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RAF
10,1 The use of financial information
by private equity funds in
evaluating new investments
46
Jan Smolarski
The University of Texas Pan American, Edinburg, Texas, USA
Neil Wilner
University of North Texas, Denton, Texas, USA, and
Weifang Yang
The University of Texas Pan American, Edinburg, Texas, USA

Abstract
Purpose – The purpose of this paper is to examine the use of financial information and valuation
methods among private equity funds in Europe and India. The authors analyze differences in the choice
of valuation methods and how the use of financial information differs among funds in the UK,
Pan Europe and India.
Design/methodology/approach – A survey approach was utilized in collecting proprietary data
from European and Indian private equity funds. The data were classified according to fund type,
country grouping, size, risk profile, labor cost and industry structure and analyzed using MANOVA and
ANOVA.
Findings – The results show that the use of valuation models is relatively homogeneous across
countries and that the use of financial information appears to be driven to a large extent by fund type and
fund focus. The use of audited financial statements appears to increase as firms mature. Significant
differences were found in standard financial adjustments between the two fund types and between the
country groupings. Results based on labor cost are weakly significant whereas industry structure does
not appear to have an impact on how fund managers evaluate investments.
Research limitations/implications – The results indicate that fund managers adapt their
decision-making behavior according to investment type and risk. The authors argue that understanding
asymmetrical and structural issues may potentially improve investment decision-making processes.
The main conclusion for researchers is that buy-out and venture capital funds should not be combined as
one asset class. Since a survey approach was used, the study is subject to the belief that fund managers
do not internalize decisions well, which could reduce the effectiveness of the research design.
Originality/value – There are few studies in the areas covered by this paper due to the proprietary
nature of the private equity industry. The results are important because they help in understanding
how fund managers use decision aids such as financial statements and valuation techniques. A better
understanding of current practices will help fund managers and fund sponsors in devising improved
decision aids and processes, which ultimately may lead to fewer non-performing investments. This is
especially important in private equity since investment decisions are often irreversible and binary.
Keywords Venture capital, Equity capital, Financial reporting, Financial risk, Europe, India
Paper type Research paper

Review of Accounting and Finance 1. Introduction


Vol. 10 No. 1, 2011
pp. 46-68 Private equity research is flourishing but few articles have been devoted to how private
q Emerald Group Publishing Limited equity funds use financial information. Valuation methods, which rely on accounting
1475-7702
DOI 10.1108/14757701111113811 and cash flow information, have been studied to some degree. Recent accounting-related
research includes Hand (2005), Wright et al. (2004) and Engel et al. (2002). Comparative Evaluating new
country studies have also started to appear in the literature with regular frequency but investments
do not focus on the use of accounting information to a great extent (Manigart et al., 2000;
Lockett et al., 2002; Wright and Robbie, 1996). The existing literature suffers from one
important design issue, namely treating the private equity industry as one homogenous
group. There are distinct branches such as venture capital (VC) and buy-out (BO) funds,
as well as specialized fields within private equity. Biotechnology is an example of a 47
specialized field. The private equity sector is typically divided according to sector or
investment focus. Sector focus is difficult to ascertain over time since fund managers
have considerable leeway in how they invest the fund sponsors’ money. VC funds
generally invest in the early stages of the life of small to medium-size firms where growth
potential is significant. Many venture funds specialize in a specific stage such as
start-up, seed or expansion financing. There is a tendency for very small funds to focus
on investing in technology-based ventures. BO funds invest in larger mature enterprises,
often in high-intensity asset industries or in firms where earnings are stable. BO funds
radically transform a mature firm to improve sales and earnings. Funds typically have
ten-year lives after which the fund is liquidated and cash is returned to the fund’s
sponsors.
Private equity is a specialized investment field requiring specific managerial and
industry skills to be successful. Insurance companies, pension funds and banks often
do not possess the requisite skill set. Instead, they invest in private equity funds
that have the skill set necessary to succeed. The private equity industry is characterized
by all-encompassing risk affecting every participant. Funds develop risk-management
processes and risk-mitigation strategies to deal with the issues inherent in the
investment process. These processes and strategies may be formal and/or informal.
Structural differences in VC markets, as well as numerous other factors also affect the
processes and strategies. Fund managers expend considerable efforts in the
pre-investment stage. The goal is to avoid making investments which later turn into
losses. This study focuses on the evaluation of pre-investment risk for new investments
emphasizing:
.
valuation methods; and
.
how private equity funds use financial information to manage risk.

Understanding how fund managers use financial information in the pre-investment


process is important since investment success has both direct and indirect effects on
stakeholders. It follows that understanding fund manager behavior may lead to improved
investment decisions on the part of the fund sponsor. Improved decision processes should
ultimately lead to less investment decision failures on the part of the fund manager.
A theoretical basis exists for the paper. Risk can be derived from asymmetric information
as implied in the principal-agent relationship (Jensen and Meckling, 1976), differences in
legal systems in which venture capitalists operate (La Porta et al., 1997), transaction cost
theory (Williamson, 1991), structural differences in VC markets (Manigart et al., 2000;
Wright et al., 2004), as well as culture and behavioral aspects (Fairchild and Mai, 2006).
Our study focuses on the use of accounting information and valuation methods used
by private equity funds in the pre-investment and assessment stages. The study
contributes to existing research by:
RAF .
documenting empirical evidence on pre-investment and assessment processes in
10,1 VC and BO funds;
.
investigating if the use of accounting information and valuation methods are
affected by country of origin, fund type, risk profile and fund focus;
.
comparing funds in developed and emerging markets; and
48 .
addressing weaknesses in earlier studies (Wright et al., 2004) where data were
collected over very long time periods using small samples.
The rest of the paper is organized as follows. Section 2 reviews the relevant literature and
develops our hypotheses. Section 3 presents issues relating to data and methodology,
which is followed by Section 4 where we analyze the results. Our conclusions are
presented in Section 5.

2. Prior research and hypothesis development


Hand (2005) examined the relevance of financial and non-financial data in US
biotechnology firms. He found that the value of financial statements increased as firms
mature and also noted that the importance of non-financial information decreased over
time. Manigart et al. (2000) studied differences in valuation techniques among VC funds in
the USA, the UK, France, Belgium and Holland. They found differences relating to maturity
level of the VC industry in the various countries, as well as differences in the corporate
governance system and industry structure. Their results, while inconsistent, provide some
support for the view that country differences exist with respect to the use of valuation
methods. Their findings indirectly support the argument that VC and BO funds use
different valuation techniques. The findings also suggest that factors such as structural,
cultural and behavioral issues affect how funds manage the pre-investment process.
Lockett et al. (2002) conducted a comparative study of VC funds in the USA, Hong Kong,
India and Singapore focusing on valuation and informational issues. They found
significant differences in valuation methods, except for discounted cash flow (DCF) and
rule of thumb approaches. Sources of information were more sensitive to cultural issues
suggesting that trusted information sources differed among countries. Lockett et al. (2002)
provide additional evidence of the fragmentation hypothesis. Megginson (2004) showed
that the VC industry is segmented into local markets, which again point toward national
differences. Based on existing literature, we argue that private equity management
practices are likely to differ among countries, risk profile, fund type and fund focus.

2.1 Legal systems


The UK market is one of the most mature private equity markets in Europe and is
characterized by an Anglo-Saxon common law system. A common law system is more
conducive to a more developed financial market (La Porta et al., 1997). La Porta et al.
argue that a common law system provides firms with better access to equity finance,
especially when compared to civil law countries such as France and Germany. This may
also affect firms’ management practices, as shown by Lel (2003). Bottazzi et al. (2008)
support La Portia et al’s argument and find that legal systems matter from both the
perspective of the fund and the firm. Their argument that the private equity sector
requires a strong legal system to flourish is relevant to our study. They also report that
an Anglo-Saxon legal system is associated with greater investor involvement and
that investor’s demand greater downside protection. Allen and Song (2003) argue
the opposite, suggesting that a lax legal system results in higher rates of VC. Their Evaluating new
reasoning is based on the argument that there are issues other than contractual rights investments
that are important in allowing private equity to flourish. Implicit relationships appear to
be a substitute for a strong legal system as it allows funds the flexibility to deal with
different environments and situations (Allen and Song, 2003). Using a double-sided
moral hazard model, Fairchild and Mai (2006) find that a strong legal system may be
value destroying, which is in contrast to Bottazzi et al. (2008) but largely in agreement 49
with Allen and Song (2003). Fairchild and Mai (2006) argue that cultural and behavioral
factors may be as important as the legal system.
Wright et al. (2002) suggest that there are contextual contrasts between US and
Indian VC funds even though the two countries’ legal system is based on similar English
common law. Sapienza and Manigart (1996) suggest that the regulatory environment,
culture and normative behavior result in differences among VC funds in different
countries. Bruton et al. (2002) argue that differences in fund operations are a result of
placing a greater value on collective action and relationship building. Dossani and
Kenney (2002) argue, to the contrary, that transfer agents are able to assist in the transfer
of VC ideas, processes and procedures. To summarize, the differences between UK and
Indian VC funds may not be as large as previously reported although existing research
does find differences. Based on differences in the legal systems, we also expect
differences between the UK and Pan-European samples. We acknowledge, in line with
the extant literature, that cultural and behavioral factors may have an impact on how
private equity funds operate.

2.2 Asymmetric information, principal agency and behavioral issues


In addition to the fragmentation hypothesis, the principal-agent relationship is one of the
main bases for our investigation into how private equity funds use accounting
information and how they choose valuation methods. The owner or manager of the firm
(the agent in our scenario) often has superior information about the business compared
to the principal (the fund manager). This may result in problems with adverse selection
(misrepresentation by the owner or manager) and moral hazard (the difficulty of
aligning the interest of various stakeholders). These problems can result in poor
decisions, which may have an adverse affect on the outcome of the investment. Adverse
selection and moral hazard are therefore of great significance to fund managers due to
the binary nature of the investment returns (return/no return). Zacharakis and Shepherd
(2001), in support of the use of contracting to mitigate risks, show that 96 percent of all
venture fund managers are overconfident in making decisions to invest.
Funds can manage issues related to asymmetric information in different
ways. Specialized financial contracts are commonly designed to minimize agency
costs (Reid et al., 1997; Kaplan and Stromberg, 2003; Repullo and Suarez, 2004). Hard
contracts are preferable in developed legal systems when cultural closeness is low
(Fairchild and Mai, 2006). Soft contracting is preferred when cultural closeness is high
and when legal systems are undeveloped (Fairchild and Mai, 2006). This suggests that
trusted referees are important in countries where soft contracting is used. Interpersonal
relationships may be of primary importance in countries where legal rights are weak and
cultural closeness is high. In emerging markets where legal rights are often
underdeveloped, informal practices are deemed more effective. Actors in culturally close
markets attempt to balance relationships through social expectations and informal
RAF control devices. This creates social receivables and payables which actors in the private
10,1 equity market attempt to balance over time. Supporting these arguments, Batjargal
(2007) concludes that funds in emerging markets rely more on informal mechanisms
such as trust and referrals than fund managers in developed markets.
Complex contracts are often formulated to influence the agent’s behavior or influence
outcomes of a certain event to manage risks resulting from both foreseeable and
50 unforeseeable contingencies. Behavior-based contracts may be used when the principal
is able to observe and verify the agent’s behavior. This is typically used in due diligence
and other pre-investment stages and also to monitor pre-agreed goals during the
post-investment stage. The principal may use outcome-based contracting if the agent’s
actions cannot be observed. Financial compensation or financing and expenditure
control related contracts are examples of outcome based contracts. Private equity funds
also use a number of non-contractual-based risk management tools in the pre-investment
process. These include using audited financial statements and adjusting projected
revenue and expense data provided by potential investee firms.

2.3 Hypothesis development


We argue, based on previous research, that there are differences in the use of financial
information among VC and BO funds and among funds in different countries. Gray
(1988) suggests that cultural influences affect the development and therefore the use of
financial information, tools and techniques. Specific to our study, Gray (1988) suggests
that the production and use of financial information depend on accounting judgment in
the UK whereas the production and use of accounting information in France and
Germany is largely prescriptive and follow detailed legal requirements. Gray also
suggests that France and Germany are strongly conservative in the use of accounting
information and valuation techniques. UK accountants exhibit less accounting
conservatism (Nobes, 1983, 1987). Finally, Barrett (1976) suggests that countries like
France and Germany have lower disclosure requirements, consistent with collectivism
rather than individualism in the UK. Previous research also supports finding variations
in the use of valuation techniques. We now provide a brief discussion of each hypothesis.
Wright et al. (2004) argue that different legal systems may be associated with
different valuation techniques. They found that VC funds operating in a common-law
environment use different valuation techniques compared to funds operating in a code
law system. We expect that there will be differences in the use of valuation techniques
between UK and Pan-European funds. In line with Wright et al. (2004), we also expect
to find differences between Indian and Pan-European funds. While the UK and
India have commonalities in their legal systems, our literature review points toward
differences in the use of valuation techniques. We also postulate that VC and BO funds
use different valuation techniques due to size, maturity of the target investment firm and
issues related to firm operations. Below are our first two hypotheses:
H1A. There will be a difference in the use of valuation techniques among VC and
BO funds.
H1B. There will be a difference in the use of valuation techniques among UK,
Pan-European and Indian funds.
Principal agency issues, regulatory environments, behavioral issues and structural
differences will result in differences in the use of adjustment techniques among
the country groups. Since the European market is characterized by a much higher Evaluating new
cost structure, a more mature market and less difficulty in obtaining information investments
compared to India, we predict that UK and Pan-European funds will focus more on cost
adjustments. Indian funds will focus more on revenue adjustments. Our arguments are
supported by Leuz et al. (2003) who conclude that firms in countries with weak legal
systems and concentrated ownership use earnings management to a larger extent than
those with strong legal systems and dispersed ownership: 51
H2A. There will be a difference in the use of standardized adjustments between the
Indian and the UK group.
H2B. There will be a difference in the use of standardized adjustments between the
Indian and the Pan-European group.
H2C. There will be no difference in the use of standardized adjustment between the
UK and Pan-European group.
H2D. There will be no difference between VC and BO funds in the use of standard
financial statement adjustments.
Hand (2005) suggests that financial statements increase in value relevance as firms
mature. Venture capitalists invest primarily in small immature firms whereas BO
funds invest in mature, well-established firms. BO funds should use audited financial
statements to a greater extent than VC funds. Since information is more abundant for
larger firms compared to smaller firms, we also argue that asymmetrical information is
a more substantial issue for VC funds since they invest in smaller firms. We also expect
to find differences in the use of audited financial statements among UK, Pan-European
and Indian funds due to differences in the regulatory environment, behavioral issues
and issues related to asymmetric information:
H3A. There will be a difference in the use of audited financial statements between
VC and BO funds.
H3B. There will be a difference in the use of audited financial statements among
UK, Pan-European and Indian funds.

3. Data and methodology


We used a survey instrument to collect non-public fund data. The survey instrument
consisted of ten questions related to valuation of new investments and the use of audited
financial statements. The survey utilized questions that required the respondents to
select their answers from a four-point Likert-type scale. The sample consisted of VC
funds available from the British Venture Capital Association (BVCA), the European
Venture Capital Association, the French Venture Capital Association, the German
Venture Capital Association and the AsianFN.com databases.
Table I provides information about the different VC markets. The UK, German and
French markets rank 2nd, 3rd and 5th, respectively, among global equity markets. India
ranks 15th and is growing rapidly compared to most other markets. The average deal
size is similar. The UK market is characterized by 41.4 percent of the value of
all investments going to the startup/seed/early stage/expansion stages. In terms of
number of deals, these investments account for 75.7 percent. In the French market,
RAF
India Francea Germany UKb
10,1
a. Global ranking based on investments 15 5 3 2
b. Growthc (%) 82.0 29.0 2.0 5.0
c. Invested amount (e) 492 3,600 2,400 7,737
d. Number of deals 77 1,700.0 876 1,290
52 e. Average deal size (e) 6.4 2.1 2.7 6.0
f. Number of funds 65 62 80 166
g. Investment stages based on amount
Startup/seed (e) 67.3 N/A 292.4 411.8
Early stage/expansion 288.2 1,600.0 373.8 1,144.1
Later stage (replacement, MBO, LBO, bridge and
turnaround) 136.3 2,000.0 2,033.8 6,181.4
h. Investment stages based on volume (in %)
Startup/seed 13.7 N/A 12.2 5.3
Early stage/expansion 58.6 55.6 15.6 36.1
Later stage (replacement, MBO, LBO, bridge and
turnaround) 27.7 44.4 84.7 60.9
i. Investment stages based on number of deals
Startup/seed 16 N/A 352 454
Early stage/expansion 44 1,260 441 522
Later stage (replacement, MBO, LBO, bridge and
turnaround) 17 140 83 314
j. Volume of investment stages based on number of deals (in %)
Startup/seed 20.8 N/A 40.2 35.2
Early stage/expansion 57.1 90.0 50.3 40.5
Later stage (replacement, MBO, LBO, bridge and
turnaround) 22.1 10.0 9.5 24.3
Table I.
a b c
Indian, French, German Notes: French-based VC only; UK-based investments only; based on 1998-2002
and UK private equity Sources: IVCA, German Venture Capital Association, French Venture Capital Association and the
markets (in million e) BVCA; data: India (2002), France (2003), Germany (2003) and the UK (2004)

start-up/seed/early stage/expansion investments account for 55.6 percent in terms of


value invested but 90 percent of the number of deals. Similarly, in the German market,
startup/seed/early stage/expansion account for 27.8 percent of the value of all
investments and 90.5 percent of the number of deals completed. The main difference
between the UK and the French and German markets is that later stage investments are
smaller in the UK. They account for less value when compared to the German market but
higher compared to the French market. The Indian market appears to be more evenly
divided between the various investment stages but the focus is on startup/seed/early
stage/expansion. This is primarily the result of a significant focus on high-technology
investments. In summary, the data reveal that the markets are similar which increases
sample comparability. We acknowledge that the Indian fund market may not be as
comparable but we believe that using an emerging market adds breadth to the study.
The survey instrument was mailed to funds in Europe. In India, an on-line survey
instrument was used. We included 499 European funds in the survey. We mailed the
survey instrument to funds in Denmark, The Netherlands, France, Luxembourg, Ireland,
the UK, Poland, Germany, Austria, Switzerland, Greece, Italy, Spain and Portugal. The
overall response rate was 28.5 percent. A total of 166 UK survey instruments were mailed.
In total, 32 useable forms were returned representing a 19.6 percent response rate. The Evaluating new
combined mailing to French and German funds consisted of 142 survey instruments investments
resulting in a 23.2 percent response rate. We e-mailed 65 survey instruments to Indian
funds and received 21 responses, representing a 32.3 percent response rate. The sample
was subsequently divided into four categories:
(1) VC versus BO funds;
53
(2) UK versus India;
(3) UK versus the Pan-European group; and
(4) India versus the Pan-European group[1].

French and German funds were used as a proxy for the Pan-European group. France
and Germany are by far the two largest Pan-European private equity markets.
Omitting smaller European private equity markets provided an opportunity to control
for level of market maturity.
We divided the sample into BO and VC funds according to industry criteria[2], and
use rank sum tests for differences in responses between the sub-samples. In order to
verify non-response bias, we performed t-tests for differences in size for responding and
non-responding funds. The test was replicated using fund type. We also performed a
x 2-test for difference in the proportion of VC and BO funds between responding and
non-responding funds. The results show that there are no distributional differences
between respondents and non-respondents. Table II displays descriptive statistics
regarding the survey and respondents. Due to the lack of lower level fund detail, we were

Panel A – response rates Panel B – respondents


No. of No. of Response Average size VC firms
Country recipients respondents frequency (%) (million e) (%)

Austria 17 11 64.7 60.9 63.6


Denmark 20 13 65.0 592.3 53.8
France 62 13 21.0 880.4 38.5
Germany 80 20 25.0 347.6 40.0
Greece 8 7 87.5 64.8 42.9
Ireland 14 5 35.7 68.5 80.0
Italy 21 9 42.9 739.5 11.1
Luxemburg 4 2 50.0 216.0 50.0
The Netherlands 20 8 40.0 602.2 37.5
Poland 12 4 33.3 293.2 50.0
Portugal 8 4 50.0 52.0 50.0
Spain 22 6 27.3 219.4 16.7
Switzerland 45 8 17.8 157.7 87.5
UK 166 32 19.3 956.4 59.4
Total 499 142 28.5 521.3 49.3
Notes: The table displays descriptive statistics concerning the survey sent to European private equity Table II.
funds; Panel A displays statistics of the sampling, i.e. the number of recipients in each country, the Descriptive statistics
number of responses received and the response frequency; Panel B displays the average size of on the 2004 survey
respondents in each country and the percentage of respondents that were classified as VC funds; note to European private
that Table II does not contain any information about Indian funds equity funds
RAF unable to present similar data for the Indian private equity market. This is consistent
10,1 with extant research.
It is evident from Table II that a large proportion of recipients are located in the UK,
and also that the respondents from the UK are on average larger than funds from other
countries. This reflects the fact that the UK private equity market is the most developed
among European markets. This could potentially affect our results regarding fund type
54 and size. We analyzed different classifications, but we found no evidence that our
classification affected the results[3]. To analyze the data and capture differences, we
used MANOVA and two-way ANOVA. The findings are reported in Tables III and IV.
We now discuss the results[4].

4. Analysis of results
Table I provides summary information about the private equity markets in India,
France, Germany and the UK. Table II shows descriptive information about the
European private equity markets. Figure 1 and Tables III and V show the results
regarding the methods private equity funds use in valuing new investments, as well as
their use of financial information. Figure 1 and Table III display the results from VC and
BO funds and Table V shows the results from the country groupings. The results are
analyzed using MANOVA because it tests for population group differences on several

No. VC No. BO Mean


VC mean BO mean diff. Sig.

Panel A – valuation method


a. Internal rate of return (IRR) * * * 46 2.326 60 2.883 0.557 * * * 0.000
b. DCF techniques (NPV, etc.) 46 1.717 60 1.950 0.233 0.225
c. Accounting-based techniques (payback
method, etc.) 46 1.217 60 1.086 0.134 0.470
d. Economic value added (EVA) 46 0.826 60 0.800 0.026 0.854
e. Factors based on sales (e.g. price-to-sales ratio) 46 1.978 60 1.783 0.195 0.296
f. Factors based on earnings (e.g. price-to-
earnings ratio) * * * 46 2.065 60 2.533 0.468 * * * 0.003
g. Real options 46 0.804 60 0.550 0.254 0.122
Panel B – Standard adjustments and audited financial statements
a. Lower the firm’s financial revenue
projections * * * 63 2.46 67 2.13 0.326 * * * 0.00
b. Increase the firm’s cost projections * * 63 2.18 67 1.97 0.204 * * 0.05
c. Increase the time required to reach expansion
goals * * * 63 2.41 67 2.06 0.353 * * * 0.00
d. Use industry averages to check reasonableness 63 2.35 67 2.43 0.08 0.52
e. Use audited financial statements * * * 70 2.54 69 2.88 0.341 * * * 0.00
Notes: Significance at: *10, * *5 and * * *1 percent level of significance, respectively; the table
displays descriptive statistics of survey responses on the evaluation of new investments; Panel A
shows the use of valuation methods and Panel B shows the result of using standard adjustments and
audited financial statements; for each question, the respondents could assign the rank 0-3, where 3 –
always, 2 – often, 1 – seldom and 0 – never; reported columns 1 and 3 contain the number of
respondents that are classified as VC funds and BO funds; reported columns 2, 4, 5 and 6 contain
Table III. estimated mean of VC, BO funds, the differences among the estimated means and the significance of
VC and BO funds the differences; the results are attained through MANOVA and two-way ANOVA
Evaluating new
No. HT No. LT Mean
HT mean LT mean diff. Sig. investments
Panel A – valuation method
a. Internal rate of return (IRR) 68 2.632 55 2.600 0.032 0.819
b. DCF techniques (NPV, etc.) 68 2.015 55 1.782 0.233 0.200
c. Accounting-based techniques (payback method, 55
etc.) 68 1.044 55 1.164 0.120 0.488
d. Economic value added (EVA) 68 0.853 55 0.855 0.002 0.991
e. Factors based on sales (e.g. price-to-sales ratio) 68 1.853 55 1.855 0.002 0.993
f. Factors based on earnings (e.g. price-to-earnings
ratio) * * 68 2.471 55 2.164 0.307 * * 0.040
g. Real options 68 0.721 55 0.709 0.011 0.942
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial revenue projections 82 2.305 66 2.273 0.032 0.746
b. Increase the firm’s cost projections 82 1.951 66 2.091 0.140 0.187
c. Increase the time required to reach expansion
goals * * 82 2.085 66 2.318 0.233 * * 0.028
d. Use industry averages to check reasonableness 82 2.439 66 2.455 0.016 0.897
e. Use audited financial statements 88 2.784 71 2.648 0.136 0.144
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often,
1 – seldom and 0 – never; reported columns 1 and 3 contain the number of respondents that are
classified as high-tech (HT) funds (funds from relatively high-tech countries) and low-tech (LT) funds
(funds from relatively low-tech countries); reported columns 2, 4, 5 and 6 contain estimated mean of Table IV.
HT, LT funds, the differences among the estimated means and the significance of the differences; the High-tech versus low-tech
results are attained through MANOVA and two-way ANOVA industry structure

dependent measures simultaneously while maintaining greater statistical power and


control for false positive results (type I errors). Means are estimated for each level of
a factor averaging across all levels of the other factors based on the estimated model.
The overall F-test indicates that population differences exist. We perform tests to
investigate which levels within a factor differ. We use the method of least significant
distance since the number of levels is small and an overall difference of group means has
already been established at the selected criterion level (0.05)[5].
Panel A of Table III shows the responses to questions regarding valuation methods
(H1A). In Figure 1, the bars show the proportion of funds that use each method, and
the lines show the intensity of use. From Table III, we observe that internal rate of return
(IRR) is used extensively by VC and BO funds. We note that almost all BO funds use this
method. Both VC and BO funds use DCF techniques and factor-based models.
Commenting on BO funds, the popularity of IRR is followed by valuations based on
earnings (e.g. price-to-earnings ratio), net present value (NPV) and revenue-based
methods (e.g. price-to-sales ratio). Accounting-based techniques appear to play a minor
role. Economic value added (EVA) and real option methods are used infrequently.
The results are consistent with the notion that less volatile cash flows and more stable
(or predictable) accounting-based earnings result in a higher use of IRR and valuation
models based on earnings. This is not surprising given that earnings-based methods are
RAF 100 3.0
10,1
75

Mean rank (users only)


Percentage of firms

56
50 2.0

25

0 1.0
IRR NPV Payback EVA Sales based Earnings Real
based options
VC percentage BO percentage VC mean rank BO mean rank

Notes: The figure displays the responses to a question asking firms to rank how often they used each
valuation method; the possible ranks are 0 – never, 1 – seldom, 2 – often and 3 – always; the left-hand
Figure 1. scale refers to the bars in the figure and displays the percentage of firms that indicated that they used a
Valuation methods method at least seldom (rank above 0); the right-hand scale refers to the lines in the figure and displays
the mean rank calculated from firms that responded that they used a method at least seldom

more suitable when earnings are stable. In Table III, we note a difference in the use
of earnings-based factor models and IRR. BO funds use IRR and factor-based earnings
valuation models to a greater extent. This is in line with our expectations since VC funds
focus on early stage financing whereas BO funds focus on mature investments. Earnings
may be non-existent or volatile in earlier stage companies making these models
less suitable for VC funds. Similarly, IRR is more suitable for larger investments. We
hypothesize that there are three primary reasons for this result. First, the assumptions
underlying IRR may frequently be violated in valuing cash flows of small firms, making
the model unsuitable in these cases. Second, the magnitude of the IRR is important for
BO funds, suggesting that BO funds are interested in the actual return rather than using
IRR as a benchmark. In VC funds, the IRR may be used as a hurdle rate to a larger extent.
Third, the nature of VC investments may make the model impractical. BO funds would
make greater use of earnings-based models according to this reasoning. We previously
discussed this contention. This reasoning is empirically supported at the 0.01 level.
We also find that VC funds use accounting-based valuation techniques and real options
to a greater extent than BO funds although the means are low (accounting-based
valuation techniques: 1.217 and 1.086 for VC and BO funds, respectively). Our findings
are contrary to H1A except for IRR and factor-based earnings models. We detect a
convergence in the use of valuation techniques, in comparison with earlier studies,
except in the case where structural issues play a role in the due diligence process. The use
of IRR and factor-based earnings models supports H1A.
Table III, Panel B reports responses to questions concerning adjustments made to
financial forecasts in the VC and BO groupings. Respondents use revenue adjustments,
cost adjustments and audited financial statements quite often. The differences between
Pan Pan
UK Europe UK India Europe India
n Mean n Mean Diff. Sig. n Mean n Mean Diff. Sig. n Mean n Mean Diff. Sig.

Panel A – valuation method


a. Internal rate of return (IRR) 23 2.783 26 2.577 0.206 0.321 23 2.783 17 2.471 0.312 0.179 26 2.577 17 2.471 0.106 0.637
b. DCF techniques (NPV et cetera) 23 1.565 26 1.846 0.281 0.336 23 1.565 17 2.294 0.729 * * 0.028 26 1.846 17 2.294 0.448 0.161
c. Accounting-based techniques
(payback method, etc.) 23 1.087 26 1.115 0.028 0.912 23 1.087 17 0.824 0.263 0.363 26 1.115 17 0.824 0.292 0.302
d. Economic value added (EVA) 23 0.739 26 1.038 0.299 0.166 23 0.739 17 1.118 0.379 0.118 26 1.038 17 1.118 0.079 0.735
e. Factors based on sales (e.g.
price-to-sales ratio) 23 1.565 26 2.000 0.435 0.139 23 1.565 17 1.765 0.199 0.541 26 2.000 17 1.765 0.235 0.459
f. Factors based on earnings (e.g.
price-to-earnings ratio) 23 2.217 26 2.308 0.090 0.723 23 2.217 17 2.353 0.136 0.634 26 2.308 17 2.353 0.045 0.87
g. Real options 23 0.565 26 0.615 0.050 0.824 23 0.565 17 1.059 0.494 * * 0.053 26 0.615 17 1.059 0.443 * 0.075
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial
revenue projections 30 2.167 30 2.167 0.000 1.000 30 2.167 18 2.278 0.111 0.528 30 2.167 18 2.278 0.111 0.528
b. Increase the firm’s cost
projections 30 1.967 30 2.033 0.067 0.664 30 1.967 18 1.611 0.356 * * 0.047 30 2.033 18 1.611 0.422 * * * 0.019
c. Increase the time required to
reach expansion goals 30 2.367 30 2.100 0.267 0.115 30 2.367 18 1.889 0.478 * * * 0.016 30 2.100 18 1.889 0.211 0.278
d. Use industry averages to check
reasonableness 30 2.467 30 2.467 0.000 1.000 30 2.467 18 2.833 0.367 * * 0.038 30 2.467 18 2.833 0.367 * * 0.038
e. Use audited financial
statements 31 2.613 32 2.781 0.168 0.262 31 2.613 20 2.800 0.187 0.274 31 2.781 20 2.800 0.019 0.912
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive statistics of survey responses on the evaluation of
new investments; Panel A shows the use of valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often, 1 – seldom and 0 – never; reported columns 1, 3, 7,
9, 13 and 15 contain the number of respondents that are classified based on countries; the rest of the reported columns contain estimated means, the
differences among the estimated means and the significance of the differences; the results are attained through MANOVA and two-way ANOVA
investments

UK, Pan European and


Table V.
Evaluating new

Indian funds
57
RAF the VC and BO groups are pronounced, except for the use of industry averages to verify
10,1 reasonableness. Supporting H2D, we find that VC funds adjust the firms’ financial
projections more often when evaluating investment performance. The results are
significant at the 0.01 level, except for cost adjustment where the result is significant at
the 0.05 level. VC funds are more likely to make standard financial adjustments
suggesting that management either produces less realistic forecasts or that it is more
58 difficult for VC funds to verify the projections realism. We also find that BO funds use
audited financial statements to a greater extent than VC funds. The result, supporting
H3A, is significant at the 0.01 level. We speculate that this is due to the availability of
meaningful financial data and audited financial statements for larger investments. The
relatively large transactions cost in producing meaningful financial data and audited
financial statements may prevent their use in small or start-up/early stage investments.
Panel A of Table V reports the responses to questions regarding valuation methods
based on country groupings (H1B)[6]. It shows that IRR is the method used most often.
Its’ use is as extensive as expected. The popularity of IRR is followed by valuation
methods based on earnings (e.g. price-to-earnings ratio), NPV valuations and valuation
methods based on revenue (e.g. price-to-sales method). EVA and real option methods are
used infrequently as was the case in Table III. The results, when comparing valuation
methods used by UK and Pan-European funds, reveal few differences and do not support
H1B. Interestingly, differences which support H1B were noted between UK and Indian
funds with Indian funds using DCF techniques to a greater extent. Indian funds also
use real options to a greater extent as compared to UK funds. Our findings suggest that
Indian funds differ from their UK and Pan-European counterparts in putting emphasis
on different valuation methods.
Panel B of Table V reports responses to questions concerning adjustments and the use
of audited financial statements (H2A-H2C and H3B). On average, the respondents make
extensive use of adjustments to revenue forecasts and cost projections. The use of audited
financial statements is also high[7]. We noted no major differences between UK and
Pan-European funds. We therefore reject H3B. Both UK and Pan-European funds use
audited financial statements to a large extent. The results show differences in three of the
five categories when comparing Indian and UK funds. UK funds increase firms’ cost
projections in evaluating the investment performance to a greater extent than Indian
funds. The emphasis on cost adjustment may be the result of a high cost structure in the
UK. The results may also be attributable to differences in the level of maturity between the
UK and the Indian private equity markets, as well as cultural and behavioral factors.
Another potential explanation is the greater focus on high-technology investments by
Indian venture capitalists, which implies a greater focus on revenue growth. UK funds give
more time to meet pre-determined goals. Indian VC funds use industry data to check the
reasonableness of the forecast to a larger extent as compared to UK funds. A comparison of
the Pan-European and Indian funds reveals similar results, except in the case of extending
additional time to meet pre-agreed goals. Cultural differences in the corporate governance
systems in Asia may also play a role. Our results support hypotheses H2A-H2C.
Pan-European funds do use audited financial statements to a greater, though
statistically insignificant extent, than UK funds (the means were 2.78 for Pan-European
funds and 2.62 for UK funds). French accounting regulations dictate that all firms use the
same set of accounting standards. This makes financial statements very standardized
and easily verified from a legal point of view. Germany’s accounting system is also
based on legal requirements although firms do not necessarily use the same accounting Evaluating new
principles to the extent that French firms do. Almost all firm financial statements in investments
France and Germany are audited and, in most instances, are available to funds. This
availability is not necessarily the case in the UK where most financial statements are
also audited. We argue that the implementation of uniform accounting standards and
harmonization of financial regulations are decreasing structural and cultural differences
across Europe. It also appears that Indian funds are using audited financial statements 59
with high frequency in assessing investment opportunities. This may be the result of
significant problems with asymmetric information. Finally, previous research indicates
that cultural aspects play a role in determining the preparation and use of financial
statements (Salter and Niswander, 1995).
The results reported in Tables III and V indicate that fund orientation may play a
role in how firms use financial information to analyze potential investments. This also
supports the argument that fund focus plays a role in how funds analyze investments.
We therefore test two additional hypotheses:
H4A. There will be a difference in the use of valuation techniques among high- and
low-risk funds.
H4B. There will be a difference in the use financial information among high and
low-risk funds.
We examine historical investments made by each fund and analyze available descriptive
information to classify funds into high and low risk. Funds are classified in the high-risk
category if they primarily invest in startup, early stage or expansion. Funds are
considered low risk if they primarily invest in late stage, pre-IPO and BOs. This
classification introduces selection bias since larger funds tend to invest in the low-risk
category. To analyze the impact of size on our results, we also classify funds into small
and large using the same cutoff as discussed previously. Classifying funds into large and
small is a proxy for investment size. We test the following hypotheses:
H4C. There will be a difference in the use of valuation techniques among small and
large funds.
H4D. There will be a difference in the use of financial information among small and
large funds.
Consistent with our previous methodology, we use both MANOVA and ANOVA to
analyze the data. Panel A of Table VI reports the results for the high/low-risk
classification. The use of valuation techniques is consistent with our previous tests.
Low-risk funds use IRR and earnings-based factor models to a greater extent when
compared to high-risk funds. This result lends further support to the argument that the
use of valuation techniques is fairly uniform across all funds. Panel B of Table VI reports
the differences in how firms use financial information in the investment evaluation
process. The results are highly significant, except for variable (d), reasonableness check.
Fund managers in high-risk funds lower firms’ revenue projections to a larger extent
compared to low-risk funds. High-risk fund managers compensate for the higher risk by
lower revenue projections due to significant and expected revenue volatility. It is
important to note that this type of fund manager behavior results in lower downside risk
while preserving the upside potential. We also find that high-risk funds increase cost
RAF
No. HR No. LR Mean
10,1 HR mean LR mean diff. Sig.

Panel A – valuation method


a. Internal rate of return (IRR) * * * 59 2.441 47 2.894 0.453 * * * 0.002
b. DCF techniques (NPV, etc.) 59 1.831 47 1.872 0.042 0.827
60 c. Accounting-based techniques
(payback method, etc.) 59 1.237 47 1.021 0.216 0.242
d. Economic value added (EVA) 59 0.847 47 0.766 0.082 0.564
e. Factors based on sales
(e.g. price-to-sales ratio) 59 1.915 47 1.809 0.107 0.567
f. Factors based on earnings
(e.g. price-to-earnings ratio) * * * 59 2.119 47 2.596 0.477 * * * 0.003
g. Real options 59 0.763 47 0.532 0.231 0.160
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial revenue
projections * * * 76 2.421 54 2.111 0.310 * * * 0.002
b. Increase the firm’s cost projections * * 76 2.158 54 1.944 0.213 * * 0.045
c. Increase the time required to reach expansion
goals * * * 76 2.395 54 2.000 0.395 * * * 0.000
d. Use industry averages to check
reasonableness 76 2.329 54 2.481 0.153 0.250
e. Use audited financial statements * * * 83 2.554 56 2.946 0.341 * * * 0.000
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often,
1 – seldom and 0 – never; reported columns 1 and 3 contain the number of respondents that are
classified as high-risk (HR) funds and low-risk (LR) funds; reported columns 2, 4, 5 and 6 contain
Table VI. estimated mean of HR, LR funds, the differences among the estimated means and the significance of
High and low-risk funds the differences; the results are attained through MANOVA and two-way ANOVA

projections to a larger extent. The result for the variable cost projection is not as strong
as the variable revenue adjustment. Fund managers are also more likely to give a
high-risk investment more time to reach the firms’ goals and objectives. Finally, the use
of audited financial statements is significantly higher for low-risk funds. We attribute
this result to:
.
the almost universal availability of audited financial statements;
.
transaction cost theory; and
.
past history.

Past historical information relating to high-risk investments may be a poorer predictor


of future performance compared to low-risk investments, especially after a large cash
infusion. While the availability of audited financial statements is fairly universal in
Europe, firms in the startup and early stage may not have a past financial history beyond
a very short time period. In addition, analysis of investments in spin-offs would not
necessarily require the use of audited financial statements. It is also possible
that transaction costs related to the entire investment process are prohibitive for certain
investments. We also speculate that in conducting due diligence of high-risk
investments, fund managers focus more on future risk and less on the historical Evaluating new
information provided in audited financial statements. Table VII reports the results for investments
the large and small fund classifications. The results, for the most part, are insignificant.
In panel A, which shows valuation techniques, IRR is only marginally significant. Panel
B reports how funds use financial information. Small funds are more likely to lower
revenue projections as a risk management tool and are more likely to provide additional
time for their investee firms to reach their goals and objectives. Based on the data in 61
Tables VI and VII, we argue that the results are driven mainly by fund type rather than
fund size.
To further verify our previous findings and assertions, we conducted three additional
tests. In the first test (results reported in Tables VII-X), we analyzed the magnitude of our
previous significant findings using MANOVA and two-way ANOVA. Table VIII
reports the results from the VC and BO classifications. We previously found in Table III
that the use of six valuation methods differed between the two groups. We eliminate the
non-significant valuations methods and re-estimate model parameters using only the six
significant valuation methods. The results show that the differences are the largest for
IRR, lowering the firm’s revenue projections and increasing the time required to reach
expansion goals. Tables IX and X report results of the same test of the UK versus India
and Pan-Europe versus India. The main finding is that increasing a firm’s cost projection

No. LF No. SF Mean


LF mean SF mean diff. Sig.

Panel A – valuation method


a. Internal rate of return (IRR) * 45 2.800 61 2.525 0.275 * 0.064
b. DCF techniques (NPV, etc.) 45 1.800 61 1.885 0.085 0.658
c. Accounting-based techniques (payback
method, etc.) 45 1.044 61 1.213 0.169 0.364
d. Economic value added (EVA) 45 0.756 61 0.852 0.097 0.495
e. Factors based on sales (e.g. price-to-sales ratio) 45 1.822 61 1.902 0.079 0.672
f. Factors based on earnings (e.g. price-to-
earnings ratio) 45 2.400 61 2.279 0.121 0.457
g. Real options 45 0.622 61 0.689 0.066 0.689
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial revenue
projections * * * 49 2.122 81 2.395 0.273 * * * 0.008
b. Increase the firm’s cost projections 49 2.000 81 2.111 0.111 0.308
c. Increase the time required to reach expansion
goals * * * 49 2.041 81 2.346 0.305 * * * 0.004
d. Use industry averages to check reasonableness 49 2.306 81 2.444 0.138 0.305
e. Use audited financial statements 49 2.776 90 2.678 0.098 0.355
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often,
1 – seldom and 0 – never; reported columns 1 and 3 contain the number of respondents that are
classified as large funds (LF) and small funds (SF); reported columns 2, 4, 5 and 6 contain estimated
mean of LF, SF funds, the differences among the estimated means and the significance of the Table VII.
differences; the results are attained through MANOVA and two-way ANOVA Large and small funds
RAF
No. VC No. BO Mean
10,1 VC mean BO mean diff. F Sig.

Panel A – valuation method


a. Internal rate of return (IRR) * * * 46 2.326 60 2.883 0.557 * * * 13.188 * * * 0.000
f. Factors based on earnings (e.g. price-
62 to-earnings ratio) * * * 46 2.065 60 2.533 0.468 * * * 7.492 * * * 0.007
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial revenue
projections * * * 63 2.46 67 2.13 0.326 * * * 11.178 * * * 0.001
b. Increase the firm’s cost projections * * 63 2.18 67 1.97 0.204 * * 3.599 * * 0.060
c. Increase the time required to reach
expansion goals * * * 63 2.41 67 2.06 0.353 * * * 11.123 * * * 0.001
e. Use audited financial statements * * * 70 2.54 69 2.88 0.341 * * * 6.694 * * * 0.011
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often,
1 – seldom and 0 – never; reported columns 1 and 3 contain the number of respondents that are
classified as VC funds and BO funds; reported columns 2, 4, 5, 6 and 7 contain estimated mean of VC,
Table VIII. BO funds, the differences among the estimated means, F-value and the significance of the differences,
VC and BO funds respectively; the results are attained through MANOVA

UK India
n Mean n Mean Diff. F Sig.

Panel A – valuation method


b. DCF techniques (NPV, etc.) * * 23 1.565 17 2.294 0.729 * * 5.960 * * 0.020
g. Real options * 23 0.565 17 1.059 0.494 * 2.889 * 0.098
Panel B – standard adjustments
b. Increase the firm’s cost projections 30 1.967 18 1.611 0.356 1.729 0.197
c. Increase the time required to reach expansion
goals * * 30 2.367 18 1.889 0.478 * * 5.779 * * 0.021
d. Use industry averages to check reasonableness * * 30 2.467 18 2.833 0.367 * * 5.828 * * 0.021
Notes: Significance at: * 10 * *, 5 * * * and 1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of valuation
methods and Panel B shows the result of using standard adjustments; for each question, the respondents
could assign the rank 0-3, where 3 – always, 2 – often, 1 – seldom and 0 – never; reported columns 1 and
3 contain the number of respondents from the UK and India; reported columns 2, 4, 5, 6 and 7 contain
Table IX. estimated mean of VC, BO funds, the differences among the estimated means, F-value and the
UK and Indian funds significance of the differences, respectively; the results are attained through MANOVA

is no longer significant in the UK/India comparison. We use MANOVA in Table XI to


analyze if any of our results are due to country labor cost differences. Using data from the
International Labor organization (ILO) and the Organization for Economic Co-operation
and Development (OECD), we derive average labor costs. We then classify funds as high
labor cost (HLC) funds (funds from relatively HLC countries) and low labor cost (LLC)
funds (funds from relatively LLC countries) based a country being above or below the
Evaluating new
Pan
Europe India investments
n Mean n Mean Diff. F Sig.

Panel A – valuation method


g. Real options 26 0.615 17 1.059 0.443 1.489 0.230
Panel B – standard adjustments 63
b. Increase the firm’s cost projections * * 30 2.033 18 1.611 0.422 * * 4.053 * * 0.051
d. Use industry averages to check reasonableness * * 30 2.467 18 2.833 0.367 * * 3.537 * * 0.067
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments; for each question, the
respondents could assign the rank 0-3, where 3 – always, 2 – often, 1 – seldom and 0 – never;
reported columns 1 and 3 contain the number of respondents from Pan Europe and India; reported
columns 2, 4, 5, 6 and 7 contain estimated mean of VC, BO funds, the differences among the estimated Table X.
means, F-value and the significance of the differences, respectively; the results are attained through Pan European and
MANOVA Indian funds

No. HLC No. LLC Mean


HLC mean LLC mean diff. Sig.

Panel A – valuation method


a. Internal rate of return (IRR) 49 2.490 74 2.703 0.213 0.136
b. DCF techniques (NPV et cetera) 49 1.857 74 1.946 0.089 0.632
c. Accounting-based techniques
(payback method etc) 49 1.061 74 1.122 0.060 0.730
d. Economic value added (EVA) 49 0.735 74 0.932 0.198 0.149
e. Factors based on sales
(e.g. price-to-sales ratio) 49 1.980 74 1.770 0.209 0.236
f. Factors based on earnings
(e.g. price-to-earnings ratio) 49 2.347 74 2.324 0.023 0.883
g. Real options * * 49 0.531 74 0.838 0.307 * * 0.053
Panel B – standard adjustments and audited financial statements
a. Lower the firm’s financial revenue
projections * 61 2.393 87 2.218 0.175 * 0.079
b. Increase the firm’s cost projections * 61 2.131 87 1.931 0.200 * 0.060
c. Increase the time required to reach
expansion goals 61 2.230 87 2.161 0.069 0.525
d. Use industry averages to check
reasonableness * * 61 2.279 87 2.563 0.285 * * 0.018
e. Use audited financial statements 65 2.646 94 2.777 0.130 0.167
Notes: Significance at: *10, * *5 and * *1 percent levels, respectively; the table displays descriptive
statistics of survey responses on the evaluation of new investments; Panel A shows the use of
valuation methods and Panel B shows the result of using standard adjustments and audited financial
statements; for each question, the respondents could assign the rank 0-3, where 3 – always, 2 – often,
1 – seldom and 0 – never; reported columns 1 and 3 contain the number of respondents that are
classified as HLC funds (funds from relatively HLC countries) and LLC funds (funds from relatively
LLC countries); reported columns 2, 4, 5 and 6 contain estimated mean of HLC, LLC funds, the
differences among the estimated means and the significance of the differences; the results are attained Table XI.
through MANOVA and two-way ANOVA HLC versus LLC funds
RAF average labor cost. Specifically, we test the assertion that HLC may impact how funds
10,1 evaluate investments. Panel A of Table XI shows that labor cost does not appear to affect
the use of valuation techniques. Overall, the country comparisons with respect
of valuation techniques lend further support to our previous findings and arguments
that country groupings have little or no effect on the use of valuation method. Panel B of
Table XI lends some support (significant only at the 10-percent level) for our previous
64 assertion that labor costs appear to have an effect on standard adjustments. The results
show that the use of valuation methods appear uncorrelated with labor cost whereas
labor costs appear to have a weakly significant impact on how fund managers make
financial adjustments. We also test one of our previous suggestions that industry
structure may affect how VC and BO evaluate investments. Based on ILO and OECD
data, we divided the countries into two categories; high technology (high tech) and
non-high technology (low-tech). Using MANOVA and two-way ANOVA, we find no
support for the argument that country-specific industry structures affect how fund
evaluate investments.
To summarize, the results demonstrate little difference between UK and Pan-European
funds. Our results are consistent with Hand (2005), regarding the use of audited financial
statements, since we find that their use increases with the level of maturity of the
investment (VC versus BO funds). While our findings do not support significant structural
differences among funds that operate in large well-developed European VC markets, the
results do indicate that differences exist between UK/Pan-European and Indian funds.
These results are consistent with Pruthi et al. (2003), who reported structural differences
between UK and Indian VC markets. Our results are inconsistent with Wright et al. (2004).
Our results neither contradict nor strongly support previous research by Gompers (1995)
and Lerner (1995). Our results do not resolve the different argument by Bottazzi et al. (2008)
on the one hand and Allen and Song (2003) and Fairchild and Mai (2006) on the other.
Finally, and most importantly, our findings strongly suggest that fund type drives the use
of financial information supporting the argument that fund risk as defined by investment
focus is an important factor in explaining the how funds use financial information.

5. Conclusion
In this study, we attempted to analyze differences in the use of valuation methods and
the use of financial information among VC and BO funds. Our initial results lead us to
investigate the role of risk and fund orientation. We analyzed the same questions
grouping the sample into three geographical categories: the UK, Pan-European and
India. The results show that there are differences in the use of valuation methods but that
these differences as not as large as previously reported. Our findings suggest that the
use of valuation models is relatively homogeneous across countries. The use of financial
information in the evaluation process appears to be driven by fund type and fund focus.
Our results suggest that future research should focus on VC and BO funds separately.
Labor costs were only weakly related to how fund managers use financial information
and unrelated to the use of audited financial statements. We find no support for the
argument that country specific industry structures affect how funds evaluate
investments.
There are several limitations associated with this study. First, it suffers from
common problems associated with survey research. Zacharias and Meyer (1998)
suggest that funds managers are poor at internalizing decisions resulting in reduced
effectiveness of survey research. Second, we used a Pan-European sample as a Evaluating new
proxy for a non-Anglo Saxon legal and economic system. Third, we were unable to investments
conduct interviews to follow-up survey answers. Fourth, we do not test for interaction
effects.

Notes 65
1. In comparing VC and BO funds, we used a larger sample consisting of funds in several
different European countries (Table II). Owing to the small sample size, we were unable to
divide the Indian sample into VC and BO funds.
2. Classification into BO and VC funds was accomplished by analyzing the investment
activities of each responding fund. In analyzing the initial results of our study, we further
divided the sample into high and low risk. We also classified funds into small versus large
funds using standard ECVA classification where a fund is considered small if its capital
under management is less than e250 million. We discuss the results later in the paper. Our
sample excludes specialized BO funds such as distressed asset and mezzanine funds.
3. UK funds may differ in the management of the pre-investment process compared to funds in
other European practices since they operate in the Anglo-Saxon legal system. Therefore, as a
robustness test, we included a UK dummy in all regressions (not reported). This approach
did not change our results, and we did not find that UK funds differed systematically from
other firms. Thus, our results are not driven by a “UK effect”.
4. Additional explanatory variables are warranted, but lack of data limit us to those presented. In
effect, we cannot control for other, potentially important, variables such as fund managers
compensation programs, or more detailed data on the inherent riskiness of funds’ investee
firms.
5. Initially, we analyzed the sample using Mann-Whitney tests. In addition, ordered LOGIT
regressions, LOGIT regressions and OLS regressions were used where applicable. However,
the repeated tests decreased the statistical power and increased possibility of a type I error.
Therefore, we report the results from the MANOVA and two-way ANOVA tests.
6. Since extant literature show differences in the use of valuation methods, we grouped all
European funds into random categories without taking into account fund type, size and risk.
We then compared the results of the various groups. A group was defined as having at least
two countries. The results are consistent with our main finding that there are few country
differences. Only one group comparison resulted in significant differences at the 10 percent
level. We found differences between group 1 (Denmark, Switzerland and the UK) and group 3
(Austria, France, Luxembourg, Poland, Portugal and Spain). There is no theoretical basis for
finding differences in random groupings so we do not comment further.
7. We observe that not all funds use auditing financial statements when evaluating potential
BO investments. This may seem odd at first. However, not all BO transactions include the
entire firm. Some transactions may be for assets only and some involve a previously
integrated division of a firm.

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About the authors


Jan Smolarski is Chair and Associate Professor of the Department of Accounting and Business
Law at the University of Texas Pan American. His research has appeared in numerous
accounting, finance and VC journals. His research interests include risk, extreme events, private
equity and hedge funds. Jan Smolarski is the corresponding author and can be contacted at:
jmsmolarski@utpa.edu
Neil Wilner is Associate Professor of Accounting at the University of North Texas. He has
published in numerous journals including Accounting, Organizations and Society and the
Accounting Review. He focuses mostly on auditing and behavioral accounting.
Weifang Yang is a PhD student in Finance at the University of Texas Pan American. Her
primary research interests include alternative investment strategies, global investing, hedge
funds and trading strategies.

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