Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in...

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Private Capital in the Wake of the Crisis Josh Lerner Harvard Business School

Transcript of Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in...

Page 1: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Private Capital in the Wake of the Crisis

Josh Lerner

Harvard Business School

Page 2: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Time of many questions

Recovery in private equity deal volume...– More limited resurgence of debt financing.

But residual unhappiness of limited partners:– Interest in “going it alone.”– Questions about explosion in secondary deal

activity.

And looming regulatory and tax uncertainties world-wide.

Page 3: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Suggests several possibilities

Will outline four scenarios:– Recovery.– Back to the future.– The LPs’ desertion.– A broken industry.

Page 4: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Four scenariosConstant Investor

BaseTurnover in Investor

Base

“Fair” Returns Recovery Back to the Future

Disappointing Returns A Broken Industry The LPs’ Desertion

Page 5: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Scenario 1: Recovery

VC and PE are inherently cyclical:– Too much investment during booms.– Too high-priced investments during booms.

But there is a well-defined value proposition associated with these investments.

While things may get out of balance in booms, steady state works well:– Classic process of recalibration going on right

now.

Page 6: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

IPOs and VC investmentsIPOs and Number of Investments -- Internet and

Computers

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1975 1979 1983 1987 1991 1995 1999 2003

Inve

stm

ents

020406080100120140160180200

IPO

s

IPOs Investments

IPOs and Number of Investments -- Biotech and Healthcare

0

200

400

600

800

1000

1200

1400

1975 1979 1983 1987 1991 1995 1999 2003

Inve

stm

ents

0

10

20

30

40

50

60

70

80

IPO

s

IPOs Investments

IPOs and Number of Investments -- Communications

0

500

1000

1500

2000

2500

3000

1975 1979 1983 1987 1991 1995 1999 2003

Inve

stm

ents

0

10

20

30

40

50

60

70IP

Os

IPOs Investments

IPOs and Number of Investments -- Energy

0

20

40

60

80

100

120

1975 1979 1983 1987 1991 1995 1999 2003

Inve

stm

ents

0

5

10

15

20

25

30

IPO

s

IPOs Investments

Source: Gompers, Kovner, Lerner and Scharfstein [2008].

Page 7: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Debt and LBO multiples over the cycle

Source: Axelson, Jenkinson, Stromberg, and Weisbach [2009].

Page 8: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Also true at a fund level

• Funds do better as they get larger… to a point!

• Fund size is measured as capital committed at closing.

• Regression results control for vintage year effect, location, and fund category.0%

5%

10%

15%

20%

25%

10 20 50 100

200

500

1,000

2,00

05,

000

Pred

icte

d R

elat

ive

IRR

Fund Size ($ millions)

Buyout

Venture Capital

Source: Lerner, Leamon and Hardymon [2011]

Page 9: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Private equity and management practices

Source: Bloom, Sandun, and van Reenen [2009].

Page 10: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Implications

Gradual recovery of returns reflecting fundamental value creation.

Inflow of funds back into VC/PE market.

Repeating boom/bust pattern that has characterized industry through 1950s.

Page 11: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Scenario 2: Back to the future

Returns to limited partners are inherently “undemocratic.”– Skewness of returns:

Only a few funds are winners.Trend seems to be intensifying.

– Most investors have done poorly, and will gradually abandon programs.

Page 12: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Returns of U.S. venture funds

Returns from inception to 12/31/09. Source: Authors’ analysis of Thomson/Reuters data.

Page 13: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Returns of U.S. buyout funds

Returns from inception to 12/31/09. Source: Authors’ analysis of Thomson/Reuters data.

Page 14: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

European private equity returns

-100%

-50%

0%

50%

100%

150%

200%

250%

300%

350%

400%

100th percentile

90th percentile

80th percentile

70th percentile

60th percentile

50th percentile

40th percentile

30th percentile

20th percentile

10th percentile

0th percentile

Returns of 1227 funds from inception to 12/31/09. Source: Venture Economics.

Page 15: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Persistence of performance

Bottom Medium Top

Bottom Tercile 61% 22% 17%

Medium Tercile 25% 45% 30%

Top Tercile 27% 24% 48%

• High likelihood that the next funds of a given partnership stays in the same performance bracket Persistence.

• 1% boost in past performance → 0.77% boost in next fund’s performance.Source: Kaplan and Schoar [2005]

Page 16: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Performance by investor type, private equity funds between 1992 and 2001

-5% 0% 5% 10% 15% 20%

Endowments

Private Pensions

Insurance Companies

Public Pensions

Funds-of-Funds

Banks

Source: Lerner, Schoar and Wongsunwai [2007]

Page 17: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Implications

Questioning of assumptions behind private equity in many investment committees.– Exit by many LPs who have:

Newer programs. “Too large” or “too small” mandates.

Limited number of LPs will remain, and will thrive.

Page 18: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Scenario 3: The LPs’ desertion

Poor returns may lead LPs to essentially abandon asset class:– Precedent of oil-and-gas partnerships,

others.

May conclude that inherently impossible to set right.

Page 19: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Fees have driven sharp wedge between net and gross returns

Payments per partner per fund, based on 240+ PE/VC partnerships ($MMs):

VC LBO– Carried interest: 5.2 10.1– Management fees 10.6 18.5– Other fees: 1.3 4.1– Total 17.1 32.7

• Metrick and Yasuda [2009]

Page 20: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

An non-addressable issue?

Failure to get traction partially reflected proponents and timing.

But more fundamental challenges:– Fractured nature of LP community.– Competition between LPs to get into top

funds.– Turnover within LPs.

Page 21: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Implications

Decreasing LP pool.

Extensive exit by funds.

Increasing reliance on non-institutionalized capital sources.

Page 22: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983
Page 23: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Scenario 4: A broken industry

Due to measurement issues and organization dynamics, PE groups may continue to raise funds.

Even if returns are not there!– May continue for years or decades more…

Example of VC industry?!

Page 24: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Decade-plus disappointment in venture capital

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Distributed/paid-in capital, by vintage year, U.S. VC funds

Average

Median

1997 is last year with >0 median and mean return

Source: Thomson/Reuters. Data as of 9/30/09.

Page 25: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Exits by venture funds ($B)

Source: Sand Hill Econometrics

Page 26: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Investments by venture funds ($B)

Source: Sand Hill Econometrics

Page 27: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Implications

Reactions by LPs may be very slow.– Triumph of hope over experience?!– In many cases, may draw wrong

conclusions:E.g., shift to direct investments by sovereign

funds.

Suggests period of protracted disappointment.

Page 28: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Final thoughts

Time to step back and think about where business is going.

Can plausibly tell a variety of stories, with supporting evidence.

All have elements of truth, but… – Believe some combination of first and

second scenario is most plausible.

Page 29: Private Capital in the Wake of the Crisis - Brookings Institution...Decade-plus disappointment in venture capital 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1980 1981 1982 1983

Josh LernerRock Center for Entrepreneurship

Harvard Business SchoolBoston, MA 02163

617-495-6065

josh @ hbs.eduwww.people.hbs.edu/jlerner


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