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Competitive strategy of private equity [Elektronische Ressource] : boundary of the investment firm / vorgelegt von Daniel Kukla

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Competitive Strategy of Private Equity: Boundary of the Investment Firm vorgelegt von Diplom-Kaufmann Daniel Kukla aus Olmütz Von der Fakultät VII – Wirtschaft und Management der Technischen Universität Berlin zur Erlangung des akademischen Grades Doktor der Wirtschaftswissenschaften Dr. rer. oec. genehmigte Dissertation Promotionsausschuss: Vorsitzender: Prof. Dr. Jan Kratzer Berichter: Prof. Dr. Dodo zu Knyphausen-Aufse β Berichter: Prof. Dr. Viral V. Acharya Tag der wissenschatlichen Aussprache: 21.12.2010 Berlin 2011 D 83 Contents 1 Introduction ................................................................................................................................ 1 1.1 Phenomenon and Research Motivation ............................................................................... 1 1.1.1 Practical Relevance . 1 1.1.2 Theoretical Relevance ............................................................................................. 4 1.2 Research Objective ............................................................................................................. 5 1.2.1 Strategic Groups ..................................... 5 1.2.2 Boundary of the Investment Firm ........... 6 1.3 Structure and Scope of Dissertation .................................................................................... 7 2 The Ascent of Private Equity ........................................

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Published 01 January 2010
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Exrait







Competitive Strategy of Private Equity:
Boundary of the Investment Firm



vorgelegt von
Diplom-Kaufmann
Daniel Kukla
aus Olmütz



Von der Fakultät VII – Wirtschaft und Management
der Technischen Universität Berlin
zur Erlangung des akademischen Grades
Doktor der Wirtschaftswissenschaften
Dr. rer. oec.

genehmigte Dissertation




Promotionsausschuss:

Vorsitzender: Prof. Dr. Jan Kratzer
Berichter: Prof. Dr. Dodo zu Knyphausen-Aufse β
Berichter: Prof. Dr. Viral V. Acharya


Tag der wissenschatlichen Aussprache: 21.12.2010




Berlin 2011

D 83
Contents



1 Introduction ................................................................................................................................ 1
1.1 Phenomenon and Research Motivation ............................................................................... 1
1.1.1 Practical Relevance . 1
1.1.2 Theoretical Relevance ............................................................................................. 4
1.2 Research Objective ............................................................................................................. 5
1.2.1 Strategic Groups ..................................... 5
1.2.2 Boundary of the Investment Firm ........... 6
1.3 Structure and Scope of Dissertation .................................................................................... 7
2 The Ascent of Private Equity ..................................................................................................... 9
2.1 Origin .................................. 9
th th2.1.1 Classic Private Equity: Merchant Banking (14 – 19 Century) ........................... 9
2.1.2 Merchant Banking Wipeout in 1933 ..................................................................... 11
th2.1.3 Renaissance of Private Equity in the 20 Century ............... 12
2.2 Contemporary Private Equity ............................................................ 16
2.2.1 Capital Commitment ............................................................. 16
2.2.2 Private Equity Investment ..................... 19
2.2.3 Credit Markets ...................................................................... 23
2.2.4 Exits ...................................................................................................................... 24
2.2.5 Performance .......... 26
3 Academic Knowledge on Private Equity ................................................................................ 27
3.1 Synthesis of PE Literature ................................................................................................. 27
3.1.1 Economic Impact .. 29
3.1.2 Asset Allocation .... 36
3.1.3 Design of the Monolithic PE Firm ........................................................................ 38
3.1.4 Governance ........................................... 55
3.1.5 Performance .......... 58
3.2 Strategy for the PE Firm ................................................................... 61
3.2.1 Conceptual Frames Related to Strategy for PE .................... 62
3.2.2 Inadequacy of Existing Business Model Frameworks .......... 64
3.2.3 Business Model Framework for PE Centered Investment Firm ........................... 65
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4 Research Design ........................................................................................................................ 69
4.1 Purpose Statement ............. 69
4.1.1 Philosophic Worldview ......................... 69
4.1.2 Mixed Methods ..................................................................................................... 71
4.2 General Research Thrust ... 72
4.2.1 Research Thrust: Strategic Groups ....... 72
4.2.2 Research Thrust: Boundary of the Investment Firm ............................................. 73
4.3 Empirical Research Design ............................................................................................... 73
5 Empirical Part I: Strategic Groups ........................ 77
5.1 Conceptual Framework and Hypotheses ........................................................................... 77
5.1.1 IO Research ........................................... 77
5.1.2 From Entry Barriers to Mobility Barriers ............................................................. 78
5.1.3 Strategic Groups ................................... 78
5.1.4 Hypotheses ............................................................................ 80
5.2 Methodology and Data ...... 82
5.2.1 Strategic Space and Strategic Variables ............................................................... 82
5.2.2 Data ....................................................................................... 86
5.2.3 Clustering Firms into Strategic Groups ................................ 88
5.2.4 Validation of Strategic Groups ............. 91
5.3 Empirical Results .............................................................................................................. 93
5.3.1 Correlation Analysis ............................. 93
5.3.2 Clustering Analysis ............................................................................................... 95
5.4 Interpretation and Discussion of Results ........................................ 107
5.4.1 Summary ............................................................................. 107
5.4.2 Limitations .......... 110
5.4.3 Implications ........................................ 111
5.4.4 Further Research ................................................................. 113
6 Empirical Part II: Boundary of the Investment Firm ........................ 115
6.1 Exploratory Framework .................................................................................................. 115
6.1.1 The Nature of the Firm ....................... 115
6.1.2 Conceptual Frames for the Boundary of the Firm .............................................. 117
6.1.3 Six Decades of Firm Boundary Seesaw .............................................................. 119
6.1.4 The Monitor of the Monitor ................................................ 121
6.2 Methodology ................................................... 122
6.2.1 Research Design ................................................................................................. 122
6.2.2 Conversation Guideline ...................... 125
6.2.3 Concurrent Strategic Grouping Approach .......................... 128
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6.3 Empirical Results ............................................................................................................ 129
6.3.1 Forces Shaping the Boundary of the Investment Firm ....... 129
6.3.2 Bundling of IF Activities .................... 147
6.3.3 Four PE Centered Investment Firm Models ....................................................... 155
6.4 Summary and Discussion ................................................................ 162
7 Conclusion and Outlook ......................................... 165
7.1 Academic Contributions ................................................................. 165
7.2 Implications for Practitioners .......................................................... 166
7.2.1 Implications for Investors ................................................... 166
7.2.2 Implications for PE Centered Investment Firms ................. 167
7.2.3 Implications for Portfolio Companies ................................................................. 168
7.2.4 Implications for Regulators ................ 169
7.3 Outlook for Future Research ........................................................... 170



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Abbreviations




ANOVA Analysis of Variance
AuM Assets under Management
b Billion
EBITDA Earnings before Interest, Tax, Depreciation, and Amortization
e.g. Exempli gratia (Latin), for example
FDIC Federal Deposit Insurance Corporation
FoF Fund of Funds
FoHF Fund of Hedge Funds
GP General Partner
HNWI High Net Worth Individual
UHNWI Ultra High Net Worth Individual
i.e. Id est (Latin), that is to say, in other words
IF Investment Firm
IRR Internal Rate of Return
JV Joint Venture
KKR Kohlberg Kravis Roberts & Co.
LBO Leveraged Buyout
MBO Management Buyout
LP Limited Partner
m Million
MD Managing Director
M&A Mergers and Acquisitions
IO Industrial Organization
p.a. Per annum (Latin), annually
PE Private Equity
PMI Post Merger Integration
PPM Private Placement Memorandum
SEC Securities and Exchange Commission
SG Strategic Group
SIC Standard Industrial Classification
tr Trillion
TMT Top Management Team
VC Venture Capital
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List of Figures




Figure 1: Structure of KKR in 1976 and in 2010 .............................................................................. 2
Figure 2: Top 100 PE Firms – AuM, % of AuM in PE, PE Funds Raised 2004-2009 ..................... 3
Figure 3: Structure of Dissertation .................................... 7
Figure 4: Origin of PE ..................................................................................... 13
Figure 5: Worldwide PE Capital Commitment (1960-Mar2010, $m) ............ 16
Figure 6: Worldwide PE Capital Commitment by Region (1980-Mar2010, $m) ........................... 17
Figure 7: Worldwide PE Capital Commitment by Stage (1980-Mar2010, $m) ............................. 18
Figure 8: Worldwide PE Funds by Stage (1980-Mar2010) ............................................................ 19
Figure 9: Worldwide PE Investment Transaction Value (1980-May2010) .................................... 20
Figure 10: Worldwide PE Investment Equity Value by Region (1990-Sep2010) .......................... 21
Figure 11: Worldwide PE Investment by Sector (1990-Sep2010) .................................................. 22
Figure 12: PE Entry Transaction Values and Transaction Multiples (2000-2009) ......................... 23
Figure 13: US Credit Spread over Treasuries ................................................. 24
Figure 14: PE Divestment Value (Europe) ..................................................... 25
Figure 15: Performance of PE Funds by Vintage ........... 26
Figure 16: Cataloging Scheme for PE Literature ............................................ 28
Figure 17: Breakdown of PE Literature by Research Area ............................. 28
Figure 18: Conversations in Research Area ‘Economic Impact’ .................................................... 30
Figure 19: First Conversations on PE ................................ 32
Figure 20: Major Topics in Conversation ‘Asset Allocation’ ......................... 37
Figure 21: Principal Agent View and Entrepreneurial View on PE ............................................... 39
Figure 22: Conglomerate and PE Entity ................................ 41
Figure 23: Strategic Dimensions of the PE Firm ............ 43
Figure 24: Fundraising Determinants and Capital Supply .............................................................. 44
Figure 25: Corporate Refocusing Catalyzed by the PE Firm .......................... 45
Figure 26: Portfolio Diversification Considerations ....................................... 46
Figure 27: Characteristics of Typical PE Targets ........................................... 47
Figure 28: Financing of PE Acquisitions ........................................................ 48
Figure 29: Syndication Motives during PE Acquisition ................................. 49
Figure 30: Monitoring Measures and Monitoring Intensity of the PE Firm ... 51
Figure 31: Conversations on ‘Resources and Characteristics’ ........................................................ 53
Figure 32: Evolution of Ideas on Ownership Structure of the Firm ................ 56
Figure 33: Comparison of Conceptual Frames Related to Strategy for PE .................................... 64
Figure 34: Gap in Existing PE Business Model Frameworks ......................................................... 65
Figure 35: Constituents of Business Model of PE Centered Investment Firm ............................... 66
Figure 36: Strategic Dimensions of PE Centered Investment Firm ................ 67
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Figure 37: Research Design ............................................................................................................ 74
Figure 38: Links between Research Design and Structure of Dissertation ..... 76
Figure 39: Sources of Mobility Barriers Creating Competitive Advantage .... 79
Figure 40: Distribution of PE Firms in Sample by Strategic Group ............................................... 96
Figure 41: Spider Matrix of Strategic Groups ................................................. 99
Figure 42: 95% Confidence Intervals of Investment Performance by Strategic Group ................ 100
Figure 43: 95% Confidence Intervals of Market Share by Strategic Group ................................. 101
Figure 44: 95% Confidence Intervals of Operational Efficiency by Strategic Group .................. 102
Figure 45: 95% Confidence Intervals of Reputation by Strategic Group ..... 103
Figure 46: Comparison of IRR Variances by Vintage Group and by SG ..................................... 104
Figure 47: SSFUZZ and CEV Matrix ........................................................................................... 105
Figure 48: SSFUZZ and CAPSUP Matrix .................... 106
Figure 49: Exploratory Investigation and Information Sources 124
Figure 50: Mindset Traits of PE Firms in Sample ........................................................................ 126
Figure 51: Building Blocks of PE Centered Investment Firm ...................... 128
Figure 52: Pros and Cons of Multi-Business PE Centered Investment Firm Model .................... 130
Figure 53: Forces Shaping the Boundary of the Investment Firm ................................................ 145
Figure 54: Fit between Traditional PE and Other Businesses ....................... 148

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List of Tables




Table 1: Most Active PE Investment Firms (1980-May2010) ........................................................ 22
Table 2: PE Divestment by Exit Route (Europe, 2009) .................................. 25
Table 3: Sample and Sources .......................................................................... 84
Table 4: Definition and Normalization of Strategic Variables ....................................................... 85
Table 5: Analysis of Correlations between Strategic Variables ...................... 94
Table 6: ANOVA of External Variables between Strategic Groups ............... 97
Table 7: Robustness Tests (Welch Test and Brown-Forsythe Test) ................................ 97
Table 8: Center Points of Strategic Groups ..................................................... 98
Table 9: PE Firms in Sample by Strategic Grouping Approach ................... 107
Table 10: Evaluation of Investment Firms with New Approach .................................................. 163








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1 Introduction
1.1 Phenomenon and Research Motivation
1.1.1 Practical Relevance
The central concept of Private Equity (PE) is fuzzier than might immediately appear. Ever
since the invention of money, the basic functions of contemporary PE firms have been
thprovided by a century old string of intermediaries. In the 14 century, European financiers
such as the Medici dynasty institutionalized the financing of ventures, typically risky ocean
voyages of merchants, by investing borrowed and their own money (Ferguson 2008).
th Five hundred years of financial intermediation later, at the beginning of the 20 century,
American financiers such as John Pierpont Morgan applied the leveraged finance concept by
acquiring railroad and electric companies with high amounts of debt. The first Leveraged
thBuyout (LBO) of the 20 century, it might legitimately be suggested, was the Morgan backed
acquisition of Carnegie Steel Company in 1901, forming United States Steel Corporation
(Baker et al. 1998).
1 2 Virtually exiled by the Banking Act of 1933, the LBO returned during the second half of
ththe 20 century. Financiers such as Jerome Kohlberg and his protégé Henry Kravis, who
jointly with George Roberts left the bank Bear Stearns to establish KKR in 1976, reintroduced
the large scale LBO as a niche financing instrument. By the end of the 1980s, LBO financing
was applied on an unprecedented scale, peaking in 1989 with KKR’s acquisition of RJR
Nabisco for $31b, which for almost two decades remained the largest LBO in history. After a
slow-down in the early 1990s, PE activity went through another full cycle before growing to
once again unprecedented scale during the mega-buyout era between 2005 and 2007.
Prevailing taxonomy in the US uses the term PE as a synonym for institutionalized LBO
activity. Often stereotypical descriptions portray a PE firm as a specialized single-product
niche financing firm using small portions of equity and large portions of debt to acquire
controlling stakes in mature companies (Kaplan et al. 2008).
This is changing. Such a monolithic, LBO centered, view of the PE firm is ignoring
newsworthy phenomena. There is a striking transformation going in the PE industry. More
than just a few PE firms have migrated from a single-product pure PE model toward multi-
business investment firms. KKR, for example, complemented its traditional PE business with
additional product lines including infrastructure funds, debt investment vehicles, mezzanine
investment vehicles, capital markets advisory services for its portfolio companies and for its

1 The Banking Act of 1933 is commonly known as the Glass-Steagall Act, after its legislative sponsors Carter Glass and
Henry B. Steagall.
2 In an LBO typically a company is acquired by an investment vehicle using a relatively small portion of equity and a
relatively large portion of debt financing.
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external clients, underwriting of debt and equity securities, and captive operational advisory
3(see Figure 1). In 2008, the financier Henry Kravis claimed that KKR’s investments “benefit
from the collective knowledge of KKR’s professionals across asset classes […] KKR’s
businesses are integrated and all have access to professionals across the entire firm […] no
longer will it be possible to invest successfully without this integration”.



Figure 1: Structure of KKR in 1976 and in 2010

Is KKR an exception? Certainly not, recognizing that in 2009 more than 40% of the top 100
PE firms worldwide had also left the monolithic PE model behind while capturing a
considerable share of funds raised by PE (see Figure 2). During the initiation of this research
endeavor a thorough literature review on contemporary PE (see Chapter 3), conversations
with practitioners, industry experts, and recognized scholars in the PE field confirmed that
this phenomenon is by and large scientifically unexplored. Respective knowledge gaps often
leave practitioners in an uncomfortable stage of ambiguity.
Some lessons from history imply that this phenomenon could represent a natural
evolution of financial species. For example, the case of the Medici dynasty, which will be laid
out in greater detail below, suggests that the key to the financiers’ success was diversification.
While other early financiers had maintained monolithic structures, which could easily blow
up due to one counterparty default, the Medici controlled multiple businesses. One can say
that the Medici were the first to make the transition from financial success to hereditary status
by being bigger and more diversified than any previous financier (Ferguson 2008).
It seems long overdue to refine the prevailing view of PE as a monolithic LBO centered
financing technique. Current PE taxonomy is not only misleading, it also thwarts scientific
investigation of relevant phenomena in PE. Ironically, determined by prevailing taxonomy
empirical PE studies often deliberately trim their samples by excluding everything that is not
LBO related, and by doing so maintain the illusion that PE in 2010 is similar to monolithic PE
in 1976. Apparently it is not.
This narrow view of PE as a synonym for monolithic LBO activity actually represents an
unnecessary self-imposed handicap on scientific progress in the field of PE research. A lot of
scientific groundwork needs to be done so that we can start having a better research grip on
stwhat PE in the 21 century is really about. There are many puzzling phenomena in PE

3 See KKR Annual Report 2008.
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