Venture Capital and Private Equity: Module II

Note: This module overview is based heavily on joint work with Paul Gompers, Dynamic Capital.

Introduction

The second module of the course considers the interactions between private equity investors and the entrepreneurs that they finance. These interactions are at the core of what private equity investors do. We will approach these interactions through a framework that highlights the particular challenges that portfolio firms pose to private equity investors, as well as the mechanisms that these investors have developed to address these challenges.

Why This Module?

It is easy to build a case that the financing and guidance of dynamic private businesses lie at the heart of the private equity process. Nonetheless, addressing the frequently complex interactions between investors and the firms in their portfolios in eight class sessions is a somewhat daunting challenge. To thoroughly examine how venture and buyout investors assess, fund, control, and shape the strategy of firms would certainly be enough to fill several courses! Fortunately, a number of courses at Harvard Business School—including "Coordination, Control, and Management of Organizations," "Entrepreneurial Finance," "Entrepreneurial Management," and "Entrepreneurial Marketing"—also explore aspects of the management of new ventures and buyouts. In our discussions, we will draw on insights from each of these classes when appropriate.

We will approach the cases in this module through a framework which will help us organize these complex interactions. First, we categorize the reasons why the types of firms backed by private equity investors find it difficult to meet their financing needs through traditional mechanisms, such as bank loans. These difficulties can be sorted into four critical factors: uncertainty, asymmetric information, the nature of firm assets, and the conditions in the relevant financial and product markets. At any one point in time, these four factors determine the choices that a firm faces. As a firm evolves over time, however, these factors can change in rapid and unanticipated ways.

We also consider six classes of responses by private equity investors to these challenges. The first three relate to the investment process itself: the determination of the sources from which the firm should raise capital, how the investment should be structured, and how the profits should be divided. The second set involves the investors’ more general interactions with the firm: the monitoring of management performance, the shaping of the firm’s assets, and the evaluation of whether to continue or terminate the investment. Thinking about these four classes of problems and six sets of responses will help organize the complex interactions between private equity investors and the firms in their portfolios.

The Framework (1): The Financing Challenge

Entrepreneurs rarely have the capital to see their ideas to fruition and must rely on outside financiers. Meanwhile, those who control capital—for instance, pension fund trustees and university overseers—are unlikely to have the time or expertise to invest directly in young or restructuring firms. It might be thought that the entrepreneurs would turn to traditional financing sources, such as bank loans and the issuance of public stock, to meet their needs. But a variety of factors are likely to lead to some of the most potentially profitable and exciting firms not being able to access these financing sources.

Private equity investors are almost invariably attracted to firms that find traditional financing difficult to arrange. Why are these firms difficult to finance? Whether managing a $10 million seed investment pool or a $1 billion leveraged buyout fund, private equity investors are looking for companies that have the potential to evolve in ways that create value. This evolution may take several forms. Early-stage entrepreneurial ventures are likely to grow rapidly and respond swiftly to the changing competitive environment. Alternatively, the managers of buyout and build-up firms may create value by improving operations and acquiring other rivals. In each case, the firm’s ability to change dynamically is a key source of competitive advantage, but also a major problem to those who provide the financing.

As mentioned above, the characteristics of these dynamic firms will be analyzed using a four-factor framework. The first of these, uncertainty, is a measure of the array of potential outcomes for a company or project. The wider the dispersion of potential outcomes, the greater the uncertainty. By their very nature, young and restructuring companies are associated with significant levels of uncertainty.

Uncertainty surrounds whether the research program or new product will succeed. The response of firm’s rivals may also be uncertain. High uncertainty means that investors and entrepreneurs cannot confidently predict what the company will look like in the future. Uncertainty affects the willingness of investors to contribute capital, the desire of suppliers to extend credit, and the decisions of firms’ managers. If managers are adverse to taking risks, it may be difficult to induce them to make the right decisions. Conversely, if entrepreneurs are overoptimistic, then investors want to curtail various actions. Uncertainty also affects the timing of investment. Should an investor contribute all the capital at the beginning, or should he stage the investment through time? Investors need to know how information-gathering activities can address these concerns and when they should be undertaken.

The second factor, asymmetric information, is distinct from uncertainty. Because of his day-to-day involvement with the firm, an entrepreneur knows more about his company’s prospects than investors, suppliers, or strategic partners. Various problems develop in settings where asymmetric information is prevalent. For instance, the entrepreneur may take detrimental actions that investors cannot observe: perhaps undertaking a riskier strategy than initially suggested or not working as hard as the investor expects. The entrepreneur might also invest in projects that build up his reputation at the investors’ expense.

Asymmetric information can also lead to selection problems. The entrepreneur may exploit the fact that he knows more about the project or his abilities than investors do. Investors may find it difficult to distinguish between competent entrepreneurs and incompetent ones. Without the ability to screen out unacceptable projects and entrepreneurs, investors are unable to make efficient and appropriate decisions.

The third factor affecting a firm’s corporate and financial strategy is the nature of its assets. Firms that have tangible assets—e.g., machines, buildings, land, or physical inventory—may find financing easier to obtain or may be able to obtain more favorable terms. The ability to abscond with the firm’s source of value is more difficult when it relies on physical assets. When the most important assets are intangible, such as trade secrets, raising outside financing from traditional sources may be more challenging.

Market conditions also play a key role in determining the difficulty of financing firms. Both the capital and product markets may be subject to substantial variations. The supply of capital from public investors and the price at which this capital is available may vary dramatically. These changes may be a response to regulatory edicts or shifts in investors’ perceptions of future profitability. Similarly, the nature of product markets may vary dramatically, whether due to shifts in the intensity of competition with rivals or in the nature of the customers. If there is exceedingly intense competition or a great deal of uncertainty about the size of the potential market, firms may find it very difficult to raise capital from traditional sources.

The Framework (2): The Activities of Private Equity Investors

Private equity investors have a variety of mechanisms at their disposal to address these changing factors. Careful crafting of financial contracts and firm strategies can alleviate many potential roadblocks. We will highlight six of these responses.

The first set relates to the financing of firms. First, from whom a firm acquires capital is not always obvious. Each source—private equity investors, corporations, and the public markets—may be appropriate for a firm at different points in its life. Furthermore, as the firm changes over time, the appropriate source of financing may change. Because the firm may be very different in the future, investors and entrepreneurs need to be able to anticipate change.

Second, the form of financing plays a critical role in reducing potential conflicts. Financing provided by private equity investors can be simple debt or equity, or involve hybrid securities like convertible preferred equity or convertible debt. These financial structures can potentially screen out overconfident or under-qualified entrepreneurs. The structure and timing of financing can also reduce the impact of uncertainty on future returns.

A third element is the division of the profits between the entrepreneurs and the investors. The most obvious aspect is the pricing of the investment: for a given cash infusion, how much of the company does the private equity investor receive? Compensation contracts can be written that align the incentives of managers and investors. Incentive compensation can be in the form of cash, stock, or options. Performance can be tied to several measures and compared to various benchmarks. Carefully designed incentive schemes can avert destructive behavior.

The second set of activities of private equity investors relate to the strategic control of the firm. Monitoring is a critical role. Both parties must ensure that proper actions are taken and that appropriate progress is being made. Critical control mechanisms—e.g., active and qualified boards of directors, the right to approve important decisions, and the ability to fire and recruit key managers—need to be effectively allocated in any relationship between an entrepreneur and investors.

Private equity investors can also encourage firms to alter the nature of their assets and thus obtain greater financial flexibility. Patents, trademarks, and copyrights are all mechanisms to protect firm assets. Understanding the advantages and limitations of various forms of intellectual property protection, and coordinating financial and intellectual property strategies are essential to ensuring a young firm’s growth. Investors can also shape firms’ assets by encouraging certain strategic decisions, such as the creation of a set of "locked-in" users who rely on the firm’s products.

Evaluation is the final, and perhaps most critical, element of the relationship between entrepreneurs and private equity investors. The ultimate control mechanism exercised by the private equity investors is to refuse to provide more financing to a firm. In many cases, the investor can—through direct or indirect actions—even block the firm’s ability to raise capital from other sources.

The Structure of the Module

This module will illustrate these frameworks with examples from a wide variety of private equity funds and industries. We will carefully identify the types of problems that emerge in different types of private equity transactions. Another important aspect of this module will be to explore the institutional and legal aspects of each type of private equity transaction: venture capital, buyouts, build-ups, and venture leasing. We will highlight how private equity organizations employ these mechanisms and react to these regulations to promote success.

Among the specific issues raised in private equity transactions that we will consider are: