From Knowledge at Wharton
Private equity firms manage $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 authors gained access to 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.
The study's most important conclusions: First, 60 percent 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 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. The general partner's compensation contains a fixed component -- an annual management fee of 2 percent 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.
There are striking differences in strategy and practice between venture capital and buyout funds -- the principal components of the private equity industry. 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 experience in operations, marketing, management, and related skills to help small companies grow. Early-stage investing is time- and labor-intensive 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. That professional typically spends the fund's second five years fostering and monitoring those five companies.
VC funds tend to derive the bulk of their revenues from hitting a "home run" -- a return five times greater than invested capital -- with one in every five investments. Another 20 percent of VC investments can be expected to fail or achieve minimal returns, with the remaining 60 percent returning an average 2.5 to 3 times invested capital.
Larger, more successful VC firms 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. In the VC world, larger scale does not necessarily mean greater profitability.
Buyout funds are much more scalable than VC funds because 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.
A buyout firm partner can oversee large investments without a proportionate increase in personnel. The job is not to supply needed management skills, but 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. The typical buyout partner monitors 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. 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 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.
