Economic Determinants of Private Equity Investments in Switzerland - Relevance of this Study

6 Introduction 1.4 Relevance of this Study Since the 1970s, private equity has developed into a major financial industry in the US with related research publications constantly on the rise. Yet it was not until the late 1980s that the research community as well as the general public devoted any significant attention to the business activities of PEFs. Although the rapid growth of PE investments since the mid-1990s also initiated substantial research efforts in Europe, the following section shows that research on PE in Europe still lags behind the US and is incomplete for the Swiss financial market in particular. As various economic, legal, and cultural factors affect the level of PE investments in a given country, the underlying analysis draws on findings from different fields of private equity research. Figure 1.2 presents an overview of the four groups of PE literature considered most relevant for this thesis.7 Facing the accelerated development of the private equity industry in the 1980s in the US, researchers focussed on the principal question: why do PEFs exist? (See research field A in the left part of Figure 1.2.) Most formal analyses tried to explain the general role of PEFs within the financial system on the grounds of agency theory.8 Empirical analyses in this field collected data primarily on the characteristics of PEFs, such as the average number of portfolio companies, the frequency of contacts and the financial instruments applied.9 For this thesis, previous research on the role of PE in economic theory proves invaluable in depicting the general characteristics and functions of PEFs. None- theless, the findings are based predominantly on the US market and are only par- 7 This is linked to the sub-category GE 240 of the Journal of Economic Literature: "Invest- ment banking, venture capital, brokerage." See JEL 2005. 8 See Jensen/Meckling 1976 on the theory of the firm, Holström 1979 on agency problems or Chan 1983 for transfers of these models to PE markets. 9 See MacMillan/Zemann/Narashima 1987, Gorman/Sahlman 1989, Amit/Brander/Zott 1998, and Sahlman 1990 for empirical research for the US and Canada. Introduction 7 tially transferable to Swiss conditions. Similar general research has been under- taken for several European countries. However, firm-level data on Swiss PEFs hardly exists. Figure 1.2 Fields of private equity research Primarily used for empirical part C) The value- added effect of private equity Primarily used for theory part A) General role Private B) Financial of private contracting equity in Equity and moni- economic Research toring theory D) The effects of public policy and financial system Subsequent research has concentrated on special characteristics of PEFs. One of these areas, research field B, falls under the heading of financial contracting and monitoring and concentrates on the PEFs’ ability to design and enforce contracts with their portfolio companies. Mostly drawn from the principles of agency the- ory, this field of research explains how PEFs attain a comparative advantage over direct investors and other intermediaries in the process of investment screening, contracting, monitoring, and exiting.10 Like field A, this field of literature serves primarily to the theoretical foundation of this thesis. The associated findings are of limited value for empirically analysing real markets though. Its contribution is 10 See, for example, Bascha/Walz 2001 on the application of convertible securities, or Hell- mann 2002 for a formal analysis. See Gompers 1995 for the use of stage financing to miti- gate agency conflicts. 8 Introduction rather the comparison of instruments and processes applied by US-PEFs with those of Swiss ones. Research field C aims at testing the so-called value-added hypothesis. According to common wisdom, PEFs have a special ability to improve the performance of their portfolio companies through non-financial management-support. It was not until the 1990s though, when the PE industry gained a certain age and track record, that empirical studies on the impact of PEFs on their portfolio companies were technically feasible. Measures most often applied were the performance of PE-backed versus non-PE-backed companies, the number of patents applied, or the growth of sales, or employment.11 The results of this field of research are not yet definite. While the majority of US-American studies supports the value-added hypothesis, the few existing European studies are inconclusive. And, so far, the author is not aware of related empirical data on the Swiss PE market. Finally, another large part of PE research may be summarised under public policy issues. (Research field D, illustrated at the bottom of Figure 1.2.) While research on the value-added effect targets the possible impact of PEFs on their portfolio companies, this research field analyses the reverse effect: what impact do eco- nomic and business cultural determinants have on the development of the national private equity industry? The determinants most commonly considered are the level of economic development and the prevalence of different legal, fiscal, and financial systems.12 One of the major underlying hypotheses for this research field is that a financial system in which companies receive their funding primarily via stock markets is more supportive to the emergence of a PE industry than a bank-based financial system.13 The macroeconomic analysis in this thesis draws heavily on this field 11 For representative studies, see Kortum/Lerner 1998 on the number of patents generated by PE-backed companies, or Hellmann/Puri 2000, on improved product development cycles in portfolio companies. 12 See LaPorta et al. 1998, Gompers/Lerner 2000, Jeng/Wells 2000, or Hämmig 2003. 13 See Black/Gilson 1998 or Schäfer 2002. Introduction 9 of research, as it offers a variety of potential determinants for PE investments. The central question of how a bank-based system affects PE investments also stems from this field of literature. Yet few related empirical studies exist. Furthermore, it is a weakness of the existing approaches that none of the studies attempts to assess the impact of the business culture on the financing decision. The preceding literature review reveals that findings on PE are strongly domi- nated by US research. However, these studies cannot offer suitable explanations for Swiss PE markets, as the two markets prove too dissimilar to transfer results. Compared to Switzerland, the PE market of the US is not only much older and larger in absolute as well as in relative size, it is also dominated by different insti- tutional investors, placed within a market- instead of bank-based financial system and founded on a different entrepreneurial culture.14 While the theoretical role and function of PEFs in the financial system are well researched, the reciprocal effects between the PEF industry and the economy need further investigation. This is especially true because best practices may vary sig- nificantly in different countries. Regarding the cooperation between PEFs and portfolio companies, current empirical data for Switzerland does not even allow for basic conclusions. This thesis intends to take remedial action by analysing possible determinants of PE investments in a comprehensive, systematic process: • The relationship of the PEF and the portfolio company forming the centre of analysis. • The experiences of entrepreneurs with PEFs are treated as key in assessing the quality and reputation of PE services in Switzerland. • Finally, the competitive potential of universal banks is investigated in order to assess its general impact on PE investments. Regarding the research methodology, this thesis combines a top-down macroeco- nomic analysis with a bottom-up industry survey. Such methodology also allows for a careful investigation of the demand-side determinants of PE investments. 14 See Schefczyk 1998, p. 7. 10 Introduction To this end, 282 Swiss companies from the high-tech medical technology industry were surveyed to evaluate the financial and non-financial services of PEFs. For Switzerland, this survey documenting the corporate finance perspective of the capital-seeking company is the first of its kind. Another unique characteristic of this survey approach is its coverage of a whole high-tech industry, comprising PE- backed and non-PE-backed enterprises alike.