Private equity and venture capital
The private equity market
• The private equity market (PE) is a source of funding for start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout financing • The size of the private equity market rose from $0.8bn in 1980 to $148.4bn in 2000, while it was $43.8bn in 2002 • The private equity market is divided into two parts
– Venture capital market, which includes funding for start-up firms – Non-venture private equity market, which includes funding for established private firms (leveraged and management buyouts)
• Well-known firms that have received PE financing
– – – – – – – – – Apple Cisco Microsoft Netscape Sun Microsystems Staples Starbucks Google Amazon
Organization of the private equity market
• The private equity market is composed of the following groups
– The firms (issuers) that seek financing from private investors – The private equity funds organized in the form of limited partnerships – The outside investors who invest in the private equity market – The agents and advisers whose role is to generate information
Who are the issuers?
• Private equity financing is very expensive given the high returns expected by private equity investors • The firms that go to the private equity market do so because they have no alternative sources of financing • These firms may
– Be too risky to issue debt – Require extensive due diligence due to the risks involved – Need investor guidance and expertise
• Private equity investors can help resolve these issues
Taxonomy of issuers
• Firms seeking venture capital
– Early-stage ventures – Later-stage ventures
• Middle-market private firms
– Grown private firms that need financing to expand or change their capital structure and do not wish to go public
• Public and private firms in financial distress • Public buyouts (LBOs)
Percentage Invested by Stage in U.S. (1996-2000)
Expansion 33.9% Start-up 12.2% Seed 1.8% Buyout 47.3% Replacement Capital 4.8%
Organization of PE funds
• The growth in the PE market during the past three decades is to a large degree attributed to the emergence of the limited partnership form of organization • Limited partnerships are financial intermediaries that raise and invest funds from investors • Until the late 1970s, most of the private equity investments were undertaken by wealthy individuals, large corporations, and banks investing directly into issuing firms
• Private equity funds are mainly structured in the form of limited partnerships • Limited partnerships are composed of
– General managing partners who are professional managers running the fund
– Limited partners who are institutional investors and other individuals who contribute to the fund’s capital
• Typically, a group of experienced investors forms a a managing partnership or LLC to act as general partner • The managing partners typically form a second entity called the PE fund partnership or a LLC to manage the fund • Outside investors, as well as the fund’s managers, promise to contribute to the capital raised by the fund • The fund managers identify and evaluate potential investments, monitor these investments, and recommend exit strategies
Characteristics of limited partnerships
• General partners (GP) run the business and have unlimited liability • Limited partners do not actively participate in the business • Liability (but not tax liability) is generally limited to contribution to the partnership • Limited transferability of partnership interest
Typical Life of a Limited Partnership
Raise Capital
Identify and structure investments
Manage and liquidate investments
0
5
10
Year
Taxonomy of PE funds
• • Venture capital funds Leverage buyout funds
– Use significant amounts of debt borrowed by using the acquired firm’s assets as collateral – Purchase firms with stable cash flows, large market share, undervalued shares, and in stable industries
•
Mezzanine funds
– Either private equity financing before an IPO or private equity investments that use subordinated debt often with attached warrants
•
•
Hedge funds
Funds of funds
Leading Technology Venture Firms as of December 2002
Rank 1 2 3 4 5 6 7 8 9 10 Company New Enterprise Associates Oak Investment Partners Sprout Group Accel Partners Spectrum Equity Investors St. Paul Venture Capital Menlo Ventures Austin Ventures Kleiner, Perkins, Caufield & Byers VantagePoint Venture Partners Capital Under Management ($ in billions) 4.9 4.2 3.4 3.2 3.0 3.0 2.7 2.6 2.6 2.6
Source: Private Equity Analyst
Largest 15 Buyout Funds Closed: October 2001 to September 2002
Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Company Blackstone Capital Partners IV, L.P. DLJ Merchant Banking Partners III, L.P. Warburg Pincus Private Equity VIII, L.P. Apollo Investment Fund V, L.P. CSFB Global Opportunities Fund, L.P. Global Private Equity IV, L.P. J.W. Childs Equity Partners III, L.P. Berkshire Fund VI, L.P. Hicks, Muse, Tate & Furst Equity Fund V, L.P. The Resolute Fund, L.P. Heartland Industrial Partners, L.P. Angelo Gordon Capital Recovery Partners III, L.P. OCM Emerging Markets Fund III, L.P. Fremont Partners III, L.P. CIVC Partners Fund III, L.P.
Committed Capital ($ in billions) 6.45 5.40 5.30 3.75 2.20 1.90 1.75 1.70 1.60 1.50 1.40 1.00 0.96 0.92 0.80
Sources: Alternative Investor/Private Equity Analyst/VentureOne
Who are the investors?
• Thirty years ago, wealthy individuals accounted for the largest share of PE investments • The “prudent man” rule of 1979 allowed pension funds to invest in riskier assets and gave a boost to the PE market • Institutional investors (private and public pension funds, financial and insurance firms) put today almost all of the contributed capital in PE funds
Investors In Private Equity (continued): LP Capital Commitments to VC Funds
100% 80% 60% 40% 20% 0% 1999 2000 2001
Private & Public Pension Funds Financial & Insurance Individuals & Families Endowments & Foundations Corporations (NonEmployee Benefit)
Source: Venture Economics/NVCA
Investors In Private Equity (continued): LP Capital Commitments to Buyouts/Other Non-Venture Funds
100% 80% 60% 40% 20% 0% 1999 2000 2001 2002 Private & Public Pension Funds Financial & Insurance Individuals & Families Endowments & Foundations Corporations (NonEmployee Benefit)
Source: Venture Economics/NVCA/Private Equity Analyst
Main developments in the PE market
• 1940s: The American Research and Development (ARD) Corp. was established in 1946 to pursue investments based on technology developed in World War II
– Almost half of profits in 26-year life came from investment in DEC
• 1950s: Not much growth in venture capital
– Venture capital firms were organized as publicly-traded closed-end funds – Unscrupulous brokers took advantage of inexperienced investors who experienced significant losses
• 1960s and early 1970s: Not much growth in VC
– The federal government launched the Small Business Investment Companies (SBIC) program in 1958 – VC firms obtained generous marching funds or loan guarantees through SBIC – Again, inexperience and fraud led to significant losses – Investment in venture capital was flat (about $2-3bn during 19691977)
• 1970s: Limited partnerships gained in popularity and regulatory and tax changes help PE market
– 1974: Pass of Employee Retirement Income Security Act (ERISA) that attempts to eliminate abuses in corporate pension funds by restricting risk investments – 1978: “Prudent man” amendment to ERISA allows pension funds to invest in riskier assets – 1978 & 1981: Capital gains tax rate reduced from 49.5% to 28% and then to 20%
• 1980s and early 1990s
– Venture capital financing increases tenfold in early 1980s – But, funding drops during 1987-1991 due to disappointing losses by investors – Rise in buyout funds coincided with the rise in the high-yield debt market
• 1990s: Dramatic rise in PE market
Capital commitments to PE funds
$160.0
Commitments ($billions)
$140.0 $120.0 $100.0 $80.0 $60.0 $40.0 $20.0 $0.0
Buyouts/Corporate Finance Venture Capital
80 81
82 83
84 85
86 87
88 89
90 91
92 93
94 95
96 97
98 99
00 01
Year
Note: 2Q03 values are annualized based on 2003 results.
2Q
02 03
Venture Capital, Buyout, and U.S. Public Stock and Corporate Bond Returns: 1982 to 2002
70% 60%
Venture Capital Funds Buyout Funds Large Public Shares in U.S. Small Public Shares in U.S. Long-T erm U.S. Corporate Bonds
Average Annual Return over Previous 5 Years
50% 40% 30% 20% 10% 0% -10% 1982
1986
1990
1994
1998
2002
Year
Sources: Thompson Venture Economics and Ibbotson Associates
Venture capital firms
• VCs differ from banking institutions in a number of ways
– They obtain funds by issuing equity shares on a quasi-private basis – They specialize in financing very young, high-risk firms
– They accept equity securities in exchange for the capital they provide
– They are much more involved with the management of these firms
– They are less regulated than banks
How do VCs value a new venture?
• It is very difficult to value a young firm that has no history of earnings and plans to operate in an industry with few existing comparable firms • VCs use the “venture capital” method
– Estimate the projected earnings of the firm at some future date when the VCs want to take the firm public, which will be given by the terminal value at that date (e.g. 8 years from today)
– Use a P/E or market-to-book multiple to obtain a value for the firm at that date
– Discount the terminal value back to the present by using a “target rate of return” for the VC, typically pretty high (50-70% for early ventures, 30-40% for later ventures) – This gives the fair value of the venture today and can be used to allocate ownership shares among VCs
• High discount rates are justified due to
– Premium for risk and illiquidity of investment – Value added by VCs – Offset for overly optimistic cash flows