FAQs About Venture Capital & Private Equity
Private equity is an investment asset class describing private investments in privately held (as opposed to publicly traded) companies. As an asset class, private equity investments are very illiquid; investment commitments have typical durations of 7 - 10 years.
Private equity firms receive their investment capital from Limited Partners (LPs). These LPs are frequently pension funds, foundations, and endowments which have large amounts of capital to invest. Private equity is generally part of an LP's overall investment strategy that may include real estate, bonds, and publicly traded company stock.
The goal of every private equity firm is to generate a higher-than-market rate of return for its investors. The S&P 500 is a typical benchmark against which returns are measured. The private equity industry generates returns by investing in the stock of private companies and subsequently generating a capital gain on that stock when the company is sold or becomes publicly traded.
A private equity firm typically has one or more funds that it manages. Each fund will have a stated investment strategy that describes aspects of investments it prefers. These preferences may include:
- Industries
- Geography
- Stage of deals, e.g., pre-revenue or post-revenue, growing or mature
- Size of total investment
Each fund has a General Partner (GP). The general partner is responsible for:
- Selecting the best investments or portfolio companies for a fund
- Working with the management of these portfolio companies to increase the value of the initial investment
- Developing a strategy for the fund to exit the investment within a given time frame
Private Equity falls into two broad groups: venture capital and other private equity.
Venture capital describes investments in companies that are in the early life-cycle stages. Typically, venture capital finances new, rapidly growing businesses. Venture capital investments are generally high-risk investments but offer the potential for returns well above the S&P 500. Venture capital is an important source of equity for start-up companies.
Most other private equity is invested in more mature or later-stage companies. Frequently, other private equity is a source of liquidity for owners of privately held companies. Often, other private equity is referred to as leveraged buyouts (LBOs) or management buyouts (MBOs).
Buyout financing, or acquisition financing, funds the purchase by an investor of full control of a business, or it finances the purchase by other new owners. Buyout firms-another form of private equity-may buy the majority of the stock of a private division of a parent company when the parent divests it. Or they may buy the majority of the stock of a company, along with its management team, when the company's owner is ready to sell. A leveraged buyout is when buyout funding is supplemented by additional money borrowed from lenders.
The IVCA references Thomson Venture Economics' terminology, which defines the following stages:
- Venture Capital
- Seed stage: Product development, market research
- Start-up financing: Key mgmt. in place, initial marketing, pre-sales
- Other early stage: Product in development or available, first institutional financing
- Expansion/growth stage: Product shipping, funds needed for working capital or plant expansion
- Later Stage: Stable growth rate, likely to be profitable, cash flow positive
- Bridge financing: Company to go public in 6 - 12 months
- Other Private Equity
- Open market: Company is publicly traded
- Acquisitions: LBOs, acquisitions, recapitalizations
- Mgmt/leveraged buyout: Management acquiring a product line or business at any stage of development
- Turnaround: Operationally or financially troubled
Private equity is a favored asset class for professional managers because it has historically produced superior returns. Annual returns over the past twenty years have averaged 13.7%, beating stocks, bonds, real estate, and most other forms of investment. Its risk is a reference to the importance of spreading investments over long time periods, in multiple industry sectors, and in a large number of investments. Professional money managers know how to do so, which is why private equity has a prominent place in large investment portfolios, even in conservative ones like those of pension funds and universities.
By law, private equity investments are open mainly to accredited investors, which are basically institutional investors and experienced individuals with resources appropriate for the long-term, illiquid nature of private equity. Exceptions include small numbers of friends and family, who often participate in seed financing. However, as indicated above, it is ordinary citizens like pensioners who ultimately benefit from the returns generated by venture capital, and the general public benefits immensely from the economic impact of the investments made.
In Illinois, The Illinois Teachers Retirement System, the Illinois State Employees' Retirement System, Northwestern University, University of Chicago, and the MacArthur Foundation are just a few. The goal of every private equity investor is to receive a higher-than-market rate of return for their investors.
These firms generate money in annual fee income which goes directly into the state's economy in the form of payroll for the firms' employees, rent, and a large variety of service fees paid to the lawyers, accountants, and other professionals who support these firms. In addition, the managers of these firms will pay the state taxes on capital gains generated.
Venture capital investments create jobs-great jobs.
On average, 75% of venture capital investment is spent on payroll, and venture capitalists generally estimate compensation per-employee at their portfolio companies to be $100,000 per year. Consequently, each $1 million of venture capital directly creates or sustains seven and one-half skilled, high-paying jobs.
- For every job directly created, another 2.2 jobs are indirectly created through the multiplier effect.
- Over time, companies that are originally financed with venture capital grow to become major employers.
Beyond jobs, venture capital drives sales, taxes, exports, and R&D.
- Per $1,000, companies backed by venture capital have approximately twice the sales, pay almost three times the federal taxes, generate almost twice the exports, and invest almost three times as much in R&D as the average company that is not backed by venture capital.
Other private equity firms have been responsible for reinvigorating failing or mature businesses/industries. These firms generate annual fee income which goes directly into the state's economy in the form of payroll for the firms' employees, rent, and a large variety of service fees paid to the lawyers, accountants and other professionals who support these firms. In addition, the managers of these firms will pay state taxes on the capital gains generated.
For all of the economic reasons we discussed above. In addition, private equity returns historically exceed those of the S&P. Prudent investments in the asset class have returned, on average, 15.7% annually versus 15.2% for the S&P. Annuitants in the public pension funds would benefit from an appropriate allocation to this asset class. Moreover, returns being equal, investments in Illinois funds drive employment and a strong tax base.
Case Studies
The IVCA Private Equity Profiles is a continuing series of portraits of Illinois venture capital and private equity investments, spotlights companies that are emerging or proven successes. Each account furnishes information about the company and the private equity firm or firms that invested in it, illuminating the important role they play in nurturing the companies. To submit a case study for a Midwest company backed by an IVCA member firm download this form.