To every season, there is a sport or an investment

Private Equity 31 May 2011

(c) 03-29-11 Anatoly MaslennikovMany of us high school jocks have wondered why professional sports seasons don’t follow the same schedules we once practiced. Football began in September and ended in early December – just before Christmas exams. Basketball began in January and ended in April. There was a predictable rhythm to the sports seasons.

And there may be one to private equity too. One of the world’s largest private equity investors, Ontario Teachers’ Pension Plan, says its ready to sell its stake in the hapless Toronto Maple Leafs, whose fans’ misery now extends from October to June (when the hockey season now ends). Despite that, the team is a perpetual money-spinner.

Why would the Leafs matter? Well, first of all extended seasons allow for geographic diversification – more teams come in from more places more times a year, at least raising the box office revenue, if not the win-loss record. Second, there is industry diversification: the Leafs are part of a private equity investment that owns a basketball team, a hockey arena-cum-basketball court that also sports swanky restaurants and condos and a soccer team with its own pitch to play on.

Two aspects wrapped up in a single investment: that twinning may apply more broadly to private equity managers, suggests Mark Humphrey-Jenner, whose research we’ve profiled before. His thesis, which he tests through eight different hypotheses, rests on two insights: diversification may  make for risk reduction while boosting returns, and how such diversification may amplify risk-reduction through knowledge-sharing from VC managers with a prior track record.

While diversification seems almost intuitive – as a means to mitigate the idiosyncratic risk associated with any one investment – it may not be obvious. In the corporate sector, Humphrey-Jenner notes, diversification gets a discount yawn. Investors don’t like firms that don’t stick to their knitting and thus mark down their stocks. (What does a hockey team owner know about basketball anyway, and can hockey really skate in regions like Florida or Arizona?)

In his paper, published by the European Central Bank and entitled Diversification in Private Equity Funds: On Knowledge-Sharing, Risk-Aversion and Limited-Attention, the key point is “whether diversification destroys value by spreading staff too thinly and limiting the attention they can pay to individual regions/industries, or by facilitating managerial risk-aversion with respect to performance bonuses.” If you’ve got a good thing going, salary-wise, why put that at peril by taking on additional risks? (Back to the sports world: some teams are perennial cash cows, so what’s the incentive to innovate?)

Diversification, by itself, can be neutral or it can increase returns. The second key point is whether this is due to risk reduction or whether experience counts. He posits, “[D]iversification in funds previously raised by the current fund’s management firm increases returns, implying that prior diversification may create skills that the present fund can use to increase returns. Mere risk-reduction and endogeneity do not drive the results. Overall, this suggests that learning and knowledge-sharing may explain why diversification increases returns in PE funds.” Endogeneity here means effects arising from model imprecisions: the variable under analysis correlates best with the error term. In alpha-speak, it means, “We don’t know why people watch hockey in gorgeous spring weather.”

Among the specific hypotheses he tests for are:

(1) diversification increases PE funds’ returns; and,

(2) this may be because diversification facilitates learning and knowledge transfers,

(3) Risk-reduction may increase PE-funds’ returns, but this does not drive the relation between diversification and returns,

(4) Endogeneity does not drive the return/diversification relation,

(5) Diversification reduces returns if it spreads staff too thinly across industries or regions,

(6) Diversification appears to reduce value if the motivation is risk-aversion over obtaining a performance bonus,

(7) Returns decrease with the number of investment rounds in which the fund participates.

Here’s how it looks, by industry (“Panel (a)”) and geography (“Panel (b)”), as Humphrey-Jenner fits the regression data:


His explanation? “It illustrates the positive relationship between returns and both industry-diversification and geographic-diversification.” However, that data needs to be set next to a number of variables described elsewhere in the paper, such as firm size, connectedness and use of its own capital.

He concludes that “returns increase with the number of portfolio companies. An explanation is that some reduction in risk reduces managerial risk aversion and encourages managers to invest in companies that are more risky. Nonetheless, industry and geographic diversification still increase returns after controlling for this effect.”

That, he thinks, is not just an error term in the regression equation. Experienced companies both learn and share the knowledge… and reduce the errors.

Now about those Leafs… or Cubs… or BoSox.

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