The rise and rise of private equity

Why have the headline-grabbing bulge bracket funds of the private equity world continued to grow ever larger, while venture capital funds have not?

A study by Andrew Metrick and Ayako Yasuda from the Wharton School takes data on 249 funds, provided by one of the world’s largest LPs – mysteriously dubbed “the Investor” – and models estimated revenue across the funds.

Metrick and Yasuda found that buyout funds earn lower revenue per dollar managed than their venture capital counterparts – but that it is the buy-out fund managers that deliver a substantially higher revenue per partner and revenue per professional.

The managers of buy-out funds can compensate for their lower unit revenue, the study suggests, by using their track record to raise ever-larger funds. As the funds grow their revenue per unit of committed capital actually falls – but revenue per partner and per professional increases significantly. So these mangers can up their fund size and deliver increased revenue without significantly increasing their numbers of partners or other staff.

In contrast, the VC fund managers’ experience also leads to higher revenue per partner in later funds, but does not lead to higher revenue per professional. In venture capital, the costs of raising and deploying ever-larger funds, in the form of more staff, are higher than for buy-out funds.

The authors suggest that VC firms add a member of staff for each additional $100m under management, while buy-out funds add only one for each additional $200m.

“There results suggest that the BO business is more scalable than the VC business…[and]…can help explain why the late 1990s growth of the VC sector was a failure, while the BO sector has continued to grow in the 21st century,” they conclude.

While bigger buy-out funds just open up a new range of (larger) companies as potential investments (see TXU, EOP, Vivendi and so on), the same is not true for venture capital, where investment size is by its nature more limited.

In VC too, investments are more likely to fall either into the raging success or utter, unmitigated disaster pile – while the challenge of picking unproven, start-up concepts to back might also suggest that experience on one deal transfers less readily to the next, than for buy-outs.

The New Economist blog also points to the IT bust as a factor: “Those venture capitalist had to go somewhere… and in a low volatility world desperate for yield and facing greater regulatory burdens for listed equity, private equity was bound to make headway.”