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Private equity firms manage some $1 trillion of global capital, yet because they are highly secretive, much remains unknown about their internal economics. How do PE firms organize themselves, for example, and how do they capitalize on their success?
Some answers emerge from a paper by Wharton finance professor Ayako Yasuda and Yale School of Management finance professor Andrew Metrick titled, “The Economics of Private Equity Funds.” The paper was presented at a recent Wharton conference, sponsored by the Weiss Center for International Financial Research, whose theme was “A Global Perspective on Alternative Investments.” The authors gained access to an unusually fertile data set, the private equity portfolio of one of the world’s largest limited partner investors. On condition of anonymity, the investor furnished data on 238 different PE funds in which it had invested between 1992 and 2006. Of those 238 investments, 144 were buyout funds and the other 94 venture capital funds.
Stable Fee Revenues
The study’s most important conclusions, according to Yasuda: First, some 60% of PE firm revenues come from fixed-revenue components that are unaffected by performance; and second, while venture capital firms tend to earn more than buyout firms per dollar under management, buyout funds are substantially more scalable and, therefore, can earn much more per partner and per employee. In addition, managers of successful funds can command better terms for themselves as they launch new, larger funds.
Most private equity funds take the form of limited partnerships, with a PE firm serving as general partner; the limited partners — large institutions and wealthy individuals — put up the bulk of the capital. Each limited partnership typically lasts for 10 years, with terms of the general partner’s compensation spelled out at the fund’s inception. The general partner’s compensation contains a fixed component — an annual management fee of 2% or more — plus a variable component that includes carried interests in partnership holdings. Successful buyout firms often lay claim to some of the transactions fees that their funds generate. In addition, the most powerful limited partners — large state pension funds, for instance — may also command a share of the carried interest.
Private equity firms stay in business by launching new funds every three-to-five years. If a firm’s previous funds have been successful, it can generally earn higher revenues with the new one by setting higher fees, demanding more variable compensation and raising more capital.
But there are striking differences in strategy and practice between venture capital and buyout funds — the principal components of the private equity industry. To begin with, Yasuda notes, the study confirms what many investors already sense — that the economics of venture capital and buyout firms are different, even though both depend upon fixed management fees for the preponderance of their revenues. The differences lie not only in the superior scalability of buyout versus venture capital funds, but also in the fundamental skill sets required.
Venture capitalists tend to be scientists and engineers by training, with the necessary experience in operations, marketing, management and related skills to help small companies grow. Early-stage investing is time- and labor-intensive, notes Yasuda, and even experienced VC professionals have difficulty overseeing more than five companies at once.
The typical venture capital firm has five partners and invests in five companies per year over the first five years of a fund’s 10-year life, with the value of each early-stage investment rarely exceeding $100 million. On average, each VC professional is apt to be responsible for one new investment a year during the fund’s first five years — for an aggregate investment of $350 million to $500 million. That professional typically spends the fund’s second five years aggressively fostering and monitoring those five companies.
VC funds tend to derive the bulk of their revenues from just 20% of their investments. They depend on hitting a “home run” — a return five times greater than invested capital — with one in every five investments. Another 20% of VC investments can be expected to fail or achieve minimal returns, with the remaining 60% returning an average 2.5-to-3 times invested capital — not a fabulous result, considering the risks, but one most firms can live with.
Larger, more successful VC firms — like Kleiner Perkins Claufield & Byers, known for such home runs as Amazon, Compaq, Genentech and Netscape; and Sequoia Capital (Google, Yahoo!, PayPal, Apple and YouTube) — can raise substantially more capital in launching new funds, but they, too, are constrained by the time-consuming nature of VC work. To invest in more small companies with outsized potential, they must hire more VC professionals. Thus, in the world of VC firms, larger scale does not necessarily mean greater profitability.
The reason buyout funds are much more scalable than VC funds is that they invest in larger, more mature companies that typically need less hand-holding. In Metrick and Yasuda’s sample, the median buyout fund began with $600 million in capital and invested an average $50 million in 10 to 12 different companies over its 10-year lifespan. By applying substantial leverage, buyout funds can acquire very large businesses — on the order of Chrysler, RJR Nabisco or Hilton Hotels.
Because buyout funds invest in businesses already equipped with sophisticated management structures, a buyout firm partner can oversee large investments without a proportionate increase in personnel. The job is not to supply needed management skills, but rather to make sure there is effective management in place, to oversee financial strategy and to help identify new efficiencies.
Buyout partners are usually grounded in finance and operations. And because buyout funds invest in larger, more sophisticated businesses, the typical buyout partner need monitor no more than two or three investments at a time.
The paucity of debt capital available to private equity firms has had relatively little effect on venture capitalists, Yasuda says, because the investments they make are seldom highly leveraged. Right now, venture capital firms are much more concerned about the long-term drought in the IPO market, which limits their ability to exit investments and makes them more dependent upon selling their businesses to larger companies.
The depressed IPO market dates from the post-2000 technology crash, which occurred just after VC firms had launched their largest funds ever. Those funds are now eight or nine years old, Yasuda notes, and will have to exit their investments over the next two years. Should they fail to do so successfully, a number of venture capital firms could themselves go out of business.
By contrast, illiquid credit markets do direct harm to buyout firms because few investments look attractive to them without a heavy dollop of leverage. The buyout firms raised record amounts of equity capital before the debt markets collapsed last summer, and many now find it difficult to put that money to work. The longer the credit markets remain in the doldrums, the higher the odds that some funds will have to return capital to their limited partners or else start investing in a greater number of small- or mid-sized companies requiring greater oversight.
Should that happen, the buyout business might become a lot less scalable, and the economic differences between buyout and venture capital funds may be somewhat harder to discern.