Venture Capital and Private Equity: Module III

Introduction

The third module of "Venture Capital and Private Equity" examines the process through which private equity investors exit their investments. Successful exits are critical to insuring attractive returns for investors and, in turn, to raising additional capital. But private equity investors’ concerns about exiting investments—and their behavior during the exiting process itself—can sometimes lead to severe problems for entrepreneurs.

We will employ an analytic framework very similar to that used in the first module of the course. We will not only seek to understand the institutional features associated with exiting private equity investments in the United States and overseas, but also to analyze them. We will map out which features are designed primarily to increase the overall amount of profits from private equity investments, and which actions seem to be intended to shift more of the profits to particular parties.

Why This Module?

At first glance, the exiting of private equity investments may appear outside the scope of "Venture Capital and Private Equity." It might seem that such issues are more appropriate for courses such as "Capital Markets" or "Investment Management," which focus on public markets. But since the need to ultimately exit investments shapes every aspect of the private equity cycle, this is a very important issue for both private equity investors and entrepreneurs.

Perhaps the clearest illustration of the relationship between the private and public markets was seen during the 1980s and early 1990s. In the early 1980s, many European nations developed secondary markets. These sought to combine a hospitable environment for small firms (e.g., they allowed firms to be listed even if they did not have an extended record of profitability) with tight regulatory safeguards. These enabled the pioneering European private equity funds to exit their investments. A wave of fundraising by these and other private equity organizations followed in the mid-1980s. After the 1987 market crash, initial public offering activity in Europe and the United States dried up. But while the U.S. market recovered in the early 1990s, the European market remained depressed. Consequently, European private equity investors were unable to exit investments by going public. They were required either to continue to hold the firms or to sell them to larger corporations at often-unattractive valuations. While U.S. private equity investors—pointing to their successful exits—were able to raise substantial amounts of new capital, European private equity fundraising during this period remained depressed. The influence of exits on the rest of the private equity cycle suggests that this is a critical issue for funds and their investors.

The exiting of private equity investments also has important implications for entrepreneurs. As discussed in the first module, the typical private equity fund is liquidated after one decade (though extensions of a few years may be possible). Thus, if a private equity investor cannot foresee how a company will be mature enough to take public or to sell at the end of a decade, he is unlikely to invest in the firm. If it was equally easy to exit investments of all types at all times, this might not be a problem. But interest in certain technologies by public investors seems to be subject to wide swings. For instance, in recent years "hot issue markets" have appeared and disappeared for computer hardware, biotechnology, multimedia, and Internet companies. Concerns about the ability to exit investments may have led to too many private equity transactions being undertaken in these "hot" industries. At the same time, insufficient capital may have been devoted to industries not in the public limelight.

Concerns about exiting may also adversely affect firms once they are financed by private equity investors. Less scrupulous investors may occasionally encourage companies in their portfolio to undertake actions that boost the probability of a successful initial public offering, even if they jeopardize the firm’s long-run health: e.g., increasing earnings by cutting back on vital research spending. In addition, many private equity investors appear to exploit their inside knowledge when dissolving their stakes in investments. While this may be in the best interests of the limited and general partners of the fund, it may have harmful effects on the firm and the other shareholders.

The Framework of the Analysis

The exiting of private equity investments involves a diverse range of actors. Private equity investors exit most successful investments through taking them public. A wide variety of actors are involved in the initial public offering. In addition to the private equity investors, these include the investment bank that underwrites the offering, the institutional and individual investors who are allotted the shares (and frequently sell them immediately after the offering), and the parties who end up holding the shares.

Few private equity investments are liquidated at the time of the initial public offering. Instead, private equity investors typically dissolve their positions by distributing the shares to the investors in their funds. These distributions usually take place one to two years after the offering. A variety of other intermediaries are involved in these transactions, such as distribution managers who evaluate and liquidate distributed securities for institutional investors.

This module will examine each of these players. Rather than just describing their roles, however, we will highlight the rationales for and impacts of their behavior. We will again employ the framework of the first module. We will seek to assess which institutions and features have evolved to improve the efficiency of the private equity investment process, while which have sprung up primarily to shift more of the economic benefits to particular parties.

Many of the features of the exiting of private equity investments can be understood as responses to many uncertainties in this environment. An example is the "lock up" provisions that prohibit corporate insiders and private equity investors from selling at the time of the offering. This helps avoid situations where the officers and directors exploit their inside knowledge that a newly listed company is overvalued by rapidly liquidating their positions.

At the same time, other features of the exiting process can be seen as attempts to transfer wealth between parties. An example may be the instances where private equity funds distribute shares to their investors that drop in price immediately after the distribution. Even if the price at which the investors ultimately sell the shares is far less, the private equity investors use the share price before the distribution to calculate their fund’s rate of return and to determine when they can begin profit-sharing.

The Structure of the Module

This module examines this important topic over three class sessions. We will begin by exploring the need for avenues to exit private equity investments. To do this, we will examine Europe’s private equity markets. As described above, the inability to exit investments has been a major stumbling block to the development of its private equity industry.

We then examine the exiting of private equity investments in the United States. In the second case of this module, we will examine the differing incentives and actions of venture capitalists, investment bankers, and public market investors during an initial public offering. The final case examines the distribution process. We explore both the rationales for stock distributions and the implications for private equity investors, entrepreneurs, firms, limited partners, and the specialized distribution managers that they hire. Once again, we will seek to assess which behavior increases the size of the "pie" and which actions simply change the relative sizes of the slices.

Venture Capital and Private Equity: Module III

Introduction

Why This Module?

The Framework of the Analysis

The Structure of the Module

Further Reading on Exiting Private Equity Investments