very subjective measure. It is also built on a long-term relationship between LPs and GPs.

These present a significant challenge for LPs in assessing it, as well as for GPs to demonstrate

such quality to investors.

39

6.3.2 The transparency practice of the GPs

The integrity of GPs is immediately followed by the transparency practices of GPs (ranking at 2

or 3 or 4). The “transparency practice” determinant is ranked highly because investors are faced

with severe asymmetries of information both before and after they commit their capital.

Investors attempt to monitor and eliminate the moral hazard problem that might potentially

deteriorate their returns. In some cases, the GPs might have a strong incentive to generate their

payoffs through fees. In other instance, GPs might have a tendency to overstate the unrealized

returns of backed companies in order to facilitate raising capital for their new funds. This

explanation is supported by Cumming and Walz (2010), who echo the problem of disclosure in

the international private equity industry. Likewise, Cumming and Johan (2009) strongly suggest

that investors rank transparency practices as one of the most important hurdles in private equity

investments.

6.3.3 The matching between GPs’ expertise and strategy

Investors also rank highly the matching of GPs’ expertise and strategy (ranking at 2, 3 or 4). LPs

are fundamentally in the business of picking winning private equity funds. To achieve abnormal

returns, investors have to rely on GPs to make operational improvement in the portfolio

companies or bring about added value externally through merger and acquisition deals. Such

improvements require the right expertise and strategy. The reason for this high ranking is

investors are attempting to increase their chances of picking winning PE funds, by identifying

the right GPs who possess skills that matter the most to the proposed investment strategies. At

ex-ante, investors would not entrust their capital to GPs if they do not think highly of the GPs’

investment strategies. Likewise, they would not invest if the GPs do not possess the necessary

expertise in implementing those strategies. This explanation is supported by Zarutskie (2010),

where task-specific human capital factors seem to matter the most and is dependent on the type

of investment. Similarly, Acharya et al (2010) present evidence that there are combinations of

GPs’ strategies and backgrounds that correlate with abnormal performance at deal level.

Follow this line of discussion, with the right expertise and strategy, GPs could create value

through different ways. For example, by imposing high leverage and powerful incentives (Jensen,

1989, and Lichtenberg and Siegal, 1990), making operational improvements (Kaplan and Schoar,

2005), adding professional structure and rigor to start-ups (Hellmann and Puri, 2002), and

improving long term innovation (Sorensen and Stromberg, 2008).

40

6.3.4 Track record

Another key determinant is track record (ranking at 2 or 3 or 4 or 5). Even though past returns do

not guarantee future returns, it gives a good reference point to a GP’s capabilities. Investors

value track records greatly because they provide the most concrete and objective measure of a

GP’s skills and capability. With proper due diligence, by assessing an extended track record,

investors are able to determine if the outperformance of the private equity fund is due to the GP’s

proven strategies and capabilities or pure luck factors.

Evidence suggest that investors indeed rely on track record such as the amount invested and

divested earlier by GPs and past performance to make their capital allocation decision (Balboa

and Marti, 2000, and Kaplan and Schoar, 2005).

6.3.5 Accessibility to deal flows

Beyond the GPs’ capability and strategy, investors want to ensure that GPs have sufficient deal

pipelines. They place significant emphasis on GP’s access to deal flows (ranking at 4 or 5). If a

GP has no accessibility to good deal opportunities, any capital allocation to the funds is wasted.

Investors would like GPs to deploy their capital in the most efficient way. The longer the initial

period of capital deployment, the more opportunity cost investors bear. Insufficient deal flows

also suggest a longer investment lifecycle, which means investors end up paying more fees and

leaving themselves in a risky situation.

6.3.6 Size of cumulative AUM, popularity of the funds and co-investment programmes

Surprisingly, investors do not rank the size of cumulative AUM highly. There are two possible

explanations for this finding. First, the size of cumulative AUM is only an indication of the

amount of experience that GPs have, but it gives little information about their performance. In

other words, a private equity firm could be quite successful at raising funds, but less successful

at generating returns than its peers. Second, PE funds in EMs generally have a smaller size of

cumulated AUM, which should not be a discounting factor.

Nevertheless, investors are not attracted by the popularity of the funds and the availability of a

co-investment programme to them. Popularity of a fund is measured by the actual fundraising

amount relative to the target fundraising amount. Investors rank this factor as one of the least

important criteria. This proves that GPs’ efforts to stay oversubscribed as suspected by Gomper

and Lerner (1999) is useless.

41

The co-investment programmes allow LPs to bypass the limited partnership structure and enable

them to invest in specific deals. With certain specific deals that they are confident of, they could

deploy more capital into it. Such programmes are useful when investors are trying to influence

their investment life cycle. However, because of the lack of direct involvement in portfolio

companies in EMs, the risk of deploying equity directly is extremely high. Hence, investors are

not attracted by co-investment programmes at all.

6.4 Reconciliation of firm-specific determinants with country-specific determinants

Informed by the two major obstacles in EMs, the main objective is to find out what firm-specific

determinants would sufficiently compensate for the country- level disadvantages. The top-five

determinants from both groups of firm-specific and country-specific factors were ranked together.

With reference to Figure.5, it seems that the majority of investors concur that firm-specific

determinants are more important than country-specific determinants. Further, in attempt to

validate the two emerging propositions mention earlier, the ranking results in Table.11 are

closely investigated. Regarding proposition (1), the integrity of GPs is the only factor that has an

absolute rank above property rights and investor protection, bribing and corruption and

regulation on repatriation of capital. This finding suggests that investors consider the integrity of

GPs as the most powerful self-governing mechanism. It would sufficiently compensate for the

shortcoming of investor protection offered by legal and social environment in emerging markets.

However, as mentioned earlier, investors face difficulty in assessing the integrity of GPs. They

have to rely on a combination of other types of firm-level governance and incentive structures in

making adjustments for the insufficient country-level protection. For example, Love (2010)

suggests other provisions or mechanisms that could be used including well-defined transparency

practices, self-governing and well- functioning boards and other disciplinary mechanisms to

prevent expropriation. Unfortunately, the transparency practice of a GP does not have an

absolute rank above property right and investor protection, and bribing and corruption issue.

Regarding proposition (2), investors rank the matching between GPs’ expertise and strategy

above entrepreneurial management and skills. Only GPs with the right match of expertise and

strategy could bring about significant improvement by transferring skills, creating powerful

incentives, imposing professional structures at portfolio companies and so on. This finding

further reinforces the literature that GPs generate abnormal return through value creation in the

portfolio companies. Investors believe that GPs with the right match of expertise and strategy

42

alone is sufficient to compensate for the shortcomings of entrepreneurial management and skills

at local countries.

6.5 Research Implications

This paper is highly differentiated from other literature since it is conducted at a global scale

with a highly diverse sample of LPs. While the majority of other pieces of literature study the

investment process through proxies or surveying GPs, this research directly addresses the source

of capital, i.e. LPs. Even though certain group of investors are overrepresented, the comparison

tests across all subsamples suggest the findings produced in this paper are not meaningfully

biased toward any particular group of investors. The internal consistency of this research is also

proved to be reliable.

6.5.1 Theoretical contribution

The findings in this paper provide direct support to Cumming and Walz (2010), and Cumming

and Johan (2009) on transparency practices as an important hurdle in PE investments. This paper

further confirms the robustness of the following studies on investor protection as a key criterion

for investment decisions: Cumming and Johnson (2007), La Porta et al (1997, 1998 and 2002),

and Lener and Scholar (2005). In response to Easterbrook and Fischel (1991), and Black and

Gilson (1998) and Love (2010), this paper successfully identifies key firm-level governance as

adjustments to country-level protections. The major contribution of this paper is that it acts as an

out-of-sample test to Groh et al. (2008). The findings on country-specific determinants are

almost identical which further confirms the reliability of both studies.

6.5.1 Implication to policy makers of EMs

Public funding and subsidies provide little or no incentive for LPs to commit their capital into

EMs. Policymakers should re-evaluate their efforts to attract investments. Investors are looking

for an investment environment with a strong growth potential and high demand for their cap ital.

While international investors are attracted by economic activities (economic growth rate) and

entrepreneurial opportunities of EMs, poor investor protection and legal environment hinder

their investments. Bribing and corruption as well as strict capital controls would also negatively

influence the supply of capital.

In order to provide investors with the desired level of security, policymakers should focus on

strengthening the country’s legal framework and law enforcement as well as encouraging

corporate governance culture and practice. Corrupt practices must also be kept within control.

43

Policymakers should also ensure fair and stable capital controls. The regulations on repatriation

of capital that favour investors would reduce their cost of capital, and hence incentivize their

investment activities.

Ultimately, investors are relying on local entrepreneurs to drive the growth of their investments.

Policymakers should have a long-term commitment to education. Likewise, they must have some

short-term strategies to improve key managerial skills such as offering training programmes and

industrial placements overseas.

6.5.2 Implication to GPs

Investors are not attracted by the size of cumulative AUM and the popularity of the funds.

Similarly, when investing in EMs, investors do not appreciate the availability of co- investment

programmes. GPs should re-evaluate their marketing and fundraising strategies when raising an

EMs fund.

Track records and accessibility of deal flows are important prerequisites for capital commitment.

In EMs, where the capital markets are relatively inactive and supporting agents are scare, GPs

have to rely on local connections and other unconventional strategies in building up deal

pipelines.

Investors believe GPs could bring about value creation at investee companies. To strengthen

investors’ confidence, GPs should emphasize the right match between their expertise and

strategy.

To lessen the negative impact of weak country- level protection, GPs should ensure sufficient

corporate governance. While the integrity of GPs is what investors most desire, this presents a

major challenge for GPs to demonstrate it.

6.6. Conclusion

The abductive research is conducted at a worldwide scale with a diverse sample of LPs in term

of fund size, geographic distribution, type of investors, markets of interest and level of

commitment to PE investments. At the country- level, investors consider the following factors as

their key determinants of capital allocation in PE investments in EMs, i.e. the expected returns of

PE investments in EMs, property rights and investor protection, bribing and corruption,

regulations on repatriation of capital and entrepreneurial management qualities and skills.

Investors are not attracted by the public funding and subsidies. At the firm-level, the key

44

determinants are the integrity and transparency practice of the GPs, the matching between GPs’

expertise and strategy, track records and the accessibility of deal flows. Investors are not

impressed by the size of cumulative AUM and the popularity of the private equity fund. They are

also less attracted by the availability of co- investment programmes as investing in specific deals

in EMs is extremely risky.

Regarding proposition (1), the integrity of GPs is an effective mechanism that could sufficiently

compensate for the shortcomings of country-level protection. However, GPs face with great

challenges to demonstrate such attributes. Similarly, LPs find it impossible to assess this as well.

Transparency practices alone are not sufficient to eliminate investors’ concerns about

expropriation. Both GPs and LPs have to rely on a combination of other firm-level corporate

governance and incentive structures to achieve the desire level of protection. Regarding

proposition (2), investors believe that GPs with the right match of expertise and strategy would

sufficiently compensate for the lack of entrepreneurial management qualities and skills in EMs.

The comparison tests across many subsamples reinforce the generalization of the findings in this

paper. The internal consistency of the research is also proven to be reliable. However, the

explanatory power of the two emergent propositions is constrained. The two propositions were

only derived after analysing the responses. The investors were not asked to provide explanations

to these propositions. The interpretation could only be offered by using abductive reasoning and

referring to the existing literature. The findings in this paper set many potential arenas for future

studies. The two propositions certainly deserve further attention for testing and validation in

order to generate more meaningful implications. Future research could pay more attention to the

investors’ decision-making process, and hence find out how investors trade off the costs and

benefits between country-specific and firm-specific advantages/disadvantages. This paper only

explores the capital allocation decision process at two levels, i.e. at the firm level and country

level. There is a need for future study to explore key determinants at the global level, such as the

implication of globalization on private equity investments and capital allocation decisions.

45

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50

Appendices

Appendix 1: Wilcoxon Signed Rank test statistics of the top five country-specific factors

Descriptive Statistics

N Mean Std.

Deviation

Minimu

m

Maximu

m

Percentiles

25th 50th

(Median)

75th

Expected return_PE

in Emrg Mkt 75 5.47 .920 1 6 5.00 6.00 6.00

Property right/investor

protection 76 5.36 .919 1 6 5.00 6.00 6.00

Bribing and corruption 74 5.23 1.245 1 6 5.00 6.00 6.00

Regulation on

repatriation of capital 75 5.19 1.009 1 6 5.00 5.00 6.00

Entrepreneurial

management quality

and skills

75 5.08 1.075 1 6 5.00 5.00 6.00

Test Statisticsa : Expected return of private equity investment in emerging market vs other

criteria

Property

right/investor

protection -

Expected

return_PE in

Emrg Mkt

Bribing and

corruption -

Expected

return_PE in

Emrg Mkt

Regulation on

repatriation of

capital -

Expected

return_PE in

Emrg Mkt

Entrepreneurial

management

quality and skills

- Expected

return_PE in

Emrg Mkt

Z -1.005 -1.426 -2.255 -2.767

Asymp. Sig. (2-tailed) .315 .154 .024 .006

a. Wilcoxon Signed Ranks Test

Test Statisticsa : Property right and investor protection vs other criteria

Bribing and

corruption -

Property

right/investor

protection

Regulation on

repatriation of

capital -

Property

right/investor

protection

Entrepreneurial

management

quality and skills

- Property

right/investor

protection

Z -.970 -2.058 -2.401

Asymp. Sig. (2-tailed) .332 .040 .016

a. Wilcoxon Signed Ranks Test

51

Test Statisticsa : Bribing and corruption vs other criteria

Regulation on

repatriation of

capital - Bribing

and corruption

Entrepreneurial

management

quality and skills

- Bribing and

corruption

Z -.630 -1.135

Asymp. Sig. (2-tailed) .529 .256

a. Wilcoxon Signed Ranks Test

Test Statisticsa : Regulation on

repatriation of capital vs

Entrepreneurial management quality

and skills

Entrepreneurial

management

quality and

skills -

Regulation on

repatriation of

capital

Z -1.140

Asymp. Sig. (2-tailed) .254

a. Wilcoxon Signed Ranks Test

52

Appendix 2: Wilcoxon Signed Rank test statistics of the top five of firm-specific factors

Descriptive Statistics

N Mean Std.

Deviation

Minimu

m

Maximu

m

Percentiles

25th 50th

(Median)

75th

Integrity of GPs 75 5.77 .509 4 6 6.00 6.00 6.00

Transparency

practice of GPs 75 5.60 .678 3 6 5.00 6.00 6.00

Match btw GPs ’

expertise and

investment strategy

75 5.53 .684 3 6 5.00 6.00 6.00

Track records 76 5.49 .663 4 6 5.00 6.00 6.00

Accessibility of deal

flows 74 5.31 .757 3 6 5.00 5.00 6.00

Test Statisticsa : Integrity of GPs vs other criteria

Transparency

practice of GPs

- Integrity of

GPs

Match btw GPs’

expertise and

investment

strategy -

Integrity of GPs

Track records -

Integrity of GPs

Accessibility of

deal flows -

Integrity of GPs

Z -2.829b -3.084b -3.085b -4.495b

Asymp. Sig. (2-tailed) .005 .002 .002 .000

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

Test Statisticsa : Transparency practice of GPs vs other criteria

Match btw GPs ’

expertise and

investment

strategy -

Transparency

practice of GPs

Track records -

Transparency

practice of GPs

Accessibility of

deal flows -

Transparency

practice of GPs

Z -.779 -1.144 -3.014

Asymp. Sig. (2-tailed) .436 .253 .003

a. Wilcoxon Signed Ranks Test

53

Test Statisticsa : The match between GPs’ expertise and

investment strategy

Track records -

Match btw GPs ’

expertise and

investment

strategy

Accessibility of

deal flows -

Match btw GPs ’

expertise and

investment

strategy

Z -.284 -2.040

Asymp. Sig. (2-tailed) .776 .041

a. Wilcoxon Signed Ranks Test

Test Statisticsa : Track records vs

accessibility of deal flows

Accessibility of

deal flows -

Track records

Z -1.781

Asymp. Sig. (2-tailed) .075

a. Wilcoxon Signed Ranks Test

54

Appendix 3: Wilcoxon Signed Rank test statistics of the top five of country-specific and firm-specific determinants

Descriptive Statistics

N Mean Std. Deviation Minimum Maximum Percentiles

25th 50th

(Median)

75th

Integrity of GPs 75 5.77 .509 4 6 6.00 6.00 6.00

Transparency practice of GPs 75 5.60 .678 3 6 5.00 6.00 6.00

Match btw GPs’ expertise and

investment strategy 75 5.53 .684 3 6 5.00 6.00 6.00

Track records 76 5.49 .663 4 6 5.00 6.00 6.00

Expected return_PE in Emrg Mkt 75 5.47 .920 1 6 5.00 6.00 6.00

Property right/investor protection 76 5.36 .919 1 6 5.00 6.00 6.00

Accessibility of deal flow 74 5.31 .757 3 6 5.00 5.00 6.00

Bribing and corruption 74 5.23 1.245 1 6 5.00 6.00 6.00

Regulation on repatriation of

capital 75 5.19 1.009 1 6 5.00 5.00 6.00

Entrepreneurial management

quality and skills 75 5.08 1.075 1 6 5.00 5.00 6.00

55

Test Statisticsa : Integrity of GPs vs other criteria

Transparency

practice of GPs -

Integrity of GPs

Match btw GPs'

expertise and

investment

strategy -

Integrity of GPs

Track records

- Integrity of

GPs

Expected

return_PE in

Emrg Mkt -

Integrity of GPs

Property

right/investor

protection -

Integrity of GPs

Accessibility

of deal flow -

Integrity of

GPs

Bribing and

corruption -

Integrity of GPs

Regulation on

repatriation of

capital -

Integrity of

GPs

Entrepreneurial

management

quality and

skills - Integrity

of GPs

Z -2.829b -3.084b -3.085b -2.409b -3.373b -4.495b -3.022b -4.183b -5.069b

Asymp. Sig.

(2-tailed) .005 .002 .002 .016 .001 .000 .003 .000 .000

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

Test Statisticsa : Transparency practice of GPs vs other criteria

Match btw GPs’

expertise and

investment

strategy -

Transparency

practice of GPs

Track records -

Transparency

practice of GPs

Expected

return_PE in

Emrg Mkt -

Transparency

practice of GPs

Property

right/investor

protection -

Transparency

practice of GPs

Accessibility of

deal flow -

Transparency

practice of GPs

Bribing and

corruption -

Transparency

practice of GPs

Regulation on

repatriation of

capital -

Transparency

practice of GPs

Entrepreneurial

management

quality and skills

- Transparency

practice of GPs

Z -.779b -1.144b -.676b -1.858b -3.014b -2.089b -2.760b -4.271b

Asymp. Sig.

(2-tailed) .436 .253 .499 .063 .003 .037 .006 .000

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

56

Test Statisticsa : The match between GPs’ expertise and investment strategy vs other criteria

Track records -

Match btw GPs’

expertise and

investment

strategy

Expected

return_PE in

Emrg Mkt -

Match btw GPs’

expertise and

investment

strategy

Property

right/investor

protection -

Match btw GPs’

expertise and

investment

strategy

Accessibility of

deal flow -

Match btw GPs’

expertise and

investment

strategy

Bribing and

corruption -

Match btw GPs’

expertise and

investment

strategy

Regulation on

repatriation of

capital - Match

btw GPs’

expertise and

investment

strategy

Entrepreneurial

management

quality and skills -

Match btw GPs’

expertise and

investment

strategy

Z -.284b -.330b -1.535b -2.040b -1.532b -2.529b -3.442b

Asymp. Sig.

(2-tailed) .776 .741 .125 .041 .126c .011 .001

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

c. The test statistic here is insignificant. However, the standard deviation of Bribing and Corruption is too large. The removal of outlier suggest

different conclusion.

Test Statisticsa : Track records vs other criteria

Expected

return_PE in

Emrg Mkt -

Track records

Property

right/investor

protection -

Track records

Accessibility of

deal flow -

Track records

Bribing and

corruption -

Track records

Regulation on

repatriation of

capital -

Track records

Entrepreneurial

management quality

and skills - Track

records

Z -.016b -.862b -1.781b -1.211b -2.089b -2.907b

Asymp. Sig.

(2-tailed) .987 .389 .075 .226 .037 .004

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

57

Test Statisticsa : Expected return in private equity investment in emerging market vs other criteria

Property

right/investor

protection -

Expected

return_PE in

Emrg Mkt

Accessibility of

deal flow -

Expected

return_PE in

Emrg Mkt

Bribing and

corruption -

Expected

return_PE in

Emrg Mkt

Regulation on

repatriation of

capital -

Expected

return_PE in

Emrg Mkt

Entrepreneurial

management

quality and skills

- Expected

return_PE in

Emrg Mkt

Z -1.005b -1.660b -1.426b -2.255b -2.767b

Asymp. Sig.

(2-tailed) .315 .097 .154 .024 .006

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

Test Statisticsa : Property right and investor protection vs other criteria

Accessibility of

deal flow -

Property

right/investor

protection

Bribing and

corruption -

Property

right/investor

protection

Regulation on

repatriation of

capital -

Property

right/investor

protection

Entrepreneurial

management

quality and skills

- Property

right/investor

protection

Z -.481b -.970b -2.058b -2.401b

Asymp. Sig.

(2-tailed) .631 .332 .040 .016

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

Test Statisticsa : Accessibility of deal flow vs other criteria

Bribing and

corruption -

Accessibility of

deal flow

Regulation on

repatriation of

capital -

Accessibility of

deal flow

Entrepreneurial

management

quality and skills

- Accessibility of

deal flow

Z -.438b -.927b -1.682b

Asymp. Sig.

(2-tailed) .661 .354 .093

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

58

Test Statisticsa : Bribing and corruption vs other

criteria

Regulation on

repatriation of

capital - Bribing

and corruption

Entrepreneurial

management

quality and skills

- Bribing and

corruption

Z -.630b -1.135b

Asymp. Sig.

(2-tailed) .529 .256

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

Test Statisticsa : Regulation on

repatriation of capital vs

Entrepreneurial management

quality and skills

Entrepreneurial

management

quality and skills -

Regulation on

repatriation of

capital

Z -1.140b

Asymp. Sig.

(2-tailed) .254

a. Wilcoxon Signed Ranks Test

b. Based on positive ranks.

59

Appendix 4: Mann Withney U test statistics of the European vs non-European investors on the top five determinants from both groups of factors

Test Statisticsa : European vs non-European investors

Integrity of

GPs

Transparency

practice of GPs

Match btw

GPs ’

expertise

and

investment

strategy

Track

records

Expected

return_PE in

Emrg Mkt

Property

right/investor

protection

Accessibility

of deal flow

Bribing and

corruption

Regulation on

repatriation of

capital

Entrepreneurial

management

quality and skills

Mann-Whitney U 471.000 480.000 435.000 450.000 529.500 431.000 456.000 503.500 418.500 453.000

Wilcoxon W 1956.000 1965.000 1920.000 1990.000 2014.500 1971.000 1941.000 693.500 1958.500 663.000

Z -1.233 -.899 -1.500 -1.362 -.152 -1.588 -1.123 -.135 -1.390 -1.139

Asymp. Sig. (2-

tailed) .217 .369 .134 .173 .879 .112 .261 .893 .165 .255

a. Grouping Variable: Fund origins [Europe]

60

Appendix 5: Mann Withney U test statistics of the fund of funds vs non-fund of funds investors on the top five determinants from both groups of

factors

Test Statisticsa : Fund of funds vs non-fund of funds investors

Integrity

of GPs

Transparency

practice of GPs

Match btw

GPs’

expertise

and

investment

strategy

Track

records

Expected

return_PE in

Emrg Mkt

Property

right/investor

protection

Accessibility

of deal flow

Bribing and

corruption

Regulation on

repatriation of

capital

Entrepreneurial

management

quality and skills

Mann-Whitney U 541.000 647.500 478.500 601.000 521.500 610.000 587.500 534.000 574.000 598.000

Wilcoxon W 1669.000 1053.500 1606.500 1777.000 1697.500 1016.000 1715.500 912.000 1702.000 1726.000

Z -1.892 -.142 -2.298 -.871 -1.647 -.745 -.580 -1.280 -.995 -.705

Asymp. Sig. (2-

tailed) .058 .887 .022 .384 .100 .456 .562 .201 .320 .481

a. Grouping Variable: Investor type [Fund of funds]

Ranks

Investor type [Fund of funds] N Mean Rank Sum of Ranks

Match btw GPs’ expertise and investment strategy

No 47 34.18 1606.50

Yes 28 44.41 1243.50

Total 75

61

Appendix 6: Mann Withney U test statistics of big vs small investors on the top five determinants from both groups of factors

Test Statisticsa : Big vs Small investors

Integrity

of GPs

Transparency

practice of GPs

Match btw

GPs’

expertise

and

investment

strategy

Track

records

Expected

return_PE in

Emrg Mkt

Property

right/investor

protection

Accessibility

of deal flow

Bribing and

corruption

Regulation on

repatriation of

capital

Entrepreneurial

management

quality and skills

Mann-Whitney U 595.000 644.500 560.000 670.000 537.000 505.000 541.500 627.000 450.500 607.000

Wilcoxon W 1001.000 1050.500 966.000 1846.000 943.000 911.000 919.500 1005.000 856.500 1783.000

Z -1.019 -.183 -1.254 -.025 -1.563 -2.008 -1.147 -.096 -2.459 -.485

Asymp. Sig. (2-

tailed) .308 .855 .210 .980 .118 .045 .251 .924 .014 .628

a. Grouping Variable: Big vs Small

Ranks

Big vs Small N Mean Rank Sum of Ranks

Property right/investor protection

Big 48 41.98 2015.00

Small 28 32.54 911.00

Total 76

Regulation on repatriation of capital

Big 47 42.41 1993.50

Small 28 30.59 856.50

Total 75

62

Appendix 7: Mann Withney U test statistics of the specialized vs diversified investors on the top five determinants from both groups of factors

Test Statisticsa : Specialized vs Diversified investors

Integrity

of GPs

Transparency

practice of GPs

Match btw

GPs’

expertise

and

investment

strategy

Track

records

Expected

return_PE in

Emrg Mkt

Property

right/investor

protection

Accessibility

of deal flow

Bribing and

corruption

Regulation on

repatriation of

capital

Entrepreneurial

management

quality and skills

Mann-Whitney U 669.000 646.000 674.500 685.000 571.500 585.000 618.500 624.000 601.000 695.500

Wilcoxon W 1264.000 1207.000 1535.500 1588.000 1132.500 1180.000 1146.500 1185.000 1196.000 1556.500

Z -.440 -.620 -.280 -.345 -1.529 -1.505 -.641 -.648 -1.105 -.017

Asymp. Sig. (2-

tailed) .660 .535 .780 .730 .126 .132 .521 .517 .269 .986

a. Grouping Variable: Specialized vs Non-specialized investors

Appendix 8: Reliability test statistics

Case Processing Summary Reliability Statistics

N %

Cronbach's Alpha

N of Items

Cases Valid 39 51.3

.881 88 Excludeda 37 48.7

Total 76 100.0

a. Listwise deletion based on all variables in the procedure.