Raising the Curtain on Private Equity Funds

Having grown steadily over the past three decades, private equity funds worldwide today manage $1 trillion in capital raised from retail, individual and institutional investors. They play an increasingly important role as financial intermediaries in addition to their significant day-to-day involvement as company board members and advisors. Yet relatively little is known about the industrial organization of these various funds.

In fact, the private equity market hit a wall last year. According to Dow Jones, U.S. private equity fund-raising closed out its worst year since 2003, with 331 funds raising $95.8 billion in 2009. That’s down 68% from the $300 billion raised by 508 funds in 2008.

Against this backdrop, Assistant Professor Ayako Yasuda and Professor Andrew Metrick of the Yale School of Management teamed up to identify and differentiae the economic characteristics of private equity sectors as an important indication of how the funds may perform for investors and fund managers.

In “The Economics of Private Equity Funds,” forthcoming in the Review of Financial Studies, Yasuda and Metrick used data from a large investor who considered investing in 238 private equity funds raised between 1993 and 2006. Yasuda and Metrick developed an innovative model that estimates the expected revenues fund managers would obtain as a function of fee and profit sharing rules. They then estimated how revenues vary across sample funds; these revenue variations allowed them to identify differences between types of funds, such as venture capital (VC) and buyout (BO) funds.

“VCs and BOs have similar fund structures, but our data show that their economic models are very different,” Yasuda explained.

One distinguishing feature is scalability. According to Yasuda’s findings, venture capital investments are consolidated into small firms with typical valuation in the tens of millions. Venture capitalists hold investments in high-growth start-ups until they mature to have an exit value of $150– $200 million or more. In contrast, once a buyout fund manager is successful in handling $100 million companies, they may apply those same skills to managing $1 billion companies. In short, venture capitalists add value to small companies while buyout fund managers add value to larger companies, making their funds more scalable. The result: buyout fund managers generally earn more revenue because they are able to build on their experience by increasing the size of their funds faster.

“Successful BO funds grow faster than successful VC funds, meaning that access to the top VC funds is more difficult for investors than access to the top BO funds,” Yasuda said. Her research is a first step in categorizing the differences and bringing to light how these private equity investments function.

Yasuda has presented these findings at the Amsterdam Business School, Cornell University, MIT, Princeton University, Stanford University, Tuck at Dartmouth College, USC and The Wharton School at the University of Pennsylvania. She also has presented on the topic at the Conference on Private Equity at the University of Chicago; the Entrepreneurship, Venture Capital and Initial Public Offerings Conference at Harvard Business School; the National Bureau of Economic Research in Cambridge, Mass.; The Institute for Financial Research’s conference on the Economics of Private Equity Market in Stockholm, the Federal Reserve Bank of San Francisco’s Center for the Study of Innovation and Productivity symposium on private equity; and the European Financial Management Association’s annual meeting in Madrid.