Venture Capital and Other Private Equity A Survey

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Venture Capital and Other Private Equity A Survey,Andrew Metrick and Ayako Yasuda. NBER Working Paper No 16652,December 2010,JEL No G24. We review the theory and evidence on venture capital VC and other private equity why professional. private equity exists what private equity managers do with their portfolio companies what returns. they earn who earns more and why what determines the design of contracts signed between i private. equity managers and their portfolio companies and ii private equity managers and their investors. limited partners and how whether these contractual designs affect outcomes Findings highlight. the importance of private ownership and information asymmetry and illiquidity associated with it. as a key explanatory factor of what makes private equity different from other asset classes. Andrew Metrick,Yale School of Management,135 Prospect Street. P O Box 208200,New Haven CT 06520,metrick yale edu. Ayako Yasuda,Graduate School of Management,3206 Gallagher Hall.
One Shields Ave,Davis CA 95616 8609,asyasuda ucdavis edu. 1 Introduction, Worldwide private equity funds manage about 2 5 trillion TheCityUK 2010 p 2. While buyouts BO generally account for one half to two thirds of private equity investments by. value venture capital VC accounts for the majority of investments by number of deals The. industry underwent an extraordinary growth in the last 15 years increasing from 100 billion in. 1994 Fenn and Liang 1998 p 2 A main driver of this change was institutional investors. portfolio allocation to private equity which increased from 3 2 on average in 1997 to 12. 6 in 2007 for large foundations endowments 1 Private equity funds roles in the economy. and their managerial compensation drew scrutiny among policymakers in the aftermath of the. 2007 8 financial crisis and there is an ongoing debate about increasing taxation on private equity. managers profit participation carried interest and on the industry s impact on innovation. competition and employment The industry has rapidly globalized in recent years with China. receiving the third highest investment after U S and U K in 2008 2009 followed by France and. India 2 Reflecting their increasingly important roles as financial intermediaries and as activist. investors the literature studying venture capital and other private equity e g buyouts funds has. grown significantly in the last decade, In this paper we review the literature on the following topics why professional private. equity exists what private equity managers do with their portfolio companies what returns they. earn who earns more and why what determines the design of contracts signed between i them. and portfolio companies and ii them and their investors limited partners and how whether. these contractual designs affect outcomes, To the best of our knowledge this is the only survey paper that treats both the venture. capital VC and the buyout BO segments as subsets of a broader private equity industry By. doing so we highlight similarities among them what makes them both private equity in. Cambridge Associates estimates,TheCityUK 2010 p 1 Table 1.
contrast to the public equity markets Key defining characteristic is the illiquidity of the capital. and the information asymmetry between insiders and outsiders of the firms Often times the. focus in the literature is on leveraged in the leveraged buyouts even though an LBO is just. one of many deal structures that private equity investors employ to deploy their fund capital We. instead focus on what distinguishes both the venture capital and buyout funds from other. investment management vehicles such as hedge funds and mutual funds and discuss the theory. and evidence on this private equity industry both as financial intermediaries and as an asset. The paper proceeds as follows We begin in Section 2 by defining private equity and then. discussing theories that motivate the existence and economic rationale for venture capital and. buyout specialists respectively Both VCs and BO investors are financial intermediaries that. raise funds from institutional investors and invest in private illiquid companies They are both. activist investors that exercise significant control rights over their portfolio companies and aim to. maximize financial returns on behalf of their investors Theories explaining the rationale for VC. emphasize the information asymmetry between entrepreneurs and investors and contrast VCs. superior information production ability vis vis banks Theories explaining the rationale for BO. instead assume that BO targets are public firms and either highlight the improved managerial. incentives of LBO firms as compared with those given to public company CEOs or are. concerned more broadly with the question of why firms go private Neither strand of theories. explains why private firms become targets of BO funds. Section 3 reviews the broad literature that documents the economic value added. activities of VC and BO investors The literature identifies three groups of economic activities. For survey papers focusing on venture capital see for example Fenn and Liang 1998 Gompers and Lerner 2001. and Denis 2004 and more recently Kaplan and Lerner 2010 and Krishnan and Masulis forthcoming for survey. papers focusing on buyouts see among others Cumming et al 2007 and Kaplan and Stromberg 2009 For a. broader survey on financial intermediation that includes private equity see Chemmanur forthcoming Also see. Lerner forthcoming, for both VC and BO namely 1 pre investment screening activities 2 monitoring governance. activities during the holding period and 3 influencing and orchestrating exiting activities. In Section 4 we focus on the performance of the private equity funds We begin by. discussing the levels of risk adjusted returns We then review the evidence on performance. persistence and various sources of both the level of excess performance and its persistence The. extant evidence on excess performance and its persistence in private equity is mixed we. provide several reasons as to why this is and suggest futures areas for research. In Section 5 we discuss the strand of literature that examines features of contracts signed. between private equity fund managers and their investors as well as contracts signed between. private equity fund managers and their portfolio companies Both VC and BO funds are. organized as closed end finite life limited partnerships with fund managers serving as general. partners GPs and investors as limited partners LPs Partnership agreements set management. fees carried interest and in case of BO funds terms of transaction fees and monitoring fees The. agreements also restrict activities of the fund managers through various covenants The literature. on VC contracts has focused on the use of convertible securities staged financing syndication. voting rights and board rights In contrast to the extensive literature on the VC contracts the. theoretical literature on the BO contracts is almost nonexistent Evidence from existing empirical. analyses suggest that agency problems between GPs and LPs of BO funds may be exacerbated. when cheap debt is available and allows GPs to collect large fees from portfolio companies. upfront in the form of transaction fees, Finally in Section 6 we conclude with a summary of what we know and what still needs to. be learned, 2 Why Do Venture Capital and Private Equity Markets Exist. 2 1 What is Private Equity, We provide a definition of private equity funds by listing the following main characteristics. 1 A PE fund is a financial intermediary meaning that it takes the investors capital and invests. it directly in portfolio companies, 2 A PE fund invests only in private companies This means that once the investments are made.
the companies cannot be immediately traded on a public exchange. 3 A PE fund takes an active role in monitoring and helping the companies in its portfolio. 4 A PE fund s primary goal is to maximize its financial return by exiting investments through a. sale or an initial public offering IPO, Characteristic 1 defines PE funds as financial intermediaries and differentiates it from angel. investors and private investment companies that use their own capital Typically these funds are. organized as limited partnerships with the venture capitalists or the buyout firm partners acting. as the general partners GPs of the fund and the investors often pension funds endowments. and other institutional investors acting as the limited partners LPs Potential agency conflicts. between GPs and LPs are addressed by contractual provisions in the limited partnership. agreements and have been examined in the literature as discussed below. Characteristic 2 is the most obvious defining feature of private equity and distinguishes. it from both the traditional investment assets of stocks and bonds as well as the other alternative. asset of hedge funds Figure 1 illustrates the relationship between various asset classes within. private equity and also between private equity and other asset classes Within private equity. there are four main subclasses of which VC and BO are the largest and most important two. Overlapping circles in Figure 1 indicates where the scopes of neighboring groups overlap for. example the mezzanine category comprises both growth equity that overlaps with later stage. venture capital and the subordinate debt layer of buyout transactions which is often attached to. some equity ownership and thus overlaps with both venture capital and buyouts Distressed. investing on the other hand can be thought of as a specialized segment of buyouts that target. mature and distressed companies, In all four cases portfolio companies of private equity funds are private companies for. which little public information exists Thus information asymmetry is thought to be far greater. in private equity compared with investments in public companies that must file regular reports. with the SEC and also are often covered by Wall Street analysts As a result portfolio values of. private equity funds are not marked to market and fund returns are not finalized until the end of. the funds lifetime In contrast while some hedge funds participate in private equity transactions. especially larger companies that buyouts and distressed investors invest in they are primarily. investors in publicly traded assets such as stocks and bonds and their portfolios are marked to. Characteristic 3 is central to the raison d tre of private equity and potentially a key. determinant of a given PE fund s performance While all active investment fund managers. mutual funds hedge funds and private equity funds select their stocks and are evaluated on. their ability to pick winners not all of them actively influence actions of the management of the. companies they invest in Except for large blockholders who gain seats on the boards of public. companies public company investors ability to influence the management is severely limited In. contrast private equity investors often condition their investments on contractual provisions such. as board seats veto rights and various contingent control rights that enable them to influence the. actions of the management while they hold their investments In Section 3 we provide an. extensive review of the literature s findings on these monitoring value adding activities. performed by PE fund managers, Finally since PE funds are financial intermediaries they need some mechanism to give. money back to their investors which gives rise to Characteristic 4 Exits can occur through an. IPO with a subsequent sale of the PE stake in the open market through a sale of the company to. another investor especially to another BO fund or through the sale of the company to a larger. company The requirement to exit and the focus on financial return differentiates PE from. strategic investments done by large corporations While corporations are active both in VC and. BO markets their investment criteria are different from professional PE because of the lack of. need for exits and greater emphasis on synergy with their existing operations. To summarize PE funds differ from both mutual funds and hedge funds in that they. invest in illiquid private companies and differ from corporations in that they are required to. return money to investors within a finite investment horizon and thus need to focus on targets. with a clear path to exits These functional differences are reflected in the ways PE funds are. organized in contrast to hedge funds and mutual funds and as described in Table 1 PE funds. have a finite life typically 10 years and a fixed fund size that is determined at the time of. the fund inception Both hedge funds and mutual funds are open ended and do not have a finite. fund lifetime Within the fund lifetime investors in PE funds must commit to illiquidity of up to. 10 years unlike hedge funds and mutual funds both of which allow redemptions on demand. subject to some waiting period, Because of the illiquidity and the long term nature of PE investments reinvestments are. not permitted or restricted to a modest fraction of the fund size in contrast hedge fund and. mutual fund investors are offered options to automatically reinvest any dividends and. distributions from funds on an on going basis PE fees are often highest first and decline in later. years because successful managers are expected to raise follow on funds with new fee streams. Venture Capital and Other Private Equity A Survey Andrew Metrick and Ayako Yasuda NBER Working Paper No 16652 December 2010 JEL No G24 ABSTRACT We review the theory and evidence on venture capital VC and other private equity why professional private equity exists what private equity managers do with their portfolio companies what returns they earn who earns more and why what

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