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NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner Antoinette Schoar Working Paper 9146 http://www.nber.org/papers/w9146 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 September 2002 We thank a number of institutional and individual investors for making this paper possible by providing access to the limited partnership agreements in their files. Richard Testa helped us identify and access the Doriot papers discussed in Section 2. Helpful comments were provided by seminar participants at New York University, the Universities of Florida and Texas, Lucian Bebchuk, Katharina Lewellen, and David Scharfstein, and a number of practitioners, especially Allan Bufferd, Rick Burnes, Peter Dolan, Tom Lupone, Ken Morse, Sarah Reed and Kevin Tunick. Matthew Espy and especially David Schannon provided excellent research assistance. Harvard Business School’s Division of Research provided fiancial support. All error and omissions are our own. The views expressed in this paper are those of the authors and not necessarily those of the National Bureau of Economic Research. © 2002 by Josh Lerner and Antoinette Schoar. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

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Page 1: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

NBER WORKING PAPER SERIES

THE ILLIQUIDITY PUZZLE:THEORY AND EVIDENCE FROM PRIVATE EQUITY

Josh LernerAntoinette Schoar

Working Paper 9146http://www.nber.org/papers/w9146

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138September 2002

We thank a number of institutional and individual investors for making this paper possible by providingaccess to the limited partnership agreements in their files. Richard Testa helped us identify and access theDoriot papers discussed in Section 2. Helpful comments were provided by seminar participants at New YorkUniversity, the Universities of Florida and Texas, Lucian Bebchuk, Katharina Lewellen, and DavidScharfstein, and a number of practitioners, especially Allan Bufferd, Rick Burnes, Peter Dolan, Tom Lupone,Ken Morse, Sarah Reed and Kevin Tunick. Matthew Espy and especially David Schannon provided excellentresearch assistance. Harvard Business School’s Division of Research provided fiancial support. All errorand omissions are our own. The views expressed in this paper are those of the authors and not necessarilythose of the National Bureau of Economic Research.

© 2002 by Josh Lerner and Antoinette Schoar. All rights reserved. Short sections of text, not to exceed twoparagraphs, may be quoted without explicit permission provided that full credit, including © notice, is givento the source.

Page 2: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

The Illiquidity Puzzle: Theory and Evidence from Private EquityJosh Lerner and Antoinette SchoarNBER Working Paper No. 9146September 2002JEL No. G24, G32

ABSTRACT

This paper presents a theory of liquidity where we explicitly model the liquidity of the security as a

choice variable, which enables the manager raising the funds to screen for ``deep pocket'' investors, i.e.these that have a low likelihood of a liquidity shock. By choosing the degree of illiquidity of the security,the manager can influence the type of investors the firm will attract. The benefit of liquid investors is thatthey reduce the manager's cost of capital for future fund raising. If inside investors have fewerinformation asymmetries about the quality of the manager than the outside market, more liquid investorsprotect the manager from having to return to the outside market, where he would face higher cost ofcapital due to asymmetric information problems. We test the predictions of our model in the context ofthe private equity industry. Consistent with the theory, we find that transfer restrictions on investors areless common in later funds organized by the same private equity firm, where information problems arepresumably less severe. Contracts involving the close-knit California venture capital community - whereinformation on the relative performance of funds are more readily ascertained - are less likely to employmany of these provisions as well. Also, private equity partnerships whose investment focus is inindustries with longer investment cycles display more transfer constraints. For example, funds focusingon the pharmaceutical industry have more constraints, while those specializing in computing and Internetinvestments have fewer constraints. Finally, we investigate whether the identity of the investors thatinvest in a private equity fund is related to the transferability of the stakes. We find that transferabilityconstraints are less prevalent when private equity funds have limited partners that are known to have fewliquidity shocks, for example endowments, foundations, and other investors with long-term commitmentsto private equity.

Josh Lerner Antoinette Schoar

Harvard Business School Sloan School of Management

South Hall, Room 220 50 Memorial Drive, E52-447

Boston, MA 02163 Cambridge, MA 02142-1347

and NBER and [email protected] [email protected]

Page 3: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

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Page 4: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

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Page 18: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

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Page 31: NBER WORKING PAPER SERIES THE ILLIQUIDITY PUZZLE: … · THE ILLIQUIDITY PUZZLE: THEORY AND EVIDENCE FROM PRIVATE EQUITY Josh Lerner ... Theory and Evidence from Private Equity Josh

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Table 1

Characteristics of the private equity funds in the sample. The sample consists of 243 U.S. private equity partnerships. The table indicates the key characteristics of the funds and the private equity organizations in the sample. Dummy variables are denoted with question marks. Note that the industry dummies do not add up to 100 percent, since private equity funds can report activities in several different industries.

Mean Standard Deviation Minimum Maximum Sequence of fund 5.4 4.9 1 36 Early-stage venture fund? 0.30 0 1 Buyout fund? 0.19 0 1 Size of fund ($ millions) 451.8 778.4 10.5 6100.0 Year of private equity group establishment 1981 9.1 1946 2000 Year of fund final closing 1992 6.6 1974 2001 California-based fund? 0.35 0 1 Massachusetts-based fund? 0.26 0 1 New York-based fund? 0.15 0 1 California-based fund? 0.35 0 1 Pharmaceutical Industry? 0.47 0 1 Computer/Internet Industry? 0.42 0 1 Business Services? 0.28 0 1 Telecommunications Industry? 0.39 0 1

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Table 2

Summary of the provisions used to construct the dependent variables in the analyses. The first column indicates how often the contractual term regarding transferability is found in the 243 partnership agreements in the sample. The second through fifth columns indicates whether the measure is included in the construction of the four composite measures used in the analysis below. A “+” sign indicates that the presence of the provision was regarded as a favorable indication in constructing the variable; a “-“ sign that its presence was regarded as a negative indication. Frequency Is This Measure Included in Dependent Variable? of Term in Composite of LP Count of LP Key Pro-GP Contract Contractual Feature Contracts “Friendliness” Transferees Restrictions Complexity Other LPs have right of first refusal? 33% + + Transfers allowed to: Other LPs? 30% + + + Partners of LP? 17% + + + Family members/trusts? 46% + + + Former spouse after divorce? 13% + + + Successor entity after merger/dissolution? 40% + + + Trustee/creditor after bankruptcy? 4% + + + Wholly owned subsidiary? 33% + + + 80% owned subsidiary? 16% + + + Majority owned corporation? 8% + + + Successor trustee/trust fiduciary? 69% + + + Sophisticated investors? 34% + + + Heir has rights to stop payments? 2% + + Transfer cannot: Add regulatory requirements for other LPs? 82% - + Result in partnership termination? 57% - + Lead to transferee not having LP status? 24% - + Violate laws? 64% - + Add taxes? 44% - + Be to entity whose business conflicts w/other LPs? 2% - + Be to entity whose business conflicts w/GPs? 3% - + + GP must approve transfer? 89% - + + Transfer must be to only one person? 9% - + Transfer can only be to one non-existing LP? 3% - + Transfer must be of no more than 50% of LP interest? 14% - +Transfer must be of no less than 100% of LP interest? 10% - +GP will manage process of finding appropriate LP? 9% - + Agent handling transfer may represent multiple sellers? 25% - + LP bears cost of transfer? 63% - + GP must approve LP’s status as appropriate LP? 73% - + + Transferee must agree to partnership agreement? 42% - +

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Table 3

Appearance of key transferability provisions in different types of partnership agreements. The sample consists of 243 U.S. private equity partnerships. The table indicates the mean of the various measures of transferability restrictions for funds with different characteristics. Test statistics from t-tests of the differences are also presented. Variable: Composite of LP Count of LP Key Pro-GP Contract “Friendliness” Transferees Restrictions Complexity Sequence of fund: Above median 3.69 3.53 1.78 10.80 Below median 2.97 2.63 1.50 9.49 Test statistic of difference 1.91

c 2.99

a 3.65

a 2.94

a

Early-stage venture fund: Yes 4.62 3.90 1.64 11.33 No 2.67 2.74 1.65 9.46 Test statistic of difference 5.11

a 3.72

a 0.11 4.03

a

Buyout fund: Yes 1.64 2.04 1.62 8.96 No 3.62 3.33 1.66 10.26 Test statistic of difference 4.34

a 3.46

a 0.35 2.34

b

Fund size: Above median 3.10 2.82 1.73 10.17 Below median 3.53 3.30 1.53 10.09 Test statistic of difference 1.13 1.58 2.57

b 0.19

Year of private equity group formation: More recent than median 2.60 2.37 1.67 9.80 Less recent than median 3.99 3.71 1.60 10.41 Test statistic of difference 3.73

a 4.55

a 0.87 1.34

California fund: Yes 5.03 4.57 1.63 12.05 No 2.28 2.28 1.66 8.91 Test statistic of difference 8.08

a 8.45

a 0.44 7.60

a

Massachusetts fund: Yes 2.28 1.89 1.51 8.62 No 3.59 3.51 1.70 10.51 Test statistic of difference 3.19

a 5.07

a 2.26

b 3.89

a

New York fund: Yes 2.47 2.58 1.81 9.69 No 3.39 3.18 1.62 10.08 Test statistic of difference 1.79

c 1.44 1.73

c 0.62

Year of fund formation: More recent than median 2.88 2.68 1.77 10.25 Less recent than median 3.72 3.41 1.50 10.02 Test statistic of difference 2.20

b 2.43

b 3.54

a 0.52

aSignificant at 1% confidence level.

bSignificant at 5% confidence level.

cSignificant at 10% confidence level.

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Table 4

Regression analysis, using composite measure of limited partner-friendly transferability restrictions. The sample consists of 243 U.S. private equity partnerships. The dependent variable, defined in Table 2, takes on values between –3 and +11. The independent variables include the sequence of the fund, dummy variables for funds specializing in early–stage venture and buyout investing and those based in California, Massachusetts, and New York, the year the private equity group was established, the logarithm of fund size (in millions of dollars), as well as dummies for the industry focus of the fund. Fixed effects for the year of the fund closing are included in all regressions; those for the private equity organization in some regressions. Standard errors are in brackets.

Dependent Variable: Composite Measure of Limited Partner-Friendly Transferability Restrictions Sequence of fund 0.09 [0.04]

b 0.06 [0.05]0.06 [0.05] 0.14 [0.05]

a 0.07 [0.04]

c 0.08 [0.04]

c 0.08 [0.04]

c

Early-stage venture fund 1.66 [0.43]a 1.62 [0.43]

a1.62 [0.43]

a -0.02 [0.48] 0.92 [0.42]

b 0.90 [0.43]

b

Buyout fund -1.49 [0.56]a -1.34 [0.57]

b-1.34 [0.57]

b 0.01 [0.58] -0.69 [0.52] -0.59 [0.54]

Logarithm of fund size 0.32 [0.22] 0.26 [0.22]0.26 [0.22] -0.33 [0.21] Year private equity group formed -0.03 [0.02]-0.03 [0.02] California fund? 2.86 [0.52]

a 2.45 [0.53]

a 2.34 [0.55]

a

Massachusetts fund? 0.25 [0.55] 0.39 [0.54] 0.32 [0.56] New York fund? 0.51 [0.60] 0.80 [0.61] 0.78 [0.69] Pharmaceutical Industry? -1.34 [0.65]

b

Computer/Internet Industry? -1.30 [0.67] Business Services? 1.90 [0.65]

a

Telecommunications Industry? -0.27 [0.69] Year fixed effects? Yes YesYes Yes Yes Yes Yes Private equity group fixed effects? No NoNo Yes No No No Number of observations 243 243243 243 243 243 233 F-statistic 2.72 2.702.70 2.47 3.52 3.68 4.31 p-Value 0.000 0.0000.000 0.001 0.000 0.000 0.000 Adjusted R

2 0.17 0.170.17 0.84 0.23 0.25 0.42

aSignificant at 1% confidence level.

bSignificant at 5% confidence level.

cSignificant at 10% confidence level.

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Table 5

Regression analysis, using alternative measures of transferability restrictions. The sample consists of 243 U.S. private equity partnerships. The dependent variables, defined in Table 2, are the count of the number of parties that the limited partners are allowed to transfer partnership interests to (taking on values between 0 and 8), the count of the number of key pro-general partner terms are included in the agreement (taking on values between 0 and 3), and the overall measure of the complexity of the agreement (taking on values between 0 and 18). The independent variables include the sequence of the fund, dummy variables for funds specializing in early–stage venture and buyout investing, and the logarithm of fund size (in millions of dollars). Fixed effects for the year of the fund closing are included in all regressions; those for the private equity organization in some regressions. Standard errors are in brackets.

Dependent Variable: Count of LP Transferees Key Pro-GP Terms Contractual Complexity Sequence of fund 0.06 [0.03]

c 0.05 [0.03]

c 0.002 [0.01] -0.03 [0.01]

b 0.08 [0.05] 0.14 [0.05]

a

Early-stage venture fund 1.20 [0.36]a 0.08 [0.25] -0.09 [0.09] 0.04 [0.13] 1.62 [0.52]

a -0.13 [0.46]

Buyout fund -0.76 [0.46] 0.06 [0.31] -0.23 [0.12]b -0.24 [0.15] -1.20 [0.68]

c -0.47 [0.56]

Logarithm of fund size 0.18 [0.18] -0.36 [0.11]a -0.0005 [0.04] 0.01 [0.05] 0.20 [0.26] -0.15 [0.20]

Year fixed effects? Yes Yes Yes Yes Yes Yes Private equity group fixed effects? No Yes No Yes No Yes Number of observations 243 243 243 243 243 243 F-statistic 2.13 3.67 2.39 4.20 2.19 8.00 p-Value 0.002 0.000 0.000 0.000 0.001 0.000 Adjusted R

2 0.12 0.93 0.14 0.75 0.12 0.90

aSignificant at 1% confidence level.

bSignificant at 5% confidence level.

cSignificant at 10% confidence level.

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Table 6

Regression analysis, using composite measure of limited partner-friendly transferability restrictions and controls for limited partner composition. The sample consists of 84 U.S. private equity partnerships with data on their limited partners. The first panel indicates the mean number and share of the limited partners in the sample funds. The dependent variable, defined in Table 2, takes on values between –3 and +11. The independent variables include the sequence of the fund, dummy variables for funds specializing in early–stage venture and buyout investing, the logarithm of fund size (in millions of dollars), and the number or share of limited partners of various types. High-status limited partners are defined as those universities who has a greater than 5% allocation to private equity in 1991, the foundations with the most established private equity programs, and the funds-of-funds that were active before 1991. Fixed effects for the year of the fund closing are included in all regressions. Standard errors are in brackets.

Panel A: Composition of Limited Partners

LPs for private equity group Limited partner type Number Share* University LPs 2.6 22% Fund-of-fund LPs 1.3 12% Bank LPs 0.4 3% Investment bank LPs 0.1 1% Pension fund LPs 1.7 17% Foundation LPs 0.7 5% Corporate LPs 0.8 6% High-status LPs 3.0 26%

Panel B: Regression Analyses Dependent Variable: Composite Measure of Limited Partner-Friendly Transferability Restrictions Using count of LPs Using share of LPs Sequence of fund 0.23 [0.08]

a 0.25 [0.07]

a 0.17 [0.07]

b 0.20 [0.06]

a

Early-stage venture fund 0.39 [0.75] 0.43 [0.73] 0.33 [0.67] 0.27 [0.62] Buyout fund -0.63 [0.90] -0.90 [0.80] -0.89 [0.79] -0.88 [0.74] Logarithm of fund size -0.75 [0.50] -0.46 [0.42] -0.39 [0.45] -0.42 [0.38] University LPs 1.58 [1.49] 0.18 [0.12] Fund-of-fund LPs 1.56 [1.96] 0.18 [0.20] Bank LPs -1.91 [4.11] -0.26 [0.33] Investment bank LPs 7.79 [9.03] 0.21 [0.82] Pension fund LPs 0.29 [1.52] -0.12 [0.13] Foundation LPs 6.50 [3.83]

c 0.59 [0.29]

b

Corporate LPs 2.37 [3.28] -0.02 [0.26] High-status LPs 1.99 [1.28] 0.34 [0.09]

a

Year fixed effects? Yes Yes Yes Yes Number of observations 84 84 84 84 F-statistic 3.38 4.34 4.45 5.84 p-Value 0.000 0.000 0.000 0.000 Adjusted R

2 0.39 0.39 0.48 0.48

*This refers to the mean share of the group among the limited partners, rather than the share of dollars invested. aSignificant at 1% confidence level.

bSignificant at 5% confidence level.

cSignificant at 10% confidence level.