Venture Capital and Private Equity

Over the past fifteen years, there has been a tremendous boom in the private equity industry. The pool of U.S. private equity funds—partnerships specializing in venture capital, leveraged buyouts, mezzanine investments, build-ups, and distressed debt—has grown from $5 billion in 1980 to over $125 billion in 1995. Private equity's recent growth has outstripped that of almost every class of financial product.

While the growth in private equity has been striking, the potential for future development is even more impressive. Despite its growth, the private equity pool today remains relatively small. For every one dollar of private equity in the portfolio of U.S. institutional investors, there are about $40 of publicly traded equities. The ratios are even more uneven for overseas institutions.

Both the demand for and supply of such capital are likely to expand. First consider the demand for private equity. Many studies suggest that privately held firms continue to face substantial problems in accessing the financing necessary to undertake profitable projects. Meanwhile, corporations are increasingly willing to sell off divisions to private equity investors as part of corporate "refocusings." The supply of private equity is also likely to continue growing. Within the past two years, numerous pension funds have invested in private equity for the first time. Many experienced investors have also decided to increase their allocations to venture capital and buyout funds. These increased allocations will take a number of years to implement.

These patterns are even more dramatic overseas. Recent rates of growth in foreign private equity markets have outstripped the United States by a wide margin. In Great Britain, for instance, the size of the private equity pool increased by 37% in 1994 alone. At the same time, the size of foreign private equity pool remains far below the United States. This suggests considerable possibilities for future growth. The disparity can be illustrated by comparing the ratio of the private equity pool to the size of the economy. In 1995, this ratio was 8.7 times higher in the United States than in Asia, and 8.0 times higher in the United States than in continental Europe. [Many of these statistics are taken from the European Venture Capital Association, 1996 EVCA Yearbook, Zaventum, Belgium, European Venture Capital Association, 1996; and Asian Venture Capital Journal, Venture Capital in Asia: 1995/96 Edition, Hong Kong, Asian Venture Capital Journal, 1995. See also the note on private equity in developing countries.]

At the same time, the private equity industry—both in the United States and internationally—has been quite turbulent. If you had invested in average venture or buyout funds at a pace that tracked the U.S. market between 1980 and 1995, your returns today would be below those from investments in most public equity markets. [Venture Economics, Investment Benchmarks Report: Venture Capital, New York, Venture Economics, 1996, page 281.] Due to the illiquidity and risk of private equity, we would expect instead a higher return. These poor returns largely stemmed from funds begun in the 1980s, when a large number of private equity investors raised first funds, and established organizations aggressively expanded. Many of the new funds could not find satisfactory investments, while rapid growth created turmoil at some established organizations. The early 1990s saw far fewer funds raised and rising returns. With the recent growth in private equity fundraising, it is unclear whether the high returns seen in the recent years can be sustained.

This cycle of growth and disillusionment has created much instability in the industry. Understanding these patterns—and their impact on investor behavior—is critical whether one intends to work for, receive money from, underwrite the offerings of, or invest in or alongside private equity funds.

Course Overview

A series of module overviews provide detailed descriptions of the themes and approaches of each unit of the course. (The overviews also provide some background to the cases, and suggest a variety of supplemental readings.) There is also an outline of a cases employed. It may be helpful, however, to at least briefly summarize the organization of the course.

The first module of "Venture Capital and Private Equity" examines how private equity funds are raised and structured. These funds often have complex features, and the legal issues involved are frequently arcane. But the structure of private equity funds have a profound effect on the behavior of venture and buyout investors. Consequently, it is as important for the entrepreneur raising private equity to understand these issues as it is for a partner in a fund. The module will seek not only to understand the features of private equity funds and the actors in the fundraising process, but also to analyze them. We will map out which institutions serve to increase the profits from private equity investments as a whole, and which seem designed mostly to shift profits between the parties.

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 two-part framework. We first identify the four critical factors that make it difficult for the types of firms backed by private equity investors to meet their financing needs through traditional mechanisms, such as bank loans. We then consider six classes of financial and organizational responses by private equity investors to these challenges. This module will illustrate these frameworks with examples from a wide variety of industries and private equity transactions, including venture capital, buyouts, build-ups, and venture leasing.

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 seek to understand which institutional features associated with exiting private equity investments 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.

The final module reviews many of the key ideas developed in the course. Rather than considering traditional private equity organizations, however, the two cases examine organizations with very different goals. Large corporations, government agencies, and non-profit organizations are increasingly emulating private equity funds. Their goals, however, are quite different: e.g., to more effectively commercialize internal research projects or to revitalize distressed areas. These cases will allow us not only to understand these exciting and challenging initiatives, but to review the elements that are crucial to the success of traditional venture organizations.

The Final Paper

An important component of the course is the final paper. Whether one intends to work for a private equity organization or to accept money from one, careful due diligence is essential. Private equity funds jealously guard their privacy, and distinguishing between top-tier organizations and less reputable concerns is not always easy. The final paper offers an opportunity to become better acquainted with the resources available at Baker Library and elsewhere.

An important resource in completing the project will be the VentureOne database of private equity financings, which the firm has generously made available to our class. Within a few broad guidelines, a broad range of final projects are encouraged. In previous years, final projects have ranged from traditional papers analyzing trends in private equity markets to case studies of particular investments and funds to draft private placement memorandums for new private equity funds. Group projects, or projects linked to those in other courses, will be encouraged.

If you want to get a head start, you may wish to consult the course text, "The Economics of the Private Equity Industry," or the note on information sources on private equity, the course bibliography, and the notebooks with paper ideas on reserve at the Baker Library circulation desk.

Josh Lerner

Home Page | Course Outline | Module I | Module II | Module III | Module IV | Information Sources Note | Bibliography | The Economics of the Private Equity Industry | Private Equity in Developing Countries Note

Comments about this page can be sent to Josh Lerner

or to Josh Lerner; Morgan Hall; Harvard Business School; Boston, MA 02163.