RISK MANAGEMENT IN PRIVATE EQUITY FUNDS: A COMPARATIVE STUDY OF INDIAN AND FRANCO-GERMAN FUNDS

1. Introduction

Global expansion in venture capital and buy-outs has increased the number of funds operating 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 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: prescreening, 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 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.

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 euro4.8 billion in 2003 split between 1400 deals, making the average deal size about euro3.4 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 observations. 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 investments 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 processes 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 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 foreseeable 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 outcomes 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 contracting. 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 venture capital investments: (1) the use of financial contracting (most commonly by financing through convertible securities); (2) syndication of investment; and (3) incremental financing. 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 relationship 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 argument 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 capitalists (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 capitalist'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 venture 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 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 revealing 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 theories 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 reasons for this. Private equity investments tend to be illiquid and data is not readily available, !!liquidity 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 measures 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 exposure 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 Richardson (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.

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.

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 information 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) suggests 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.

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 useable 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 buyout 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 FrancoGerman 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 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 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 FrenchGerman funds.

Franco-German funds perform market analysis more frequently than their Indian counterparts. 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 cashflow-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 cashflow 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 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 prescreening risk assessment methods. The results are generally consistent with adverse selection 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 aligning 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 relationship 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 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.

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 wellbalanced 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 FrancoGerman 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 arc 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 specialization is feasible because mainline portfolio theory does not apply to venture capital investing (Norton and Tenenbaum, 1993). Norton and Tenebaum (1993) also suggest that specialization 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 technical 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.

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 companies 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 opportunities to diversify through specialization. second, it is possible that asymmetric information 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.

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), 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 occasional 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 compared 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 significant, 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 criteria 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 existing 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 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.