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Journal of Developmental Entrepreneurship

Vol. 11, No. 1 (2006) 35–55
© World Scientific Publishing Company

RISK MANAGEMENT IN PRIVATE EQUITY FUNDS: A COMPARATIVE

STUDY OF INDIAN AND FRANCO-GERMAN FUNDS

CAN KUT and JAN SMOLARSKI∗

Stockholm University School of Business
SE-106 91 Stockholm, Sweden
∗jsm@fek.su.se

Received October 2004

Revised August 2005

Venture capitalist and buy-out funds are often considered experts at investing in high-risk projects and
companies. To be successful investors, private equity funds must therefore manage the many aspects
of risk that are associated with investing in non-public enterprises. This study examines how Indian
private equity funds manage several dimensions of risk in comparison to non-Anglo-Saxon funds. We
analyze risk management preferences in Indian and Franco-German funds in pre- and post-investment
stages. The results, which are discussed in detail, show significant differences between the two groups.

Keywords: Risk management; agency theory; legal systems; culture; venture capital.

1. Introduction
Global expansion in venture capital and buy-outs has increased the number of funds oper-
ating in mature and developing markets. Globalization has also increased the number of
cross-border deals, the number of funds expanding into different geographic areas and the
number of funds looking to complete deals outside their country of domicile. Expansion
in any firm entails taking risks, to a large extent as a result of information asymmetry but
also due to numerous other reasons. The expansion of the venture and buy-out industry
has corresponded to another well-studied phenomenon: how developing countries attempt
to increase wealth by supporting and financing small-to medium-sized business and by
restructuring large enterprises.1
International expansion among established funds and newly started domestically based
funds require an increased understanding of how funds manage existing and new risks. Risk

1 In this study, we use the term private equity when referring to the entire industry. We use the terms venture capital
and buy-out funds to refer to the main branches of the private equity industry. We also note that terminology
followed in extant literature is inconsistent. Buy-out generally refers to buying a controlling stake in a firm, often
as much as 100 percent ownership. Venture capital generally refers to buying a minority stake. While buy-out
transactions tend to be larger and used with mature firms, this is not always the case. Most private equity funds
undertake both buy-out and venture capital transactions. Thus, the classification is problematic in most published
articles. We deal with this issue when discussing limitation of this study.

35
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36 C. Kut & J. Smolarski

management among venture capital and buy-out funds has only recently received attention
from researchers although private equity funds face many different types of risks. Recent
research (e.g., Manigart et al., 2000) point to structural differences among venture capital
markets in different countries. Kut et al. (2004) found differences in risk management among
European private equity funds. Other studies investigate if the private equity industry differs
from country to country based on country of origin (e.g., Wright et al., 2002). In this study,
we analyze how risk management practices differ in Indian and Franco-German private
equity funds. According to extant research by La Porta et al. (1997), legal systems have an
impact on a number of economic variables such as shareholder rights, which are generally
the strongest in countries with an Anglo-Saxon legal system (e.g., India), which is based on
common law. The legal systems in France and Germany are based on civil law (Fauver et al.,
2003) and offer less protection for shareholders. Wright et al. (2004) compared valuation
mechanisms used in US, UK, French, German and Asian funds. Their results suggest that
legal systems play a major role in how venture capital funds value their investments. This
implies that differences exist in how Franco-German funds manage risks compared to funds
operating in an Anglo-Saxon legal environment. Wright et al. (2002) and Pruthi et al. (2003)
found similarities between US and UK-owned and domestically based Indian venture and
buy-out funds although some differences were noted.
While existing research dealing with legal systems are in broad agreement, research
results are inconsistent at the micro level. This study fills a gap in existing research since
we compare how venture capital and buy-out funds manage different types of risk: pre-
screening, post-investment firm specific risk and portfolio risk in an established market and
a developing market. Therefore, in general, we expect to find differences in how Indian and
Franco-German funds manage their risks.
The study is presented as follows. First, we discuss the Indian private equity industry
since it is of relatively recent origin. We also provide a brief discussion of the Franco-German
private equity markets. This is followed by a discussion about risk management in the venture
capital and buy-out industry. In the third section, we discuss data, and methodology, which
is then followed by analysis and concluding comments.

2. Private Equity in India

The development of the Indian private equity market has only recently received attention in
the literature. In the Indian context, venture capital can be defined as investment in the form
of equity, quasi-equity and conditional loans made in new unlisted high-risk or high-tech
firms started by entrepreneurs (Pandey, 1998). The structure of the Indian private equity
industry is transparent and funding sources may be grouped into four categories (Gupta
et al., 2003). Three categories are directly state sponsored: the India Development Financial
Institutions, State Finance Corporation sponsored venture funds, and bank-sponsored, or
captives. These venture funds are owned by public sector banks. The fourth category includes
all privately owned funds, including those owned by foreign banks, private sector firms and
private financial institutions. Conditions in India, until recently, were not encouraging for
the growth of entrepreneurship and risk capital. According to Chitale (1989), there were not
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Risk Management in Private Equity Funds 37

many incentives for individuals to invest in risk capital. Bank loans were still the leading
source of finance despite the problems for some companies to get such credit. After acquiring
statutory powers in 1992, the Securities and Exchange Board of India (SEBI) introduced
a range of reforms. These included mandatory quarterly reports, facility for companies to
buy back securities, and a reduction in minimum percentage of shares that were required to
be listed to 20 percent (Pruthi et al., 2003). Until recently, three bodies regulated the Indian
venture capital funds: the Government, the Securities and Exchange Board of India (SEBI)
and the Central Board of Direct Taxes (CBDT). This was seen as over-regulation with the
complication that each set of guidelines was different. Until recently, there was also some
bias toward foreign-based venture capital funds, as they were not required to register with
the SEBI, unlike the requirements for local funds. There were also special tax concessions
for overseas firms operating in India from a base in Mauritius, while local funds did not
receive such incentives. In 2000, the Chandrasekhar Committee on Venture Capital made a
number of recommendations to liberalize the venture capital industry including tax changes,
fairness for all funds operating in India, extending the list of institutional investors allowed
to invest in venture capital funds, and relaxation of requirements for initial public offerings
(IPO). Further amendments have brought requirements for local and foreign funds into line
and some additional restrictions have been removed (Pruthi et al., 2003). This essentially
created a venture capital market similar to that of the US and Western Europe, although
many aspects of an emerging economy remains in the Indian market. As mentioned above,
the growth in the Indian private equity market was stimulated in the late 1980s through a
series of measures to establish government sponsored risk capital corporations and capital
gains tax concessions for venture capital investments (Verma, 1997). In 2003, the Asian VC
Guide reported that total funds under management in India were $2.8 billion, an increase of
more than 300 percent since 1998. Another feature of the Indian private equity industry is
that it invests primarily in early stage opportunities (IVCA, 1997). In 2002, India ranked 15th
in the global private equity market. The total invested amount was $590 million, focused
primarily on venture capital investments (see Table 1). Seventy-seven private equity deals
averaging $7.6 million were completed in 2002. Buy-out transactions were common but the
emphasis was on high-technology venture capital transactions.

Table 1. French, German and Indian venture capital markets.

INDIA FRANCE GERMANY

Global ranking based on investments 15 5 3
Global ranking based on growth 82.0% 29.0% 2.0%
Invested amount $590M 4.8B 2.4B
Number of deals 77 1400 876
Average deal size $7.6M 3.4M 2.7M
Number of funds 65 62 80

Source: IVCA, German Venture Capital Association and the French Venture
Capital Association.
Data: India (2002), France (2003), and Germany (2003).
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38 C. Kut & J. Smolarski

3. Private Equity in France and Germany

The French and German venture capital and buy-out markets have been studied in some
detail (e.g., Dubocage et al., 2002; Mayer, 2002; Tykova, 2000). Since these markets are
well developed, we only provide a brief background. The French private equity market was
distributed fairly even between investing in established firms and in small businesses. In
2003, the French Venture Capital association reported that 44 percent of all investments
were made in small firms (see Table 1). Historically, this figure is high due to the absence
of large LBO and MBO transactions in 2003. Total investments amounted to 4.8 billion in
2003 split between 1400 deals, making the average deal size about 3.4 million. The data
from the German Venture Capital Association showed that in 2003, 90.5 percent (793 deals)
of total investments financed small and medium sized firms (see Table 1). However, 50.5
percent of the total invested amount in 2003 funded 20 very large transactions.
In analyzing the difference between the three markets, we make the following observa-
tions. The Franco-German sample is focused on both buy-out transactions and investments
in small to medium sized enterprises. The Indian market is focused primarily on invest-
ments in small- to medium-sized enterprises, although buy-out transactions are common.
As expected, the Franco-German market is much larger, but due to the focus on either very
large or small transactions, the average transaction size is larger in India. The number of
funds is similar in all countries and the average deal size is similar. We acknowledge that
there may be differences in the Indian and Franco-German markets. However, we are unable
to investigate this further since data on the portfolio mix is unavailable due to the non-public
nature of the private equity industry. Information about Indian funds’ portfolio composition
is difficult to ascertain and disclosure in the Franco-German market is incomplete.

4. Risk Management in the Private Equity Industry

To deal with the issues inherent in pre- and post-investment processes, funds develop risk
management processes and risk mitigation strategies to deal with identifiable risks. The pro-
cesses and strategies may be formal and informal. In this study, we classify risk in five main
categories: evaluation of pre-investment risk (new investments), risk in existing portfolio
companies, portfolio risk, macro-oriented risks and other. We argue that a substantial part
of private equity related risks can be derived from the concept of asymmetric information.
Asymmetric information results in two important issues related to risk: agency-principal
relationships (e.g., Jensen and Meckling, 1976) and portfolio management related issues
(e.g., Norton and Tenenbaum, 1993; Elton and Gruber, 1997).
The principal-agent relationship is one of the main bases for our investigation into how
venture capital and buy-out funds manage risks. Principal-agency theory identifies several
problems with this type of relationship. The basic problem is asymmetry of information: the
agent has more information about the business than the principal. The selection, corporate
governance and investment management related issues are paramount to venture capital fund
success. Two specific problems stemming from information asymmetry relating directly to
this study are: the adverse selection problem and the moral hazard problem (Osnabrugge,
2000). In this study, adverse selection refers to misrepresentation by the entrepreneur and
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Risk Management in Private Equity Funds 39

moral hazard refers to the difficulty in aligning the interest of the entrepreneur and venture
capitalist. In practice, principal-agent problems and costs are caused by two primary reasons:
conflict alignment and issues surrounding goal verification.
Designing specialized financial contracts is one possibility of overcoming some of the
costs. However, the theory specifically suggests that optimal contracting requires that the
principal considers foreseeable future contingencies. In managing risks resulting from fore-
seeable and unforeseeable contingencies, complex contracts are often formulated by private
equity funds in order to influence the agent’s behavior or influence the probability of out-
comes of a certain event. 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 but also to monitor pre-agreed goals during the post-investment stage.
If the agent’s actions cannot be observed, the principal may use outcome-based contract-
ing. Examples include financial compensation or financing and expenditure control related
contracts. Outcome based contracts may also be used during the pre-investment process.
Gompers (1995) maintains that three control mechanisms are common to almost all ven-
ture capital investments: (1) the use of financial contracting (most commonly by financing
through convertible securities); (2) syndication of investment; and (3) incremental financ-
ing. Financial contracts are actively used by private equity funds to monitor and mitigate
agency costs due to moral hazard problems. In financial and entrepreneurship terms, the
principal is primarily concerned with determining the optimal contract structure such as the
structure of venture capital equity financing. Reid et al. (1997) suggest that venture capital
funds manage risk within a principal-agent framework. Kaplan and Stromberg (2003) also
maintain that venture capitalists’ primary method of controlling the principal-agent relation-
ship is through financial contracting. Osnabrugge (2000) argues that venture capitalists use
different financial contracting mechanisms to reduce agency risks. Gompers (1995) show
that research and development intense firms receive greater amounts of financing but in
shorter duration, suggesting that these firms are more likely to be financed incrementally
and therefore more tightly monitored. Thus, extant research is broadly supporting the argu-
ment that financial contracting is used by the venture capitalists to manage the principal
agency relationship. Most research dealing with risk management in a venture capital or
buy-out setting involves convertible securities.2
Syndication is one of the major control mechanisms that are available to venture cap-
italists (Gompers, 1995). Venture Capitalists use syndication to confirm investment risk
through the participation of a co-investor, thus decreasing adverse selection problems due
to information asymmetry. Investments are made only if at least two independent observers
agree about the prospects of superior returns (Sah and Stiglizt, 1986). Another venture cap-
italist’s willingness to invest in a potentially promising firm may be an important factor
in the lead venture capitalist’s decision to invest. However, it should be noted that a ven-
ture capitalist who is involved in the firm’s daily operations may exploit this informational
advantage, overstating the proper price for the securities in the next financing round. Admati

2 Due to almost universal use of convertible securities, we do not investigate this area.
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40 C. Kut & J. Smolarski

and Pfleiderer (1994) suggest that the only way to avoid opportunistic behaviour on the part
of the lead investor is if he or she maintains a constant share of the firm’s equity. Lerner
(1994) argues that syndication can be efficient when high information asymmetry is present
in a venture capital financing round, suggesting that syndication is a strategy to mitigate
adverse selection problems.
Another mitigation strategy is staged financing. Staged financing can reduce the agency
costs related to financing small and medium sized enterprises since it artificially creates a
multi-period financial relationship (Duffner, 2003). It mitigates agency problems by reveal-
ing information about the project over time, which is not normally observable in a single
financing round. Staging means that the investor first invests a small amount of capital and,
in subsequent rounds of financing, adds further capital at new valuations (Duffner, 2003).
Using staged financing, a venture capitalist defines goals that the firm has to meet before
any subsequent payouts take place.
Incremental (or staged) financing has a number of implications for both parties. The
venture capitalist maintains the option to abandon a venture that is not developing according
to expectations, thus limiting losses. To the entrepreneur, incremental financing provides
an incentive to reach a predetermined goal. In doing so, it conserves capital and creates
value. However, staged financing may have negative implications as well. Relevant to this
study, using incremental financing may slow down the venture’s development according
to Duffner (2000). Therefore, based on the literature, we argue that it can be expected
that financial contracting mainly reduce moral hazard problems, that incremental financing
also reduces moral hazard problems, and that syndication reduces both moral hazard and
adverse selection issues.
Portfolio risk is another important aspect of managing risk. Private equity portfolio the-
ories and management of existing portfolios have not received significant attention in the
literature and are not well understood. From a historical perspective, there are good rea-
sons for this. Private equity investments tend to be illiquid and data is not readily available.
Illiquidity has a number of implications such as non-observation of short-term returns and
prices. While there are periodic revaluations, these are often subjective. Traditional mea-
sures of risk may therefore be inappropriate for measuring risk and return of private equity
investments (Chiampou and Kallet, 1988). Ljungqvist and Richardson (2003) support this
view. They found that fund returns are unlikely to be explained by either the underlying
systematic or unsystematic risk of the portfolio companies.
Portfolio diversification is an essential and well-known means of controlling risk expo-
sure by reducing unsystematic (firm specific) risk. Weidig (2002) suggests that diversifying
by increasing the number of underlying companies reduce the skewed return distribution
of an individual private equity fund. Diversification would imply maintaining a portfolio
of investments across different investment stages and industries. Ljungqvist and Richard-
son (2003) found that private equity funds are not well diversified. On average, they invest
close to 40 percent of their capital in a single industry. Since portfolio management within
private equity framework is not well studied, we offer exploratory hypotheses, which are
discussed below.
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Risk Management in Private Equity Funds 41

Megginson (2002) showed that the VC industry is segmented into local markets, which
suggests that we can expect national differences in management practices. We expect that
private equity risk management practices are more advanced in the Franco-German markets
compared to India. This argument is primarily based on the number of funds and size of
venture fund industry in these markets. The UK market is probably the most developed
venture capital market in Europe and is characterized by an Anglo-Saxon legal system,
which is indicative of more developed financial markets (see La Porta et al., 1997). La Porta
et al. (1997) argue that legal systems can be divided into four classifications: the English
system, which includes India, the French system, the German system and the Scandinavian
system. Fauver et al. (2003) and Mueller and Yurtoglu (2000) show that the English and
Scandinavian legal systems exhibit the greatest differences. While the French and German
legal systems are different from the English or Anglo-Saxon system, the differences are not
as pronounced as compared to the Scandinavian system (Fauver et al., 2003). La Porta et al.
(1997) and Mueller and Yurtoglu (2000) argue that a common law system provides funds
with better access to equity finance and provide better protection for minority shareholders
and creditors compared to civil law countries. This may affect funds’ risk management
practices, as shown by Lel (2003). Wright et al. (2002) suggest that there are contextual
contrasts between US and Indian private equity 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 results in differences among
venture capital and buy-out funds in different countries. On the contrary, Dossani and Kenney
(2002) argue that Indian expatriates (transfer agents) are able to assist in the transfer of
venture capital ideas, processes and procedures. Based on existing research, we argue that
there are differences between Indian and Franco-German venture capital funds. Relevant to
this study, we expect that Franco-German funds make greater use of formal risk management
techniques compared to Indian funds.
Based on our assertions, literature review and theory development, we developed the
hypotheses presented below. We provide a brief explanation of our expectations and offer
predictions where possible.

4.1. Pre-screening risk management tools

Pre-screening tools represent a major risk management technique prior to investing in a firm
and are commonly used by most private equity funds to minimizing making investments
in sub-performing firms. A wide range of pre-screening tools is available. We argue that
due to informational asymmetry and a less developed legal system available to enforce
financial contracts in developing markets, the two groups will exhibit differences in the use
of pre-screening techniques.

H1: There will be a difference in the use of pre-screening risk management tools and
techniques between the two groups.
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42 C. Kut & J. Smolarski

4.2. Valuation methods

Wright et al. (2004) argue that different legal systems are associated with different valuation
techniques. They found that private equity funds operating in a common-law environment
use different valuation techniques compared to funds operating in a non-English based
system. Our expectation is that Indian funds will make greater use of standardized valuation
techniques such as discounted cash flow analysis.
H2: There will be a difference in the use of valuation methods between the two groups.

4.3. Adjustments
We argue that asymmetric information; principal agency issues and regulatory environments
(e.g., accounting standards) result in differences between the two groups. Asymmetric infor-
mation is likely to be a larger issue for Indian funds. Since the German market is characterized
by a much higher cost structure and less difficulty in obtaining information compared to
India, we predict that German funds will focus more on cost adjustment whereas Indian
funds will focus more on revenue adjustments.
H3: There will be a difference in the use of standard adjustments between the two groups.

4.4. Risk in existing portfolio companies

We expect that the local nature of private equity markets will result in the use of different
techniques in managing risk in existing portfolio companies (Megginson, 2002). In addition,
we expect that emphasis on different types of investments will result in differences in
how funds in the two samples manage risk in existing portfolio companies. Indian funds
focus more on high-technology investments whereas Franco-German funds invest across
industries to a greater extent. The emphasis on shared responsibility in Asia may also play
a role in how firms manage risk (Bruton and Althstrom, 2003). Therefore, we expect that
both outcome- and behaviour based contracts will be used to a larger extent by German
funds. We also expect that Indian funds focus more on managing product development and
technology risks due to their investment emphasis.
H4: There will be a difference in managing risk in existing portfolio firms between the two
groups.

4.5. Portfolio management risk

Portfolio risk can be managed either through specialization or through diversification. While
this area is largely underdeveloped in entrepreneurship research, Megginson (2002) sug-
gests that the private equity industry is segmented into local markets, which may result in
differences in managing portfolio risk between the two samples. Further, since the structure
of the Franco-German market is different compared to the Indian market as outlined above,
we expect that there will be differences between the two groups.
H5: There will be a difference in managing portfolio risk between the two groups.
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Risk Management in Private Equity Funds 43

Note that we are investigating these hypotheses at a lower level rather than at the macro
level presented above. In discussing the results, we focus on the detailed results rather than
individual hypotheses.

5. Data and Methodology

We used a survey instrument to collect non-public fund specific data. The survey instrument
consisted of 18 major questions related to evaluation of new investments, existing portfolio
companies, portfolio risk, macro-risk, and other issues. In addition to the major questions,
we asked 75 sub-questions, which added detail to the breadth of the survey. The survey
utilized several different types of questions but most required the respondents to select their
answers from a 4 point-likert scale.
Our sample consisted of private equity funds available from the data bases of the
European Venture Capital Association (EVCA) and the AsianFN.com databases. We mailed
the survey instrument to funds in France and Germany. In India, we used an online survey
instrument. The mailings took place during the latter part of 2003 and the first half of 2004.
A total of 142 survey instruments were mailed to France and Germany. Thirty-three use-
able forms were returned representing a 23.2 percent response rate. We mailed 65 survey
instruments to Indian funds and received 21 responses, representing a 32.3 percent response
rate. In 2003, there were 80 venture capital and buy-out funds in India. Of these, 15 were
considered non-active since we were unable to (1) contact them via email, telephone or
visit them on-site; (2) verify deal flow or find any investments made by these funds; and
(3) verify their status with IVCA. Thus, we were able to survey the entire population of 65
active funds in India. We divided the sample into two categories: Franco-German versus
India, as previously discussed, and we used tests for differences of rankings between the
samples.

6. Results
In this section, the main results from the study are discussed. First, we discuss the results from
the pre-screening/project phase of a venture capital investment. A section discussing how
funds manage risks in existing portfolio companies follows. The two subsequent discussions
cover portfolio risk and macro risks, respectively. The Franco-German group contains buy-
out and venture capital funds operating in France and Germany. The India group contains
buy-out and venture capital funds operating in India. Note that the Indian and Franco-
German samples are not sufficiently large to allow us to analyze venture capital and buy-out
groups separately.

6.1. Evaluation of new investments

Table 2, Panel A displays the results from the project assessment part of the study. The results
suggest that performing investment legal due diligence is important for a majority of the
funds, ranking highest with a mean score of 2.87. This is followed closely by verifying the
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44 C. Kut & J. Smolarski

Table 2. Evaluation of new investments.

Total FRANCE- INDIA Mann Whitney
GERMANY p-value
n Mean n Mean n Mean
Panel A: Project
a. Invest where the management team is previously 51 1.67 32 1.59 19 1.79 0.24
known to us
b. Make co-investment with trusted partners 52 1.77 33 1.61 19 2.05 0.06
c. Verify track record of the management team 53 2.85 33 2.79 20 2.95 0.17
d. Verify track record on board members 52 2.15 33 2.00 19 2.42 0.10
e. Perform legal due diligence on the firm 52 2.87 33 2.91 19 2.79 0.44
f. Use audited financial statements 53 2.79 33 2.79 20 2.80 1.00
g. Perform product due diligence 53 2.79 33 2.85 20 2.70 0.13
h. Perform product market analysis 53 2.70 33 2.79 20 2.55 0.07
i. Perform customer due diligence 53 2.58 33 2.48 20 2.75 0.15
j. Perform competitor analysis 53 2.77 33 2.79 20 2.75 0.60
k. Consider synergies with existing portfolio 53 1.72 33 1.55 20 2.00 0.12
companies
l. Consider risk preferences of the investors 49 1.94 31 1.77 18 2.22 0.16
in the fund
m. Perform criminal background checks 51 1.37 31 1.32 20 1.45 0.68

Panel B: Valuation Method

a. Internal rate of return (IRR) 52 2.52 33 2.52 19 2.53 0.80
b. Discounted cash flow-techniques (NPV et cetera) 51 2.02 32 1.91 19 2.21 0.12
c. Accounting based techniques (Payback method 49 1.04 30 1.17 19 0.84 0.22
etc.)
d. Economic value added (EVA) 49 1.06 30 1.00 19 1.16 0.51
e. Factors based on sales (e.g., price to sales ratio) 49 1.88 30 1.97 19 1.74 0.47
f. Factors based on earnings (e.g., price to earnings 50 2.32 31 2.29 19 2.37 0.70
ratio)
g. Real options 45 0.78 28 0.61 17 1.06 0.10

Panel C: Standard
a. Lower the firm’s financial revenue projections 49 2.22 31 2.19 18 2.28 0.56
b. Increase the firms cost projections 49 1.90 31 2.06 18 1.61 0.03
c. Increase the time required to reach expansion goals 50 2.04 31 2.13 19 1.89 0.36
d. Use industry averages to check reasonableness 50 2.62 31 2.48 19 2.84 0.03

The table displays descriptive statistics of survey responses on the evaluation of new investments. Panel A contains
results on project assessment, Panel B contains results on evaluation methods, and Panel C contains standard
adjustments. The first two columns contain the total number of respondents and the mean rank. Respondents
could assign the rank zero to three, where 3 = Always, 2 = Often, 1 = Seldom, and 0 = Never. In columns
three to seven, the sample is divided based on country-of-origin for the respondent (France-Germany vs India).
For the divided sample p-values for differences in means are reported, using the Mann Whitney rank summary
statistics.

track record of the management team, performing product due diligence and using audited
financial statements with means of 2.85, 2.79 and 2.79, respectively.
At the project assessment stage, comparisons between the two groups reveal several
significant differences. In general, the results indicate that Indian funds are more likely to
use project assessment techniques compared to their French-German counterparts. Indian
funds make co-investment with trusted partners and verify the track record of board members
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Risk Management in Private Equity Funds 45

more frequently compared to Franco-German funds. Regarding the co-investment category,

we argue that the results may be due to a higher likelihood that information asymmetries
exist in developing countries compared to the developed countries. Lerner (1995) argues
that syndication is a better way to asses the information provided by potential portfolio
companies. Also, Sorensen and Stuart (2002) and Wright and Locket (2002) argue that
reputation of the parties involved in the syndicate is important. Manigart et al. (2002)
suggests that better-established funds with a track record of success will have a more valuable
reputation and will become more attractive partners for other funds.
Regarding the verification of board members, there are major differences between board
structures in various countries. Legal requirements may also play a role in major differences
(Mallin, 2001). For example, France and Germany adopts a stakeholder board model to a
greater extent than firms operating in an Anglo-Saxon legal environment (Reberioux, 2002).
Due to the different legal environment, board structures, and high information asymmetry
problems, Indian funds verify the board members more intensively compared to the French-
German funds.
Franco-German funds perform market analysis more frequently than their Indian coun-
terparts. We speculate that this result may be due to Franco-German funds propensity to
invest in a wider geographic area and across different industries compared to Indian funds.
Market risk may pose greater problems for funds that invest globally. Venture capital funds
generally view market risk as more important than agency risk as they can deal with latter by
contractual arrangements (Fiet, 1995). Although the results are not significant, we argue that
Indian funds verify track record of management more frequently since the degree of agency
related risks are higher. Gupta et al. (2003) argue that venture capital funds look for the past
track record of entrepreneurs and try to collect information from various sources. Gompers
(1995) and Lerner (1995) suggest that venture capitalists limit downside risk exposure by
assessing a number of different elements of risk. Hisrich and Jankowicz (1990) suggest that
managerial experience at a strategic level, a track record of previous success, and relevant
experience in the same industry are highly valued.
Panel B of Table 2 displays the responses to questions regarding valuation methods. The
overall results show that internal rate-of-return (IRR) is the method used most often with
a mean of 2.52, followed by factor based earnings models and valuations models based
on discounted cash flow-techniques with means of 2.32 and 2.02, respectively. It should
be noted that valuation methods such as Accounting based techniques, Economic Value
Added (EVA) and Real options are seldom used among the responding funds. In comparing
valuation methods, we found only one significant distributional difference between the two
groups. Indian funds use Real Options more frequently compared to Franco-German funds.
One possible explanation is that Indian funds use real options as an option to abandon the
venture by not providing additional financing. While not significant, Indian funds also use
Discounted cash flow techniques to a greater extent than their Franco-German counterparts
( p-value = 12%, which is very close to the 10 percent significance level). Our results are
contrary to Wright et al. (2004) and do not support our hypothesis.
Table 2, Panel C displays responses relating to standard adjustment methods that funds
make in evaluating financial projections. On average, funds use industry averages to check
March 21, 2006 8:56 WSPC WS-JDE SPI-J076 00025

46 C. Kut & J. Smolarski

reasonableness, lower the firm’s financial revenue projections, as well as increasing the time
to reach expansion goals on a regular basis with means of 2.62, 2.22 and 2.04, respectively.
We found differences between the two populations. In evaluating investment opportunities,
Franco-German funds increase the firm’s cost projections to a greater extent and, while
insignificant, the results also point to Franco-German funds increasing the time to reach
the expansion goals on a regular basis. Indian funds use industry averages to check the
reasonableness of cost and revenue projections to a greater extent compared to their French-
German counterparts.
In summary, the results suggest that Indian and French-German funds favor pre-
screening risk assessment methods. The results are generally consistent with adverse selec-
tion theory and extant literature, except for Wright et al. (2004). The main difference between
the two populations in terms of standard adjustments (Panel C, Table 2) is that Indian
funds favor verifying projections using industry averages whereas funds in the Franco-
German population favor increasing cost projections. Adjusting revenue projections is also
a common technique in both samples. Based on the results, our hypothesis is only partially
supported.

6.2. Risk in existing portfolio companies

Table 3, Panel A displays responses to questions concerning the fund’s risk management
practices in existing portfolio companies. Panel B and C concerns the efficiency of financial
contracts. Overall, lack of management performance is seen as the most important risk in
managing companies with a mean value of 2.77. Also, the lack of management focus, the
risk of aligning managements’ interest with those of venture capitalist and financial risk are
also seen as important. Although the Mann-Whitney tests do not show much significance,
some of the results warrant additional consideration. Franco-German funds consider align-
ing the management’s interest with those of venture capitalist a significantly more important
risk in managing their portfolio companies compared to their Indian counterparts. Bruton
et al. (1999) suggest that because of the emphasis on shared responsibility in Asia, the rela-
tionship between entrepreneurs and venture capital funds may be seen as part of a unified
network rather than within a traditional western-style agency framework. Indian funds may
therefore perceive less of a need to control agency risks through formal arrangements.
Operational risk not related to management is considered of low importance, perhaps
reflecting the view that operational risk cannot be managed without negative impact on
the development of the business. In aligning the interest of venture capitalist with that
of the entrepreneur, financial compensation is rated as the most effective outcome based
contract by all funds. However, there are no significant distributional differences between
the funds in the two samples in rating outcome-based contracts. In general, staged finance
is seen as an effective method to deal with outcome based principal-agent problems. We
support Megginson’s (2002) argument that the staged financing is not only an effective way
to minimize risk but also provides a valuable option to deny or delay additional funding.
Control of management focus is rated as the most effective behavior based contract by
all funds. Significantly, the Franco-German funds rate the Control of the development of
business model more effective compared to their Indian counterparts. This may be the result
March 21, 2006 8:56 WSPC WS-JDE SPI-J076 00025

Risk Management in Private Equity Funds 47

Table 3. Risk in existing portfolio companies.

Total FRANCE- INDIA Mann Whitney

GERMANY p-value
n Mean n Mean n Mean
Panel A: Important Risks in Managing Companies
a. Lack of management performance 52 2.77 33 2.79 19 2.74 0.25
b. Lack of management focus 52 2.50 33 2.48 19 2.53 0.80
c. Aligning management’s interest with those of the 52 2.25 33 2.30 19 2.16 0.37
venture capitalist
d. Product development risk 52 1.88 33 1.82 19 2.00 0.43
e. Technology risk 52 1.94 33 1.91 19 2.00 0.80
f. Financial risk 52 2.15 33 2.15 19 2.16 0.99
g. Operational risk not related to management 51 1.75 33 1.82 18 1.16 0.36
Panel B: Rating Outcome Based
a. Financial compensation 48 2.44 31 2.52 17 2.29 0.13
b. Stages finance 47 1.72 30 1.63 17 1.88 0.40
c. Expenditure control 47 1.81 30 1.93 17 1.59 0.11
Panel C: Rating Behaviour Based
a. Control of the development of the 49 2.14 30 2.33 19 1.84 0.02
b. Control of management focus 49 2.16 30 2.20 19 2.11 0.53
c. Control of expansion (functional and geographic) 49 1.90 30 1.93 19 1.84 0.73

The table displays descriptive statistics of survey responses on the risks of existing portfolio investments. Panel A
displays the responses to questions on risks of existing portfolio companies. For the questions in Panel A, the
respondents could assign the rank zero to three, where 3 = Very Important, 2 = Important, 1 = Somewhat
Important, and 0 = Not Important. Panels B and C report on questions on financial contracting. For the questions
in Panels B and C, the respondents could assign the rank zero to three, where 3 = Very Effective, 2 = Effective,
1 = Not Effective, and 0 = Do Not Use. The first two report columns contain the total number of respondents
and the mean rank. In columns three to seven, the sample is divided based on country-of-origin for the respondent
(France-Germany vs. India). For the divided samples p-values for differences in means are reported, using the
Mann Whitney rank sum statistic.

of Franco-German funds investing across countries and industries to a greater extent than
their Indian counterparts.
Our results, while providing direction, are inconclusive. Extant research suggests that
it is difficult to write a complete contract due to regulatory restrictions or lack thereof. We
also suggest that enforcement may be difficult or that there are alternative mechanisms,
which may be used to circumvent contractual intentions. While not directly supportive, La
Porta et al. (1998) show in their assessment that risks associated with undertaking certain
types of contracts in India, such as contract repudiation and corruption, are markedly higher
compared to developed countries. Pruthi et al. (2003) argue that the weaker contracting
environment in India reinforces problems in using contracts to deal with agency risks.

6.3. Portfolio risk

Table 4 displays responses to questions concerning portfolio risk in venture capital funds.
Responses in Panel A suggest that 80 percent of the respondents consider their portfolio
holdings when evaluating a new project.
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48 C. Kut & J. Smolarski

Table 4. Portfolio risk.

Total FRANCE- INDIA Chi Square
GERMANY p-value∗
n Mean n Mean n Mean
Panel A: Do you consider how a new project affects
total risk of your investment
49 0.80 32 0.81 17 0.76 0.69
Panel B: Important Risks in Managing Companies
a. Volatility of earnings 43 0.63 28 0.54 15 0.80 0.09
b. Volatility of cash flows 45 0.71 29 0.69 16 0.75 0.67
c. Value-at-Risk 42 0.64 27 0.70 15 0.53 0.27
d. Volatility of existing portfolio companies’ values 45 0.64 28 0.64 17 0.65 0.98
Panel C: Actively Diversifying By
a. Investing vertically from existing 44 0.45 28 0.29 16 0.75 0.00
b. Investing in other sectors of the economy 48 0.67 31 0.74 17 0.53 0.14
c. Investing in other geographic regions 46 0.39 29 0.41 17 0.35 0.68
d. Syndicate investments 50 0.76 31 0.65 19 0.95 0.02

Panel D: Tools To Measure Financial Risk

a. Beta 38 0.37 23 0.22 15 0.60 0.02
b. Standard deviation 36 0.25 21 0.14 15 0.40 0.08
c. Correlation with the stock market 39 0.56 23 0.52 16 0.63 0.52
d. Correlation with other companies in your portfolio 39 0.74 24 0.79 15 0.67 0.38

Panel E: Do you actively try to invest horizontally,

i.e., invest in companies in the same industry as
existing portfolio companies?
49 0.51 31 0.42 18 0.67 0.10

Panel F: Do you hedge your stakes in publicly

quoted companies?
50 0.12 32 0.03 18 0.28 0.01

Panel G: Do you hedge your stakes in privately

owned portfolio firms?
50 0.18 32 0.13 18 0.28 0.18
Panel H: Tools To Hedge Financial Risk
a. Insurance 38 0.24 22 0.18 16 0.31 0.35
b. Hedging using futures 37 0.08 22 0.00 15 0.20 0.03
c. Forward contracts 38 0.11 22 0.05 16 0.19 0.16
d. Standardised derivatives (i.e. options traded on 37 0.05 22 0.00 15 0.13 0.08
a stock exchange or over-the-counter)
e. Customised derivatives (i.e. options that are 37 0.03 22 0.00 15 0.07 0.22
not traded)

The table displays descriptive statistics of survey responses on portfolio risk. Panel A and B contain results on
risk assessment for the total portfolio, Panel C contains results on diversification, Panel D contains results on
risk measurement, Panel E contains additional questions on diversification and hedging, and Panel F contains
results on the use of financial instruments. The first two columns contain the total number of respondents and
the mean rank. For all questions, the respondents could reply “Yes” or “No”. In columns three to seven, the
sample is divided based on country-of-origin for the respondent (France-Germany vs India). For the divided
samples p-values for differences in proportions, using the Pearson Chi-square statistic (Panels A-F), and for
differences in mean rank, using the Mann Whitney rank sum statistic (Panels G and H) are reported.
March 21, 2006 8:56 WSPC WS-JDE SPI-J076 00025

Risk Management in Private Equity Funds 49

The next set of questions (Panel B) refers to risk measures used by the funds. Volatility
of cash flows is used by a large majority of funds (71 percent) followed by value at risk
and volatility of existing portfolio company values (both 64 percent). The results show that
most of the funds consider how a new project affects the total risk of their portfolios. In
comparing the two groups, we find that Indian funds are more likely to use volatility of
earnings as a risk management tool compared to Franco-German funds.
Panel C displays how funds view active portfolio diversification. A majority of funds
transfer and diversify their portfolio risk by syndicating their investments, followed by
actively diversifying their portfolios by investing in other sectors of the economy. Traditional
financial theory shows that building a well-diversified portfolio can reduce risk without
reducing return. The risk of any investment can be subdivided into non-systematic risk
and systematic risk. Holding a well-diversified portfolio of investments, which means that
the variation in returns is reduced without reducing the expected return of the portfolio,
eliminates systematic risk. However, it is also well known by scholars and professionals,
that systematic risk cannot be totally eliminated. Therefore, risk will still remain for a well-
balanced portfolio (Manigart et al., 2002). From a private equity perspective, funds syndicate
because a fully diversified portfolio is more difficult to obtain for illiquid assets compared
to institutional investors who invest in listed (liquid) stocks. This occurs partly because of
the presence of large ex-ante asymmetric information problems in private equity investment
decisions, which is less of a problem in listed companies, and partly because of the capital
constraints, due to the relatively small size of many funds (Reid, 1998; Sahlman, 1990).
Syndication provides the opportunity to invest in a larger number of portfolio companies
than would otherwise be possible, thereby increasing diversification and reducing the overall
fund risk.
The results of our study show that Indian funds actively diversify their portfolios by
investing vertically and syndicate their investments to a greater extent than their Franco-
German counterparts. Investing vertically is a form of specialization that may allow Indian
private equity funds to decrease risk associated with the supply chain to a greater extent
than their Franco-German counterparts. We argue that Indian venture capitalists use both the
classic Finance perspective and new school financial risk management techniques, which
are being implemented across private equity markets. Diversification benefits may also be
achieved by specializing. Investors focusing on early stage financing are less diversified
across different industries and firms.
Moreover, venture capitalists appear to specialize in certain stages rather than spread
their investments across different stages. We do not test for this. The practice of specializa-
tion is feasible because mainline portfolio theory does not apply to venture capital investing
(Norton and Tenenbaum, 1993). Norton and Tenebaum (1993) also suggest that specializa-
tion is alternative to diversification since knowledge of certain technologies and products
results in a high informational advantage. The high fixed costs of gaining expertise in techni-
cal and product areas means that specialization is an alternative to portfolio diversification.
We also speculate that the differences across the two samples are due to a difference in
investment focus.
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50 C. Kut & J. Smolarski

In analyzing the tools to assess and manage financial risks (Panel D), it appears that the
use of financial risks measurement tools is generally low. Correlation with other companies
in the portfolio and correlation with the stock market show the highest scores. Indian funds
are more likely to use beta and standard deviation compared to Franco-German funds in
measuring financial risk.
Panel E and F display the results for investing and hedging strategies. Most funds actively
try to invest horizontally to manage risk but they are less likely to hedge their stakes in either
publicly quoted or privately held firms. This is surprising since the benefits of hedging are
well documented. There are significant proportional differences between groups; Indian
funds actively try to invest horizontally and hedge their stakes in publicly quoted compa-
nies more compared to their counterparts. There are a number of potential explanations why
Indian funds attempt to invest horizontally. First, it is consistent with behavior in developing
markets where funds may face limited opportunities at any given time. This is problematic
since fund investors may only make funds available for a limited time period. If the funds
are not invested, they are returned to the fund investor. There may also be limited oppor-
tunities to diversify through specialization. Second, it is possible that asymmetric informa-
tion issues and underdeveloped enforcement mechanisms cause Indian private equity funds
to attempt to control risk through horizontal investing, in addition to investing vertically.
Third, the Indian venture capital market is more focused on high technology compared to
the Franco-German markets suggesting that Indian funds actively invest horizontally to try
to achieve a higher return for a given level of risk. This is consistent with traditional portfolio
theory.
The results are partially indicative that Indian funds attempt to use specialization as a
means of diversifying. On the other hand, Indian funds also invest horizontally. Too few
investment opportunities and the nature of the deal flow may explain this result. The results
also show that Franco-German funds use diversification as an attempt to reduce portfolio
risk.
Table 4, Panel H, shows responses to questions concerning the respondents’ use of
financial instruments. Responding funds do not use derivatives and futures to any greater
extent. In general, most funds in our survey are more likely to use insurance and forward
contracts to hedge financial risk. Indian funds are more likely to hedge their financial risk
by using futures and standardized derivatives compared to Franco-German counterparts.
Over-the-counter derivatives are rarely used. It should be noted that these results only show
proportional differences between two groups and not the extent to which they are used.
There may be many reasons for these results. First, management agreements between the
fund management company and their investors may prohibit the use of derivates. Second,
lack of knowledge on the part of fund managers may prevent their use in significant terms.
Third, it is possible that recent events such as Enron have resulted in a pullback in the
use of derivatives. Fourth, the general lack of liquidity for some derivatives may make
it prohibitively expensive to hedge. The results suggest a lower degree of sophistication
in private equity markets compared with more developed financial markets, e.g., stock
markets.
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Risk Management in Private Equity Funds 51

6.4. Macro risks and other issues

Table 5 presents evidence regarding the funds’ hedging of macro risks and their participation
in the board and management-level of investee firms. In managing macro-oriented risks,
foreign exchange risk and interest rate risk appear to be seen as the most important macro
risk to be hedged by all funds. In comparing the groups, the results suggest that business
cycle risk and inflation risk appear to be more important to Indian funds. We speculate that
Franco-German funds are more likely to make investments globally so these funds may have
longer time horizons for their investments and therefore need to manage interest rate risk to
a greater degree compared to domestic or foreign subsidiary funds operating only in India. A
size effect, which is well documented in empirical research (see, e.g., Bodnar et al., 1998),

Table 5. Macro risks and other issues.

Total FRANCE- INDIA Chi square
GERMANY p-value∗
n Mean n Mean n Mean
Panel A: Hedging of Macro Risks
a. Foreign exchange risk 47 0.40 29 0.34 18 0.50 0.29
b. Interest rate risk 48 0.29 30 0.37 18 0.17 0.14
c. Business-cycle risk 46 0.17 29 0.10 17 0.29 0.10
d. Inflation risk 46 0.09 29 0.03 17 0.18 0.10
Panel B: Board and Management Meetings Mann Whitney
a. How many board meetings do you attend p-value
each year?
Large investments 45 6.56 27 7.48 18 5.17 0.19
Small investments 42 8.65 24 9.40 18 7.67 0.29
b. On average, how many hours does each board
meeting last?
Large investments 43 5.88 26 5.92 17 5.82 0.07
Small investments 40 7.35 23 6.13 17 9.00 0.00
c. How many times per year do you
meet with management?
Large investments 44 7.70 26 11.08 18 2.83 0.00
Small investments 42 7.67 24 11.88 18 2.06 0.00
d. On average, how many does each meeting
with management last?
Large investments 41 3.98 24 4.88 17 2.17 0.17
Small investments 38 3.75 21 4.98 17 2.24 0.04

*Pearson Chi-square test.

The table displays descriptive statistics of survey responses on macro risks and the participation in portfolio
firms’ management. Panel A contains results on the hedging of macro risks, and Panel B contains results on
the participation in board and management meetings For questions in Panel A, the respondents could reply
“Yes” or “No”. For questions in Panel B, respondents answered by number of times or number of hours, as
appropriate. In columns three to seven, the sample is divided based on country-of-origin for the respondent
(France-Germany versus India). For the divided samples p-values for differences in proportions, using the
Pearson Chi-square statistic (Panel A), and for differences in sample median, using the Mann Whitney rank
sum statistic (Panel B) are reported.
March 21, 2006 8:56 WSPC WS-JDE SPI-J076 00025

52 C. Kut & J. Smolarski

may play a role in determining hedging of FX exposures. Gupta et al. (2003) states that if
investee companies operate in export markets, take on foreign currency loans, or imports raw
materials or machinery, they become more vulnerable to the fluctuations in foreign exchange
rates. FX exposure may be hedged either by the portfolio firms themselves or by the fund.
Hedging by funds may or may not benefit the portfolio firms depending on contractual
relationships and whether fund exposure is inter-related with portfolio company exposure.
Provided that Franco-German portfolio companies are more exposed to the Euro-zone, they
have a lesser need to hedge FX exposure compared to Indian funds. The results support
this view.
Franco-German funds attend longer board meetings for large investments, use occa-
sional meetings with the management team to a greater extent for large and small investments
and also have, on average, longer meetings with the management for small investments com-
pared to Indian funds. On the other hand, Indian funds attend much longer board meetings
for small investments compared to Franco-German funds. Since the results are highly sig-
nificant, we argue that Franco-German funds have a more developed corporate governance
structure. We speculate that differences between groups on formal and informal meetings
have specific properties. Supporting low-level differences, funds in both samples use formal
board meetings to a large extent but Franco-German funds make significantly more use of
management meetings.

7. Conclusion
Much research exists dealing with various aspects of the principal agent problem. Relevant to
this study is the research covering information asymmetries based on the strong quantitative
theory within microeconomics and classical finance contract theory. Empirical research on
agency theory and specifically information asymmetries also exist within a private equity
framework. We also analyzed the existing literature dealing with different legal frameworks,
as we predicted that it might have an impact on how funds manage risks.
Our findings partially support previous research findings. We find that evaluation cri-
teria are partly used to mitigate adverse selection problems. In general, all funds tend to
favor pre-screening risk assessment methods. Specifically, Indian funds favor more project
assessment techniques compared to Franco-German funds. There are differences between
the two populations in valuation methods and standard adjustment techniques but they are
mainly directional. The questions concerning the fund’s risk management practices in exist-
ing portfolio companies are rated as high in importance but we did not note significant
differences between the groups. An interesting finding was that Indian funds do not see
financial contracting as efficient in dealing with risk as their Franco-German counterparts
do, suggesting that their respective legal frameworks play a role in how risks are managed.
The lack of exact investment and portfolio theory covering investments in illiquid assets
leads us to speculate about our findings. We find that the country of origin defines the activity
of measuring risk and hedging as well as managing financial and portfolio risk. We speculate
that the regulatory environment affects risk management preferences. Surprisingly, since
their investment and financing alternatives may be restricted compared to those available
March 21, 2006 8:56 WSPC WS-JDE SPI-J076 00025

Risk Management in Private Equity Funds 53

to Franco-German funds, portfolio risk management strategies appear to be used more

frequently by the Indian funds. We also argue that Indian funds are more likely to use classical
financial tools, techniques and measures. Most funds in the study show a reluctance to use
financial instruments for hedging. We also observed that corporate governance structures
vary according to the country of origin. The involvement of Indian Venture Capitalists in
management meetings lags behind their Franco-German counterparts.
Based on the overall results, we argue that risk management techniques specific to private
equity investments like pre-investment screening, syndication and specialization are being
used more widely by Indian funds in managing risk. We argue that portfolio risk management
is an underdeveloped area among all funds. Our results suggest that risk management styles
vary according to country of origin. There is a collective trend in evaluating and controlling.
We also note different structures in formal-informal corporate governance.
There are several limitations associated with this study. First and foremost, our small
sample size prevents us from conducting further statistical analysis. As a result, we do not
capture within-sample differences such as differences between venture capital and buy-out
funds. Any study that uses a likert-scale is prone to differences in how respondents interpret
the scale. In addition, while we believe that the samples are compatible, we base this assertion
on incomplete information, a common trait in private equity research. As we did not consider
all possibilities, there may be other factors that help explain differences between the groups.
Then there is the obvious question of country selection. Our results may, to some degree, be
driven by the choice of countries. Part of our motivation for comparing Franco-German and
Indian funds has to do with existing research, which deals primarily with the US and UK
private equity markets. Within the non-Anglo Saxon markets in Europe, we selected France
and Germany since they represent the largest private equity markets outside the UK. It is
possible that our results may have been different had we selected other countries in Europe.
The same may have held true had we selected other countries in Asia. We conclude from
our study that venture capital corporate governance is a fruitful area for future research. In
addition, portfolio management relating to venture capital financing is an underdeveloped
area where research is needed. Finally, comparative studies investigating how private equity
funds in other countries manage risk are also needed.

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