A week in Harvard - Private Equity
The two cases for Wednesday were a private equity investment on Orangina by Lion Capital and the Blacksone group, and a middle-east private equity company Abraaj Capital. Our professor for the day was Josh Lerner, professor of investment banking at HBS with a joint appointment in the finance and the entrepreneurial management units. Professor Lerner's research focuses on private equity and venture capital. His latest book is titled "Boulevard of broken dreams: Why public efforts to boost entrepreneurship and venture capital have failed - and what to do about it". Another extremely timely topic.
In addition to thoroughly examining the two cases, prof Lerner also walked us through the history, and the future of private equity (PE) and venture capital (VC).
How we have gotten to where we are today
The pioneering funds were created post great depression. This early phase of PE lasted from 1946 to 1977. After the war there was a worry about post-war stagnation, and difficulty in raising capital for new businesses, so the government set up some limited initial equity funds. Also wealthy families acted as business angles, and the Ivy League universities did fund early start up businesses.
Around 1975 Intel and other technology companies began receiving funds and settling in Silicon Valley, which led to an era of hyper growth between 1978 and 1987. This is the time of birth for PE companies like Kleiner Perkins, KKR, etc. This era saw a change in the way large pension funds viewed PE, and they began allocating up to 5% of their funds to PE, instead of stock/bond only. The government also reduced capital gains taxes. Together these measures resulted a 3-fold increase in in the number of funds, rapid growth in existing funds, creation of first European and Asian funds, and the dominance in limited partnerships (VC).
Years 1988 to 1996 saw a slower period in private equity in response to low returns, until another boom came along. From 1997 onwards there was a tremendous growth in VC, and diversification to new regions, and new industries. Lots of new entry, and competition for deals, buyouts, public VC alternatives and incubators saw daylight. This lasted, naturally, only as long as the .com boom was running. Our current decade has seen a boom, a drop, another boom, and now a complete bust due to the financial crisis in 2008 and 2009.
Professor Lerner pointed out some learning from the past, presented in myths:
Myth 1: PE has had spectacular returns. The truth is that some investors have had a fantastic track record, e.g. returns for Yale in 1973-2006 are 30,6% in general (34,8% in US VC). However, the average returns are somewhere around 10-15%.
Myth 2: PE is an asset class. The truth here is that there is a big difference between different fund classes, and between different funds in VC. There are funds that can generate up to a 700% return, but those are extremely rare. Most funds provide zero, so the trick is to find the right fund, not to rely blindly on the category.
Myth 3: Regression to the mean. This refers to the sort of thinking that there would be a mean to fund returns. "our last two funds were a disappointment, so the next one should be ok..." The truth is there is no mean. Usually the good guys keep on staying good, and the less performing guys stay less performing.
Myth 4: Anyone can play. New players like public pension funds, and non-US governmental entities have been attracted to PE and VC activity, encouraged by winnings of others. The truth is, there is great performance variance by investor types. Anyone can play but everyone will not get the same returns.
In short, lessons from the past include the importance of cycles, diversity of groups, and the persistence of winners.
The future of Private Equity
The financial and real economy crisis has now led to a dramatic collapse in buyout volume, and troubles in both existing PE portfolios and VC. Year 1997 was the last year with median and mean returns on VC above zero. Succesful pioneers have suffered great losses in their PE portfolio (Yale -25%, Harvard and Stanford both -27% in 2009, and many other down -30% or more).
Professor Lerner looks into the viability of PE model as a whole, and tries to understand what will change. His argument is that there is a fundamental paradox between the power of a PE model, and the current industry structure. According to him, it is a healthier industry structure that we need, as he showed with numerous proof that PE funded companies
- have a lower bancruptcy rate
- destroy old jobs quicker, but also build new jobs quicker
- has a better productivity
- has the best management practices
- adds more to innovation
PE brings all these benefits, but it's not all so rosy. The cycles in alternative investing, increasing concentration of funds, and increasing fees are cutting the benefits from private equity funding. Professor Lerner proposes a new private equity funding model where fewer players will do better. These new funds will be small or mid-sized, they have a well defined focus, don't have a troubled legacy, have ready access to capital and are experts on developing countries.
In addition to thoroughly examining the two cases, prof Lerner also walked us through the history, and the future of private equity (PE) and venture capital (VC).
How we have gotten to where we are today
The pioneering funds were created post great depression. This early phase of PE lasted from 1946 to 1977. After the war there was a worry about post-war stagnation, and difficulty in raising capital for new businesses, so the government set up some limited initial equity funds. Also wealthy families acted as business angles, and the Ivy League universities did fund early start up businesses.
Around 1975 Intel and other technology companies began receiving funds and settling in Silicon Valley, which led to an era of hyper growth between 1978 and 1987. This is the time of birth for PE companies like Kleiner Perkins, KKR, etc. This era saw a change in the way large pension funds viewed PE, and they began allocating up to 5% of their funds to PE, instead of stock/bond only. The government also reduced capital gains taxes. Together these measures resulted a 3-fold increase in in the number of funds, rapid growth in existing funds, creation of first European and Asian funds, and the dominance in limited partnerships (VC).
Years 1988 to 1996 saw a slower period in private equity in response to low returns, until another boom came along. From 1997 onwards there was a tremendous growth in VC, and diversification to new regions, and new industries. Lots of new entry, and competition for deals, buyouts, public VC alternatives and incubators saw daylight. This lasted, naturally, only as long as the .com boom was running. Our current decade has seen a boom, a drop, another boom, and now a complete bust due to the financial crisis in 2008 and 2009.
Professor Lerner pointed out some learning from the past, presented in myths:
Myth 1: PE has had spectacular returns. The truth is that some investors have had a fantastic track record, e.g. returns for Yale in 1973-2006 are 30,6% in general (34,8% in US VC). However, the average returns are somewhere around 10-15%.
Myth 2: PE is an asset class. The truth here is that there is a big difference between different fund classes, and between different funds in VC. There are funds that can generate up to a 700% return, but those are extremely rare. Most funds provide zero, so the trick is to find the right fund, not to rely blindly on the category.
Myth 3: Regression to the mean. This refers to the sort of thinking that there would be a mean to fund returns. "our last two funds were a disappointment, so the next one should be ok..." The truth is there is no mean. Usually the good guys keep on staying good, and the less performing guys stay less performing.
Myth 4: Anyone can play. New players like public pension funds, and non-US governmental entities have been attracted to PE and VC activity, encouraged by winnings of others. The truth is, there is great performance variance by investor types. Anyone can play but everyone will not get the same returns.
In short, lessons from the past include the importance of cycles, diversity of groups, and the persistence of winners.
The future of Private Equity
The financial and real economy crisis has now led to a dramatic collapse in buyout volume, and troubles in both existing PE portfolios and VC. Year 1997 was the last year with median and mean returns on VC above zero. Succesful pioneers have suffered great losses in their PE portfolio (Yale -25%, Harvard and Stanford both -27% in 2009, and many other down -30% or more).
Professor Lerner looks into the viability of PE model as a whole, and tries to understand what will change. His argument is that there is a fundamental paradox between the power of a PE model, and the current industry structure. According to him, it is a healthier industry structure that we need, as he showed with numerous proof that PE funded companies
- have a lower bancruptcy rate
- destroy old jobs quicker, but also build new jobs quicker
- has a better productivity
- has the best management practices
- adds more to innovation
PE brings all these benefits, but it's not all so rosy. The cycles in alternative investing, increasing concentration of funds, and increasing fees are cutting the benefits from private equity funding. Professor Lerner proposes a new private equity funding model where fewer players will do better. These new funds will be small or mid-sized, they have a well defined focus, don't have a troubled legacy, have ready access to capital and are experts on developing countries.
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Petra, thanks for an interesting review of what you learned about PE investments. I think you should receive extra credit just for writing this blog entry!
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