Inside the $2.5 Trillion Global Private Equity Market

Private equity funds’ roles in the economy and their managerial compensation drew scrutiny following the recent global financial crisis, and there is an ongoing debate about increasing taxation on private equity managers’ profit participation, and on the industry’s impact on innovation, competition and employment.

Over the past 15 years, worldwide private equity investment has skyrocketed from $100 billion in 1994 to about $2.5 trillion today, driven by institutional investors’ portfolio allocation to private equity, which increased from 3 percent on average in 1997 to 12 percent in 2007 for large foundations.

Associate Professor Ayako Yasuda recently teamed with Professor Andrew Metrick of the Yale School of Management to publish the first survey paper of its kind to treat and examine both the venture capital (VC) and the buyout (BO) segments as subsets of a broader, private equity industry. The paper, “Venture Capital and Other Private Equity: A Survey,” was the lead article in European Financial Management (September 2011).

“We focus on what distinguishes both VC and BO funds from hedge funds and mutual funds, for example,” the authors write, “and discuss the theory and evidence on this ‘private equity’ industry both as financial intermediaries and as an asset class.”

Their study notes the importance of private ownership, and information asymmetry and liquidity associated with it, to explain what makes private equity different from other asset classes. The paper reviews the literature on various topics, including value-added activities of VC and BO investors, performance of private equity funds, and contracts between private equity fund managers and their investors.

“Both VC and BO backing is associated with significant changes in the ways the investee companies are operated, including more independent and hands-on boards, higher earnings quality, and higher CEO turnover,” Yasuda and Metrick write. On the flip side, investors in VC and private equity funds ink contracts that will best align their interests, via a profit-sharing agreement, closed-end, finite-life fund structure, limited reinvestments, and explicit negative covenants preventing VC and BO fund managers from taking excessive risk and/or diverting efforts away from funds.