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Home , Market (economics), Private equity

The private is an important The source of funds for start-ups, private middle- market , firms in , of the Private and public firms seeking financing.1 Over the past fifteen years, it has been the fastest growing market for corporate , far Equity Market surpassing others such as the public equity and markets and the market for private place- Stephen D. Prowse Senior and Policy Advisor ment . Today the private equity market is of Dallas roughly one-quarter the size of both the market for commercial and industrial bank and the market for in terms of outstandings (Figure 1). In recent years, private equity raised by partnerships has matched, and sometimes exceeded, funds raised through initial public offerings and gross This article examines issuance of public high- corporate bonds. Probably the most celebrated aspect of the pri- the economic foundations vate equity market is the in small, often high-tech, start-up firms. These invest- of the private equity market ments often fuel explosive growth in such firms. For example, Microsoft, Dell Computer, and and describes its Genentech all received private equity backing in their early stages. In addition, the private institutional structure. equity market supplied equity funds in the huge leveraged of such large public compa- nies as Safeway, RJR Nabisco, and Beatrice in the 1980s. Despite its dramatic growth and increased significance for , the private equity market has received little attention in the financial press or the academic literature.2 The lack of attention is due partly to the nature of the instrument itself. A private equity is exempt from registration with the Securities and Exchange Commission by virtue of its being issued in transactions “not involving any .” Thus, information about private trans- actions is often limited, and analyzing develop- ments in this market is difficult. This article examines the economic foun- dations of the private equity market and describes its institutional structure. First, I briefly discuss the growth of the as the major intermediary in the private equity market over the last fifteen years. Next, I explain the overall structure of the market, focusing in turn on the major , inter- mediaries, and issuers. I then look at returns to private equity over the last fifteen years. Finally, I analyze the role of limited partner- ships and why they are a particularly effective form of intermediary in the private equity mar- ket. This entails a detailed examination of the contracts these partnerships write with their investors and the companies in which the part- nerships invest.

FEDERAL RESERVE BANK OF DALLAS 21 ECONOMIC REVIEW THIRD QUARTER 1998 Figure 1 Flows and Outstandings in Private Equity and Other Corporate Finance Markets

Amounts raised in 1996 Outstandings at year-end 1996

Billions of dollars Billions of dollars 100 1,000

80 800

60 600

40 400

20 200

0 0 Private IPOs Junk Private Private C & I Commercial Private equity bonds placements equity loans paper placements

SOURCES: Federal Reserve Board flow of funds accounts; author’s estimates.

THE GROWTH OF LIMITED PARTNERSHIPS equity market. The specific advantages of lim- IN THE PRIVATE EQUITY MARKET ited partnerships are rooted in the way in which they address these problems. The general part- The private equity market consists of pro- ners specialize in finding, structuring, and man- fessionally managed equity in the aging equity investments in closely held private unregistered securities of private and public com- companies. Limited partnerships are among the panies.3 Professional management is provided largest and most active shareholders with signif- by specialized intermediaries called limited part- icant means of both formal and informal nerships, which raise from institutional and thus can direct companies to serve the investors and invest it in both publicly and pri- of their shareholders. At the same time, vately held . Private equity man- limited partnerships employ organizational and agers acquire large stakes and take contractual mechanisms that align the interests an active role in monitoring and advising com- of the general and limited partners. panies in which they invest. They often exercise Limited partnership growth was also fos- as much or more control than insiders. tered by regulatory changes in the late 1970s The growth of private equity is a classic that permitted greater private equity investment example of how organizational , aided by regulatory and changes, can ignite activity in a particular market. In this case, the Figure 2 innovation was the widespread adoption of the Private Equity Capital Outstanding, limited partnership as the means of organizing by Source of Funds, 1980 and 1995 private equity investments. Until the late 1970s, Billions of dollars private equity investments were undertaken 200 mainly by wealthy families, industrial corpora- Other Limited partnerships tions, and financial investing directly 160 in issuing firms. By contrast, most investment since 1980 has been undertaken by intermedi- aries on behalf of institutional investors. The 120 major intermediary is the limited partnership; institutional investors are the limited partners, 80 and professional investment managers are the general partners. 40 The of the limited partnership as the dominant form of intermediary is a result 0 of the extreme information asymmetries and 1980 1995 incentive problems that arise in the private SOURCES: Venture Economics; Fenn, Liang, and Prowse (1997).

22 Figure 3 Organized Private Equity Market

Investors Intermediaries Issuers

Dollars Corporate pension funds Limited partnerships New ventures ¥ Managed by indepen- ¥ Early stage dent partnership Dollars, ¥ Later stage Public pension funds Limited partnership organizations monitoring, consulting ¥ Managed by affiliates Middle-market Endowments of financial institutions private companies Private ¥ Expansion equity Foundations Dollars Other intermediaries securities Ð Capital expenditure ¥ Small Business Ð Acquisitions Bank holding companies Investment ¥ Change in capital Equity structure claim on Companies (SBICs) Ð Financial intermediary ¥ Publicly traded Wealthy families and individuals investment companies Ð Financial distress ¥ Change in ownership companies Ð of owner Ð Corporate spinoffs Direct investments Investment (includes direct investments by both BHC-affiliated SBICs and Public companies Nonfinancial corporations subsidiaries of nonfinancial companies) ¥ Management or Dollars ¥ Financial distress Other investors ¥ Special situations Private equity securities

Investment advisers Placement agents for Placement agents to investors partnerships for issuers

¥ Evaluate limited partnerships ¥ Locate limited partners ¥ Advise issuers ¥ Manage “funds of funds” ¥ Locate equity investors by pension funds. The results of these changes lists the major investors, the middle column lists are telling: from 1980 to 1995, the amount of major intermediaries, and the right-hand col- capital under management in the organized pri- umn lists the major issuers in the private equity vate equity market increased from roughly $4.7 market. Arrows pointing from left to right indi- billion to over $175 billion. In addition, limited cate the flow of dollars and other services; partnerships went from managing less than 50 arrows pointing from right to left indicate the percent of private equity investments to manag- flow of private equity securities or other claims. ing more than 80 percent (Figure 2).4 Most of The bottom of Figure 3 lists an assortment of the remaining private equity is held agents and investment advisors that help issuers directly by investors, but even much of this or intermediaries raise money or advise in- direct investment activity is the result of knowl- vestors on the best intermediaries in which to edge that these investors have gained investing invest. The role of each of these players in the in and alongside limited partnerships. private equity market is discussed below.

Investors THE STRUCTURE OF THE ORGANIZED PRIVATE EQUITY MARKET Figure 4 illustrates the total estimated pri- vate equity outstanding at year-end 1996 and The organized private equity market has the portions held by the various three major players and an assortment of minor groups. Public and corporate pension funds are ones. Figure 3 illustrates how these players the largest groups, together holding roughly 40 interact with each other. The left-hand column percent of capital outstanding and currently

FEDERAL RESERVE BANK OF DALLAS 23 ECONOMIC REVIEW THIRD QUARTER 1998 supplying close to 50 percent of all new funds firms typically invest in early-stage develop- raised by partnerships.5 Public pension funds mental ventures that may fit with their competi- are the fastest growing investor group and re- tive and strategic objectives. cently overtook private pension funds in terms of the amount of total private equity held. En- Intermediaries dowments and foundations, bank holding com- Intermediaries—mainly limited partner- panies, and wealthy families and individuals each ships—manage an estimated 80 percent of pri- hold about 10 percent of total private equity. vate equity investments. Under the partnership Insurance companies, investment banks, and arrangement, institutional investors are the lim- nonfinancial corporations are the remaining ited partners and a team of professional private major investor groups. Over the 1980s the equity managers serves as the general partners. investor base within each investor group broad- Most often the general partners are associated ened dramatically, but still only a minority of with a partnership management firm (such as institutions within each group (primarily the the venture capital firm Caufield larger institutions) hold private equity. & Byers or the buyout group Kohlberg Kravis Most institutional investors invest in pri- Roberts & Co.). Some management companies vate equity for strictly financial reasons, spe- are affiliates of a financial (an insur- cifically because they expect the risk-adjusted ance company, bank holding company, or invest- returns on private equity to be higher than ment bank); the affiliated companies generally those on other investments and because of the are structured and managed no differently than potential benefits of diversification.6 Bank hold- independent partnership management companies. ing companies, investment banks, and nonfi- Investment companies not organized as nancial corporations may also invest in the limited partnerships—Small Business Invest- private equity market to take advantage of ment Companies (SBICs), publicly traded of scope between private equity investment companies, and other companies— investing and their other activities. Commercial today play only a marginal role as intermedi- banks, for example, are large lenders to small aries in the private equity market.7 SBICs, and medium-sized firms. As such, they have established in 1958 to encourage investment in contact with many potential candidates for pri- private equity, can their private capital vate equity. Conversely, by investing in a pri- with loans from, or guaranteed by, the Small vate equity partnership, banks may be able to Business Administration.8 In the 1970s they generate lending opportunities to the firms in accounted for as much as one-third of private which the partnership invests. Nonfinancial equity investment, but today they account for

Figure 4 Investors in the Private Equity Market, by Holdings of Outstandings at Year-End 1996 Billions of dollars

Other $16 Corporate pension funds $34.7 Investment banks $8.6

Nonfinancial corporations $7.5

 yyyzz{{{||

Insurance companies $12.7



Public pension funds

Bank holding companies {{{|| $39.5 $19.3

Wealthy families and individuals $18.2 Endowments and foundations $20

 Total Private Equity Outstanding = $176.5 billion

24 Table 1 Characteristics of Major Issuers in the Private Equity Market

Public and private firms Other Early-stage Later stage Middle-market in financial Public public Characteristic new ventures new ventures private firms distress buyouts firms Size Revenues Revenues Established, Any size Any size Any size between between with stable zero and $15 million flows $15 million and $50 between million $25 million and $500 million Financial High growth High growth Growth May be over- Under- Depend on attributes potential potential prospects leveraged or performing reasons for vary widely have operating seeking private problems High levels of equity Reason(s) for To start To expand plant To finance a To effect a To finance a To ensure seeking private operations and operations required change turnaround change in confidentiality equity in ownership or management or To cash out in management To issue a early-stage incentives small offering investors To expand by acquiring or For convenience purchasing new plant Because industry is temporarily out of favor with public equity markets Major source(s) “Angels” Later stage Later stage “Turnaround” LBO and Nonventure of private equity venture venture partnerships mezzanine partnerships Early-stage partnerships partnerships debt venture partnerships partnerships Nonventure partnerships Extent of access For more Access to bank Access to bank Very limited Generally, Generally, to other financial mature firms loans to finance loans access access to all access to all markets with collateral, public and public and limited access For more private private to bank loans mature, larger markets markets firms, access to private place- ment market

less than $1 billion of the $176.5 billion market. institutional investors looking for appropriate The reduced role of SBICs has resulted in part partnerships in which to invest and for part- from their inability to make -term equity nerships looking for appropriate portfolio com- investments when they themselves are financed pany investments. The mechanisms the limited with debt. Publicly traded investment compa- partnerships use to control these problems are nies also played a role in the past, but today explored in detail in a following section. fewer than a dozen such companies are active, and together they manage less than $300 mil- Issuers lion. Apparently the long-term nature of private Issuers in the private equity market vary equity investing is not compatible with the widely in size and their motivation for raising -term investment horizons of stock analysts capital, as well as in other ways. They do and public investors.9 a common trait, however: because private equity The dramatic growth of the limited part- is one of the most expensive forms of finance, nership as the major intermediary in the private issuers generally are firms that cannot raise equity market is a result of the limited partner- financing from the debt or public equity markets. ship’s success in mitigating the severe informa- Table 1 lists six major issuers of private tion problems that exist in the market—both for equity and their main characteristics. Issuers of

FEDERAL RESERVE BANK OF DALLAS 25 ECONOMIC REVIEW THIRD QUARTER 1998 Table 2 Average Internal Rates of Return for Venture and Nonventure Private Equity Limited Partnerships low-technology , , ser- and for Public Small-Company vices, and industries. They use the private Average annual return (percent) equity market to finance expansion—through new capital expenditures and acquisitions— Partnerships Venture Nonventure Public small- and to finance changes in capital structure and formed in: capital capital company stocks in ownership (the latter increasingly the result 1969Ð79 23.3 — 11.5* of private business owners reaching retirement 1980Ð84 10.0 24.8 15.3† age). 1985Ð89 15.2 15.3 13.4‡ Public companies also are issuers in the § 1990Ð91 24.1 28.9 15.6 nonventure sector of the private equity market. * Over the period 1969 to 1988. Such companies often issue a combination of † Over the period 1980 to 1993. debt and private equity to finance their man- ‡ Over the period 1985 to 1996. § Over the period 1990 to 1996. agement or leveraged buyout. Indeed, between SOURCE: Fenn, Liang, and Prowse (1997). the mid- and late 1980s such transactions absorbed most new nonventure private equity capital. Public companies also issue private equity to help them through periods of financial distress, to avoid registration and public traditional venture capital are young firms, most disclosures, and to raise funds during periods often those developing innovative technologies when their industry is out of favor with public that are predicted to show very high growth market investors. rates in the future. They may be early-stage companies, those still in the research and devel- Agents and Advisors opment stage or the earliest stages of com- Also important in the private equity mar- mercialization, or later stage companies, those ket is a group of “information producers” whose with several years of sales but still trying to role has increased significantly in recent years. grow rapidly. These are the agents and advisors who place Since 1980, nonventure private equity private equity, raise funds for private equity investment—comprising investments in estab- partnerships, and evaluate partnerships for lished public and private companies—has out- potential investors. They exist because they paced venture investment, as illustrated in reduce the costs associated with the information Figure 5. Nonventure investments include those problems that arise in private equity investing. in middle-market companies (roughly, those Agents facilitate private companies’ searches for with annual sales of $25 million to $500 mil- equity capital and limited partnerships’ searches lion), which have become increasingly attractive for institutional investors; they also advise on to private equity investors. Many of these com- the structure, timing, and pricing of private panies are stable, profitable businesses in equity issues and assist in negotiations. Advisors facilitate institutional investors’ evaluations of limited partnerships; they may be particularly Figure 5 valuable to financial institutions unfamiliar with Private Equity Capital Outstanding, the workings of the private equity market. by Type of Investment, 1980 and 1995 Billions of dollars RETURNS IN THE PRIVATE EQUITY MARKET 200

Nonventure A major reason for the explosive growth Venture of the private equity market since 1980 has been 160 the anticipation by institutional investors of returns substantially higher than can be earned 120 in alternative markets. Of course, private equity investments are regarded as considerably more 80 risky and more illiquid than other assets. For those institutional investors that can bear such 40 risk and illiquidity, however, the high expected returns are a major attraction.

0 Available data indicate that returns to pri- 1980 1995 vate equity have at times far exceeded returns SOURCES: Venture Economics; Fenn, Liang, and Prowse (1997). in the public market. Table 2 shows internal

26 Table 3 Mechanisms Used to Align the Interests of Participants in the Private Equity Market rates of return on venture and nonventure private equity partnerships during the period Limited partners Ð general partners Partnership Ð portfolio companies in which the partnership was formed. These Performance incentives Performance incentives returns are those experienced by the limited Reputation Managerial ownership partners; they are measured of management General partner compensation Managerial compensation fees and other partnership expenses. Returns Direct means of control Direct means of control to partnerships that have not yet been liqui- Partnership covenants Voting rights dated reflect the of a residual com- Advisory boards Board seats ponent comprising investments whose market Access to capital values are unknown but are often reported at NOTE: Most important mechanisms are in bold type. . This may bias downward the returns re- ported for the funds formed from the mid-1980s onward. Overall, Table 2 suggests that returns to private equity have generally been above those larly, nonventure sectors of the private equity experienced in the public equity market. The market over the past fifteen years. fourth column of Table 2 shows the annual To a certain extent, returns are driven by average returns on a portfolio of public small- capital availability. For venture investments, for company stocks over various periods. These example, returns have been greatest on invest- periods are intended to be roughly comparable ments made during periods when relatively with the ones during which the partnerships small amounts of capital were available (Figure listed were earning the bulk of their returns.10 6 ). Conversely, there is concern, if not a large Except for the early 1980s, returns to both ven- amount of evidence, that periods of greater ture and nonventure private equity are greater capital availability depress future returns. than returns to public small-company stocks, sometimes substantially so. Whether this is THE ROLE OF LIMITED PARTNERSHIPS IN THE enough to compensate investors for the in- PRIVATE EQUITY MARKET creased risk of such investments is, of course, another matter. However, as mentioned above, Accompanying the rapid growth of the returns for more recent partnerships may be private equity market in the 1980s was the rise biased downward. of professionally managed limited partnerships Table 2 also suggests that returns have as intermediaries, as illustrated in Figure 2. In been higher for nonventure than for venture certain respects, the success of limited partner- partnerships. This pattern may partly explain ships is paradoxical. Funds invested in such the faster growth of the later stage and, particu- partnerships are illiquid over the partnership’s life, which in some cases runs more than ten years. During this period, investors have little control over the way their funds are managed. Figure 6 Nevertheless, the increasing dominance of lim- Capital Raised by Venture Capital Partnerships ited partnerships suggests that they benefit both and Internal Rates of Return as of 1995 investors and issuers. Billions of dollars Percent Table 3 provides an overview of the mech- 4 40 Capital raised (dollars) anisms that are used to align the interests of Internal rates of return (percent) (1) the limited and general partners and (2) the

3 30 partnerships and the management of the com- panies in which they invest. These mechanisms can be categorized under the broad headings of

2 20 performance incentives and direct means of control. As shown on the left-hand side of Table 3, 1 10 performance incentives that align the interests of the limited and general partners are twofold. First, the general partners must establish a favor- 0 0 ’69Ð ’76Ð ’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 able track record to raise new partnerships. ’75 ’79 Second, they operate under a pay-for-perform- Year partnership was formed ance scheme in which most of their expected SOURCE: Fenn, Liang, and Prowse (1997). compensation is a share of the profits earned on

FEDERAL RESERVE BANK OF DALLAS 27 ECONOMIC REVIEW THIRD QUARTER 1998 investments. These provisions are the principal intermediaries can be resolved.12 In the private means by which the interests of the general and equity market, reputation plays a key role in limited partners are harmonized. Of secondary addressing these problems because the market importance are direct control mechanisms such consists of a few actors that repeatedly interact as partnership agreements and advisory boards with each other. For example, partnership man- composed of limited partners. Partnership agers that fail to establish a favorable track agreements give limited partners restricted record may subsequently be unable to raise direct control over the general partners’ activi- funds or participate in investment syndicates ties. These agreements consist mainly of restric- with other partnerships.13 tions on allowable investments and other partnership covenants, which the advisory Overview of Private Equity Partnerships board can waive by majority vote. Private equity partnerships are limited In contrast, the direct means of oversight partnerships in which the senior managers of a and control are the principal mechanisms for partnership management firm serve as the gen- aligning the interests of the partnership and eral partners and institutional investors are the portfolio company management. The most limited partners. The general partners are important of these mechanisms are a partner- responsible for managing the partnership’s ship’s voting rights, its seats on the company investments and contributing a very small pro- board, and its ability to control companies’ portion of the partnership’s capital (most often, access to additional capital. Performance 1 percent); the limited partners provide the bal- incentives for company management, includ- ance and bulk of the investment funds. ing managerial ownership of stock, are also Each partnership has a contractually fixed important but are secondary to direct partner- lifetime—generally ten years—with provisions ship control. to extend the partnership, usually in one- or two-year increments, up to a maximum of four Information Problems in Private Equity Investing years. During the first three to five years, the Two types of problems frequently occur partnership’s capital is invested. Thereafter, the when outsiders finance a firm’s investment investments are managed and gradually liqui- activity—sorting problems and incentive prob- dated. As the investments are liquidated, distri- lems. Sorting (or adverse selection) problems butions are made to the limited partners in the arise in the course of selecting investments. form of cash or securities. The partnership man- Firm owners and managers typically know agers typically raise a new partnership fund at much more about the condition of their busi- about the time the investment phase for an ness than do outsiders, and it is in their interest existing partnership has been completed. Thus, to accent the positive while downplaying poten- the managers are raising new partnership funds tial difficulties (see Leland and Pyle 1977; Ross approximately every three to five years and at 1977). Incentive (or ) problems any one time may be managing several funds, arise in the course of the firm’s operations. each in a different phase of its life. Each part- Managers have many opportunities to take nership is legally separate, however, and is actions that benefit themselves at the expense of managed independently of the others. outside investors. A partnership typically invests in ten to Private equity is used in financing situa- fifty portfolio companies (two to fifteen compa- tions in which the sorting and incentive prob- nies a year) during its three- to five-year invest- lems are especially severe.11 Resolving these ment phase. The number of limited partners is problems requires that investors engage in in- not fixed: most private equity partnerships have tensive preinvestment and postin- ten to thirty, though some have as few as one vestment monitoring. These activities are not and others more than fifty.14 The minimum com- efficiently performed by large numbers of in- mitment is typically $1 million, but partnerships vestors; there can either be too much of both that cater to wealthy individuals may have a types of activities because investors duplicate lower minimum and larger partnerships may each others’ work, or too little of each owing have a $10 million to $20 million minimum. to the tendency for investors to free ride on the Most partnership management firms have efforts of others. Thus, delegating these activi- six to twelve senior managers who serve as ties to a single intermediary is potentially efficient. general partners, although many new firms The efficiency of intermediation depends are started by two or three general partners on how effectively the sorting and incentive and a few large firms have twenty or more. problems between the ultimate investors and Partnership management firms also employ

28 associates—general partners in training—usu- investigation varies with the type of investment. ally in the ratio of one associate to every one or With distressed companies, efforts are focused two general partners. General partners often on discussions with the company’s lenders; for have backgrounds as entrepreneurs and senior buyouts of family-owned businesses, manage- managers in industries in which private equity ment succession issues will greater partnerships invest and, to a lesser extent, in attention; and for highly leveraged acquisitions, investment and commercial banking. efforts will focus on developing detailed cash- flow projections. RELATIONSHIP BETWEEN A PARTNERSHIP Extensive due diligence in the private AND ITS PORTFOLIO COMPANIES equity market is needed because little, if any, information about issuers is publicly available Partnership managers receive hundreds of and in most cases the partnership has had no investment proposals each year. Of these pro- relationship with the issuer. Thus, the partner- posals, only about 1 percent are chosen for ship must rely heavily on information that it can investment. The partnership managers’ success produce de novo. Moreover, the management of depends upon their ability to select these pro- the issuing firm typically knows more than out- posals efficiently. Efficient selection is properly siders do about many aspects of its business. regarded as more art than science and depends This , combined with the on the acumen of the general partners acquired fact that issuing private equity is very expensive, through experience operating businesses as has the potential to create severe adverse selec- well as experience in the private equity field. tion problems for investors. In the private equity Investment proposals are first screened to market, this problem is mitigated by the exten- eliminate those that are unpromising or that fail sive amount of due diligence and by the fact to meet the partnership’s investment criteria. that alternative sources of financing for private Private equity partnerships typically specialize equity issuers are limited. by type of investment and by industry and Information asymmetries between inves- location of the investment. Specialization re- tors and managers of the issuing firm give rise duces the number of investment opportunities to a potential moral hazard problem, whereby considered and reflects the degree of special- management pursues its own interests at the ized knowledge required to make successful expense of investors. Private equity partnerships investment decisions. rely on various mechanisms to align the in- This initial review consumes only a few terests of managers and investors. These mech- hours and results in the rejection of up to 90 anisms can be classified into two main percent of the proposals the partnership categories. The first category comprises mecha- receives. In many cases, the remaining pro- nisms that relate to performance incentives, posals are subjected to a second review, which including the level of managerial stock owner- may take several days. Critical information ship, the type of private equity issued to included in the investment proposal is verified investors, and the terms of management and the major assumptions of the business plans contracts. The second comprises are scrutinized. As many as half the proposals mechanisms that relate to direct means of con- that survived the initial screening are rejected at trol of the firm, including board representation, this stage. allocation of voting rights, and control of access Proposals that survive these preliminary to additional financing. These mechanisms are reviews become the subject of a more compre- examined in turn. hensive due-diligence process that can last up to six weeks. It includes visits to the firm; meet- Performance Incentives ings and telephone discussions with key Managerial Stock Ownership. Private equity employees, , suppliers, and creditors; managers usually insist that the portfolio firm’s and the retention of outside lawyers, accoun- senior managers own a significant share of their tants, and industry consultants. For proposals company’s stock, and stock ownership often that involve new ventures, the main concerns accounts for a large part of managers’ total com- are the quality of the firm’s management and pensation. In venture capital, management the economic viability of the firm’s or stock ownership varies widely depending upon (Gladstone 1988). For proposals involv- the management’s financial resources and the ing established firms, the general objective is to company’s financing needs and projected future gain a thorough understanding of the existing . It also depends upon the number of business, although the precise focus of the rounds of financing, as dilution typically occurs

FEDERAL RESERVE BANK OF DALLAS 29 ECONOMIC REVIEW THIRD QUARTER 1998 with each round. Even in later stage companies, uating the firm’s performance, and contributing however, management ownership of 20 percent significantly to the firm’s business and financial is not unusual. For nonventure companies, planning process. managerial share ownership usually ranges General partners can be extremely influ- between 10 percent and 20 percent. ential and effective outside directors. As large A common provision in both venture and stakeholders, they have an incentive to incur the nonventure financing is an equity “earn-out” expense necessary to monitor the firm. (Golder 1983). This arrangement allows man- Moreover, they have the resources to be effec- agement to increase its ownership share (at the tive monitors—in the form of their own staff expense of investors) if certain performance members, information acquired during the due- objectives are met. diligence process, and the expertise acquired Type of Private Equity Issued to Investors. while monitoring similar companies. Convertible is the private equity Private equity partnerships in many cases security most frequently issued to investors. The dominate the boards of their portfolio compa- major difference between convertible preferred nies. Lerner (1994) reports that general partners stock and is that holders of pre- hold more than one-third of the seats on the ferred stock are paid before holders of common boards of venture-backed biotechnology firms, stock in the event of liquidation. From the part- which is more than the share held by manage- nership’s standpoint, this offers two advantages. ment or other outside directors. Even if it is a First, it reduces the partnership’s investment minority investor, a private equity partnership risk. Second, and more important, it provides usually has at least one board seat and is able to strong performance incentives to the company’s participate actively in a company’s management. management because management typically Allocation of Voting Rights. For early-stage holds either common stock or warrants to pur- new ventures, leveraged buyouts, and finan- chase common stock. If the company is only cially distressed firms, the investment is often marginally successful, its common stock will be large enough to confer majority ownership. In worth relatively little. Thus, the use of convert- other situations, the partnership may obtain ible preferred stock mitigates moral hazard voting control even if it is not a majority share- problems. with conversion holder. Even if the partnership lacks voting privileges or warrants is sometimes used as an control, however, it is generally the largest non- alternative way of financing the firm: it confers management shareholder. Thus, it has a dispro- the same liquidation to investors as portionate degree of influence on matters that convertible preferred equity and, thus, the same come to a shareholder vote. performance incentives to management. In general, a partnership’s voting rights Management Employment Contracts. In do not depend on the type of stock issued. principle, management’s equity in the For example, holders of convertible preferred firm could induce excessive risk taking. stock may be allowed to vote their shares on However, management compensation can also an “as-converted” basis. Similarly, subordinated be structured to include provisions that penalize debt can be designed so that investors have poor performance, thereby offsetting incentives voting rights should a vote take place. The issue for risk taking. Such provisions often take the of voting control can also be addressed by form of employment contracts that specify creating separate classes of voting and nonvot- conditions under which management can be ing stock. replaced and buyback provisions that allow the Control of Access to Additional Financing. firm to repurchase a manager’s shares in the Partnerships can also exercise control by pro- event that he or she is replaced. viding a company with continued access to funds. This is especially the case for new ven- Mechanisms of Direct Control tures. Venture capital is typically provided to Although managerial incentives are a very portfolio companies in several rounds at fairly important means of aligning the interests of well-defined development stages, generally management and investors, a private equity with the amount provided just enough for the partnership relies primarily on its ability to exer- firm to advance to the next stage of develop- cise control over the firm to protect its interests. ment. Even if diversification provisions in the Board Representation. In principle, a firm’s partnership agreement prevent the partnership board of directors bears the ultimate responsi- itself from providing further financing, the gen- bility for the management of the firm, including eral partners have the power, through their hiring and firing the CEO, monitoring and eval- extensive contacts, to bring in other investors.

30 Conversely, if the original partnership is unwill- tives can significantly curtail the general part- ing to arrange for additional financing, it is ners’ inclination to engage in behavior that does unlikely that any other partnership will choose not maximize value for investors. Direct control to do so; the reluctance of the original partner- mechanisms in the partnership agreement are ship is a strong signal that the company is a relatively less important means of controlling poor investment. the moral hazard problem between general and Nonventure capital is also provided in limited partners. stages, though to a lesser extent. For example, middle-market firms that embark on a strategy Performance Incentives of acquisitions periodically require capital infu- Reputation. Partnerships have finite lives. sions to finance growth; that capital is not pro- To remain in business, private equity managers vided all at once. Similarly, companies that must regularly raise new funds, and fund raising undergo leveraged buyouts are forced to service is less costly for more reputable firms. In fact, to debt out of free cash flow and subsequently invest in portfolio companies on a continuous must justify the need for any new capital basis, managers must raise new partnerships (Palepu 1990). once the funds from the existing partnership Other Control Mechanisms. Other mecha- are fully invested, or about once every three to nisms by which partnerships control and moni- five years. tor the activities of the companies in which they Raising partnership funds is time consum- invest include covenants that give the partner- ing and costly, involving presentations to insti- ship the right to inspect the company’s facilities, tutional investors and their advisors that can books, and records and to receive timely finan- take from two months to well over a year, cial reports and operating statements. Other depending on the general partners’ reputation covenants require that the company not sell and experience. A favorable track record is stock or securities, merge or sell the company, important because it conveys some information or enter into large contracts without the about ability and suggests that general partners approval of the partnership. will take extra care to protect their reputation. Also, experience itself is regarded as an asset. RELATIONSHIP BETWEEN THE LIMITED PARTNERS To minimize their expenses, partnership man- AND THE GENERAL PARTNERS agers generally turn first to those who invested in their previous partnerships—assuming, of By investing through a partnership rather course, that their previous relationships were than directly in issuing firms, investors delegate satisfactory. to the general partners the labor-intensive Certain features of a partnership enhance responsibilities of selecting, structuring, manag- the ability of the general partners to establish a ing, and eventually liquidating private equity reputation. These features essentially make both investments. However, limited partners must be the partnership’s performance and the man- concerned with how effectively the general agers’ activities more transparent to investors partners safeguard their interests. Among the than might be the case for other financial inter- more obvious ways in which general partners mediaries. One such feature is segregated can further their own interests at the expense of investment pools. By comparing one partner- the limited partners are spending too little effort ship’s investment returns with those of other monitoring and advising portfolio firms, charg- partnerships raised at the same time, it is easier ing excessive management fees, taking undue to account for factors that are beyond the con- investment risks, and reserving the most attrac- trol of the general partners, such as the stage of tive investment opportunities for themselves. the or the condition of the mar- Private equity partnerships address these ket for initial public offerings, mergers, and problems in two basic ways: by using mecha- acquisitions. By contrast, if private equity inter- nisms that relate to performance incentives and mediaries did not maintain segregated invest- mechanisms that relate to direct means of con- ment pools, earnings would represent a blend trol. Performance incentives are the more of investment returns that occur at different important means of aligning general partners’ stages of the business cycle or under different interests with those of the limited partners. market conditions. These incentives involve the general partners’ Another feature is the separation of man- need to protect their reputations and the terms agement expenses and investment funds. In a of the general partners’ compensation structure, limited partnership, management fees are spec- such as their share of the profits. These incen- ified in the partnership agreement (described

FEDERAL RESERVE BANK OF DALLAS 31 ECONOMIC REVIEW THIRD QUARTER 1998 below). Thus, the amount of investment capital Partnership covenants also limit deal fees that can be consumed in the form of manager (by requiring that deal fees be offset against salaries and other perquisites is capped. More- management fees), restrict coinvestment with over, because such expenses are transparent, it the general partners’ earlier or later funds, and is easier to compare expenses across partner- restrict the ability of general partners and their ships. Other types of financial intermediaries associates to coinvest selectively in the partner- pay expenses and finance investments out of ship’s deals. the same funds raised from investors; although Finally, partnership agreements allow lim- expenses are reported, they are difficult to con- ited partners some degree of oversight over the trol before the fact and are not always transpar- partnership. Most partnerships have an advisory ent after the fact. board composed of the largest limited partners. Compensation Structure. General partners These boards help resolve conflicts involving earn a and a share of a part- deal fees and conflict-of-interest transactions. nership’s profits, the latter known as carried They do so by approving exemptions from part- interest. For a partnership that yields average nership covenants. Special committees are also returns, may be several times created to help determine the value of the part- larger than the management fees (Sahlman nership’s investments. However, these two 1990). This arrangement—providing limited types of bodies do not provide the kind of man- compensation for making and managing invest- agement oversight that a board of directors can ments and significant compensation in the form for a ; indeed, their power is limited of sharing—lies at the heart of the part- by the legal nature of the partnership, which nership’s incentive structure. prohibits limited partners from taking an fees are frequently set at a role in management. fixed percentage of committed capital and remain at that level over the partnership’s life. CONCLUSION Fee percentages range from 1 percent to 3 per- cent. Carried interest is most often set at 20 This article has presented an economic percent of the partnership’s net return. analysis of the private equity market. In par- ticular, it has detailed how the contracts that Direct Control Mechanisms limited partnerships write with investors and Partnership agreements also protect lim- portfolio firms address many of the adverse ited partners’ interests through covenants that selection and moral hazard problems that face place restrictions on a partnership’s investments investors considering investments in small and and on other activities of the general partners. medium-sized firms. Restrictions on investments are especially im- The private equity market’s success in portant because a considerable portion of the addressing these problems is evidenced by the general partners’ compensation is in the form of large number of successful firms that received an -like claim on the fund’s assets. This initial financing in this market. This success has form of compensation can lead to excessive risk been much admired in the rest of the indus- taking. In particular, it may be in the interest of trialized world, particularly in Japan and the general partners to maximize the partner- Germany. In these countries, private equity mar- ship’s risk—and hence the expected value of kets of the U.S. kind do not exist, primarily due their carried interest—rather than the partner- to the heavily regulated nature of their securities ship’s risk-adjusted expected rate of return. markets, and so firms rely much more on bank To address the problem of excessive risk financing. While such bank-centered taking, partnership covenants usually set limits may have had advantages in the past, there is on the percentage of the partnership’s capital an increasing feeling that such systems may that may be invested in a single firm. Covenants not adequately provide funds for small and may also preclude investments in publicly medium-sized firms that are the engine of future traded and foreign securities, derivatives, other and innovation. Both Japan private equity funds, and private equity invest- and Germany have recently taken steps to ments that deviate significantly from the part- deregulate their financial markets. By fostering nership’s primary focus. Finally, covenants the growth of U.S. private equity market prac- usually restrict the fund’s use of debt and in tices, these countries hope to solve the informa- many cases require that cash from the sale of tional and problems of small firms portfolio assets be distributed to investors looking for capital. immediately.

32 NOTES management may have little or no incentive to act in equityholders’ best interests. 1 This article draws selectively from a longer, more 12 If, for example, investors must investigate the interme- comprehensive research paper on the private equity diary to the same extent that they would investigate market by Fenn, Liang, and Prowse (1997). the investments that the intermediary makes on their 2 Some studies have been made of particular market behalf, using one may be less efficient (Diamond 1984). sectors, such as venture capital and leveraged buy- 13 Intermediaries are also important because selecting, outs (LBOs) of large public companies. On venture structuring, and managing private equity investments capital, see Sahlman (1990) and special issues of require considerable expertise. Gaining such exper- Financial Management (1994) and The Financier tise requires a critical mass of investment activity that (1994). For a summary of the LBO literature, see most institutional investors cannot attain on their own. Jensen (1994). Managers of private equity intermediaries are able to 3 An equity investment is any form of security that has an acquire such expertise through exposure to and equity participation feature. The most common forms are participation in a large number of investment oppor- common stock, convertible preferred stock, and sub- tunities. Although institutional investors could also ordinated debt with conversion privileges or warrants. specialize in this way, they would lose the benefits of 4 The emergence of limited partnerships is actually diversification. Finally, intermediaries play an important more dramatic than these figures indicate. As recently role in furnishing business expertise to the firms in as 1977, limited partnerships managed less than 20 which they invest. Reputation, learning, and speciali- percent of the private equity stock. zation all enhance an intermediary’s ability to provide 5 These and other figures in this section are my esti- these services. For example, a reputation for investing mates based on information from a variety of sources. in well-managed firms is valuable in obtaining the ser- See Fenn, Liang, and Prowse (1997) for details on how vices of underwriters. Likewise, specialization allows these estimates are constructed. an intermediary to more effectively assist its portfolio 6 Private equity is often included in a portfolio of “alter- companies in hiring personnel, dealing with suppliers, native assets” that also includes distressed debt, and helping in other operations-related matters. emerging market stocks, , oil and gas, 14 Many partnerships that have a single limited partner timber and farmland, and economically targeted have been initiated and organized by the limited part- investments. ner rather than by the general partner. Such limited 7 Two other types of private equity organizations are partners are in many cases nonfinancial corporations SBICs owned by bank holding companies and venture that want to invest for strategic as well as financial capital subsidiaries of nonfinancial corporations. Both reasons—for example, a corporation that wants expo- types were extremely important in the 1960s, and they sure to emerging technologies in its field. still manage significant amounts of private equity. How- ever, these organizations invest only their corporate REFERENCES parent’s capital. In this sense, neither is really an inter- mediary but rather a conduit for direct investments. Diamond, Douglas W. (1984), “Financial Intermediation I treat the investments by these organizations as direct and Delegated Monitoring,” Review of Economic Studies investments, not as investments by intermediaries. 51 (July): 393–414. 8 See the Venture Capital Journal, October 1983. 9 This, of course, raises the question of why private Fenn, George, Nellie Liang, and Stephen D. Prowse equity investments haven’t proven to be ideal for (1997), “The Private Equity Market: An Overview,” Finan- closed-end mutual funds, wherein the fund invests cial Markets, Institutions and Instruments 6 (4): 1–105. money for the long term but investors can get out in the short term. Financial Management 23 (1994), May. 10 For example, partnerships in the first row were formed between the years 1969 and 1979. These funds would The Financier 1 (1994), Autumn. have invested and earned returns on their capital between the years 1969 and 1988. The first row/fourth Gladstone, David (1988), Venture Capital Handbook column thus shows the annual average return to public (Englewood Cliffs, N.J.: Prentice Hall). small companies over this 20-year period. Returns for small-company stocks for the other periods are simi- Golder, Stanley (1983), “Structuring and Pricing the larly calculated. Returns for small-company stocks are Financing,” in Guide to Venture Capital, ed. Stanley Pratt after transactions costs (Ibbotson 1997). (Wellesley, Mass.: Capital Publishing Corp.). 11 In venture investing, for example, the firm is often a start-up with no track record. In a leveraged buyout, Ibbotson, Roger (1997), Stocks, Bonds, Bills, and while there may be ample information about the firm, 1997 Yearbook (Chicago: Ibbotson Associates).

FEDERAL RESERVE BANK OF DALLAS 33 ECONOMIC REVIEW THIRD QUARTER 1998 Jensen, Michael C. (1994), “The Modern Industrial Revo- Ross, Stephen A. (1977), “The Determination of Financial lution, Exit, and the Failure of Internal Control Systems,” Structure: The Incentive-Signalling Approach,” Bell Journal of Applied Corporate Finance 6 (Winter): 4–23. Journal of Economics 8 (Spring): 23–40.

Leland, Hayne, and David Pyle (1977), “Information Sahlman, William A. (1990), “The Structure and Govern- Asymmetries, Financial Structure and Financial ance of Venture Capital Organizations,” Journal of Intermediation,” Journal of Finance 32 (May): 371–87. 27 (Spring): 473–521.

Lerner, Joshua (1994), “Venture Capitalists and the Venture Capital Journal (1983), “SBICs After 25 Years: Oversight of Private Firms” (unpublished working paper, Pioneers and Builders of Organized Venture Capital,” Harvard University). October.

Palepu, Krishna (1990), “Consequences of Leveraged Buyouts,” Journal of Financial Economics 27 (September): 247–62.

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