48 Pages Posted: 23 Apr 1998
Over the past fifteen years, there has been a tremendous boom in the private equity industry. The pool of U.S. private equity funds (partnerships specializing in venture capital, leveraged buyouts, mezzanine investments, build-ups, and distressed debt) has grown from $5 billion in 1980 to about $150 billion in 1997. Private equity's recent growth has outstripped that of almost every class of financial product. While some of this growth was driven by the easing of federal regulations, it also reflects investors' growing appreciation of the effectiveness of the organizational structures and control mechanisms employed by private equity funds.
This document describes a course exploring this industry, "Venture Capital and Private Equity." This course was introduced by the author of this working paper at Harvard Business School in the 1993-1994 academic year. In recent years, two full sections, each of approximately 100 MBAs and other students have signed up for the course, with a significant waiting list. The cases in this course have also been used in a variety of other settings, including an annual executive education course on private equity organized by Paul Gompers and the author at Harvard Business School, and in entrepreneurship and private equity courses at a variety of other major business schools.
Three primary pedagogical objectives motivate the design and structure of the course. First, and most fundamentally, the course seeks to deepen students' understanding of corporate finance. This course differs from some academic programs in entrepreneurship, which emphasize the uniqueness of private equity finance and the limited applicability of academic theory. For instance, one leading entrepreneurship text [Timmons, 1994] states, "there are both stark and subtle differences, both in theory and practice, between entrepreneurial finance as practiced in higher potential ventures and corporate or administrative finance, which usually occurs in larger publicly traded companies. Further, there are important limits to some financial theories as applied to new ventures." By way of contrast, this course emphasizes the relevance of the intellectual frameworks used to analyze corporate finance problems (incomplete contracting theory, agency problems, etc.) for the private equity industry. Wherever possible, the links to other finance courses are emphasized. Thus, one goal is to review and apply the key concepts and tools of corporate finance in an environment that the students perceive as very interesting.
Second, the course seeks to build familiarity with the key institutional features of the private equity industry. Whether discussing fund structures, potential investments, or returns, participants in the private equity industry often describe phenomena in language that is somewhat different from other financial investors. Understanding the key frameworks employed by private equity investors, and relating them to traditional finance practice, is thus an important goal. A related objective is building an appreciation for the gradations inherent in the industry. Students often consider the private equity industry as an undifferentiated whole, without appreciating the very significant differences in the standards and practices that exist between these groups. An appreciation of the many important differences between these groups is important lesson. Much of the fulfillment of this second goal, it is important to note, takes place outside of the classroom. An important component of the course is the final paper. Whether students intend to work for a private equity organization or to accept money from one, careful due diligence is essential. Private equity funds jealously guard their privacy, and distinguishing between top-tier organizations and less reputable concerns is not always easy. The final paper offers an opportunity to become better acquainted with key resources, including trade magazines, legal handbooks, academic articles, and on-line databases. An important resource in completing the project is the VentureOne database of private equity financings, which the firm has generously made available to the class.
Finally, a crucial objective is to build an appreciation of the valuation process in the private equity setting. Valuation issues are often the subject of contentious disputes, whether the context is assessing the relative past returns of several private equity groups, determining the impact of a shift in a buyout fund's fee structure, allocating equity in a start-up to management and one or more private equity groups, or assessing the impact of a "sweetener" of warrants (a grant of warrants in addition to a block of equity) on the price paid per share by private equity investors. Industry practice, reflecting private equity's early state of evolution relative to many other financial sectors, can often appear to the outside observer as sloppy and not standardized. Skill in analyzing value is likely to be an increasingly important competitive skill in the private equity industry. This course consequently introduces a wide array of valuation methodologies. These range from approaches commonly seen in practice (e.g., the use of comparables and the "venture capital" method) to those less frequently employed but likely to be useful nonetheless (the use of Monte Carlo simulations and option pricing techniques). The course emphasizes not only the mechanisms employed, but also how to clearly communicate the strengths and limitations of each approach. These discussions are facilitated by the use of Harvard Business School's electronic infrastructure. For a typical class, a spreadsheet containing the case problems is posted on the School's intranet prior to class, the class discussion includes an analysis of the spreadsheet (with the spreadsheet simultaneously projected on the central screen), and the fully worked analysis is posted on the intranet immediately after class.
The course is organized in four modules. The first module of "Venture Capital and Private Equity" examines how private equity funds are raised and structured. The structure of private equity funds have a profound effect on the behavior of venture and buyout investors. The module seeks not only to understand the features of private equity funds and the actors in the fundraising process, but also to analyze which institutions serve to increase the profits from private equity investments as a whole, and which seem designed mostly to shift profits between the parties.
The second module of the course considers the interactions between private equity investors and the entrepreneurs that they finance. The course approaches these interactions through a two-part framework, first identifying the four critical factors that make it difficult for the types of firms backed by private equity investors to meet their financing needs through traditional mechanisms, and then considering six classes of financial and organizational responses by private equity investors.
The third module of "Venture Capital and Private Equity" examines the process through which private equity investors exit their investments. Successful exits are critical to insuring attractive returns for investors, but private equity investors' behavior around the exiting process can sometimes lead to severe problems for entrepreneurs. We seek to understand which institutional features associated with exiting private equity investments increase the overall amount of profits from private equity investments, and which actions seem to be intended to shift more of the profits to particular parties.
The final module reviews many of the key ideas developed in the course. Rather than considering traditional private equity organizations, however, the two cases examine organizations with very different goals, examining funds established by a large corporation and a non-profit organization. These cases allow us not only to understand these challenging initiatives, but to review the elements that are crucial to the success of traditional private equity organizations.
See also my related papers "Money Chasing Deals?: The Impact of Fund Inflows on Private Equity Valuations", "What Drives Venture Capital Fundraising?", and "Conflict of Interest and Reputation in the Issuance of Public Securities: Evidence from Venture Capital".
JEL Classification: G31, G32
Suggested Citation: Suggested Citation
By Cullen Roche