Private equity is not a new phenomenon but, over the last decade, the level of private equity activity has increased significantly in Australia. Despite the growth in private equity it's still relatively small. According to The Australian Private Equity and Venture Capital Association Limited (AVCAL) (2008) the value of businesses purchased by private equity in Australia in 2007 was less than 0.4% of the value of all businesses listed on the Australian Securities Exchange (ASX) but the scope for growth in private equity in Australia is immense. The purpose of this paper is to examine private equity and venture capital in Australia with the analog on benchmark and historical performance, investment characteristics, roles in the portfolio management and economic effects of private equity and venture capital.
Lockett, Murray & Wright (2002 p. 1009) broadly defines;
Private equity involves investment in unquoted companies and includes both early stage venture capital and later stage buyouts. While early stage venture capital investments have raised major issues concerning the stimulation of policies to address financing gaps, their economic and social impact are generally seen as benign.
In its bilateral meaning private equity is furnished by pool of investors, usually classified as the institutional investors or accredited investors who funds investments directly into private companies or conduct buyouts of public companies that result going private from public. The sole purpose of the institutional investors is to generate revenues from funding in companies that are challenged with financial difficulties such as distressed debt or has an attractive inventive to exert on institutional investors.
In particular, a transaction where private equity fund buys out a mature publicly listed company has shown an increasing trend in Australia (AVCAL 2008). The growth in private equity as an asset class has been a source of finance for companies in Australia and worldwide, particularly venture capital.
The concept of buyouts involves radical changes in the corporate governance of firms while private equity firms backed by substantial borrowings acquire a significant equity stake in an existing business (Wood & Wright, 2009). Harris, Siegel & Wright (2005) suggest the growth in private equity investments has important managerial, financial and public policy implications.
Private equity consists of partnerships specializing in venture capital, leveraged buyouts, mezzanine debts and distressed debts. For the purpose of this paper the main concentration of the topic will be on venture capital.
Venture capital is viewed as investments by institutional investors in high growth companies such as Microsoft, Google, Dell, Intel computer and Apple. These companies were financed by venture capitalists at the initial stage of establishing the companies because the entrepreneurial ideas are evaluated as high growth ventures (Gompers & Lerner 1999; Da Rin, Nicodano, & Sembenelli 2006).
Venture capital is acknowledged as a subset of private equity and venture capitalists seek to invest in companies through fund managers who are inquisitively looking to increase the portfolio value for their customers. The concept of venture capital does not only limit to newly established businesses but rather extends to companies with potential for high growth rate who fund the expansions through venture capital such as include management buyouts (MBO's) (Jelic, Saadouni & Wright, 2005).
The importance of the study and this paper is on Private Equity and Venture capital because both the funding methods are an important source of funds for start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout financing. With time the increasing know-how of private equity fund is setting the platform for future growth. Despite the fact in Australia the private equity market in 2007 was of less than 0.4%, in the rest of the world in the last decade, private equity funds are viewed as the fastest growing market for corporate finance over other markets such as public equity or the bond market (Fenn, Liang & Prowse, 1997). The notable point is the rise of innovation through technological advancements such as the operating system (Windows) amplified the rise of venture capital through private equity.
The growth of private equity and venture capital
The increase of private equity market is mainly attributed towards the development of the private limited partnership along with changes in the legal, regulatory and tax changes added a helping hand for the growth of private equity.
The early stages of private equity were seen from the years of 1946 to 1969, after the World War II the financial sector was emerging into expansions of businesses and the unavailability of long term financial aid for the new business enterprise leading to private investors to intervene by supporting businesses financially. By the period of 1968 - 1969 success of many new venture investments made during the previous years had started to gain valuable experiences while some companies had started enjoying the rewards from acquiring funding through private equity. Some opportunistic investors sought to improve existing arrangements through the formation of venture capital limited partnerships (Fenn et al. (1997).
In 1980's when the Australian capital markets was constrained and was observed as immature financial market due to the underdevelopment of the venture capitalism on the emerging high technology business. In 1987 The Bureau of Industry Economic (BIE) developed a scheme to achieve the goal of building a venture capital market in Australia. The highlights of the report included that the Australian financial sector (Ryan, 1991 p. 64) utilizing tax concessions, by deregulating of removal of the interest rate ceiling on bank loans to the businesses facilitated more flexible financing arrangements between lending institutions and innovative projects. The rapid growth in demand for capital from emerging high technology companies created a new market for venture capital investment. This led to the increases in competition in equity finance and advantaged entrepreneurs to access investment funds in Australia (Ryan, 1991).
The aftermath of the limited partnership in combination with the numerous favorable regulatory and tax changes stimulated the flow of capital to the private equity market.
There after the formation of Private equity investment was categorized in two stages. Private equity comprised of the expansion and buy - out stage investment and on the other hand seed and early stage investments are termed venture capital investment (AVCAL, 2008).
Benchmark and historical performance
Although the Australian private equity market is seen as sufficiently smaller and younger compared to the US private equity market, empirical evidence suggests that is has some characteristics similar to more developed markets.
Fleming (2004) examined the returns on venture capital in Australia. Fleming's hypothesized that returns to venture capital would be associated with the type of venture capital firm (captive or non-captive; specialist or non-specialist), venture capital experience, syndication, duration and exit strategy. Fleming conducted the research from a sample of 129 venture capital exits between 1992 and 2002. The findings of the research revealed the Australian venture capitalists take only the best firms public, generating higher returns than from other exit strategies. There was no difference found on the basis of whether the firm was captive, specialist, experienced or duration of investments.
Da Silva Rosa et al. (2003) citied by Suchard, (2009), conducted a research and hypothesized to find if there is or there isn't any difference in under pricing between venture capital backed and non-venture capital backed (Initial public offering) IPOs in Australia. The conclusion of their research revealed that they did not find a difference in long-term, performance between the two variables. Further the research was concluded by stating the superior performance by venture capital backed IPOs is often attributed to the creation of more effective management teams and corporate governance structures that assist the firm's long-run performance (Suchard, 2009).
After the findings above Suchard (2009) conduct research on private equity market in Australia. The underlying purpose for Suchard's research was to further extent the literature of Fleming (2004) and Da Silva Roas et al. (2003). While the research area was on the same area of study but the underlying principles were somewhat different. Suchard's (2009) research particularly targeted whether the differences in the Australian private equity market and corporate governance environment have an impact on the contribution of venture capital managers to corporate governance practices.
The research was conducted with the sample consisting of 552 IPOs from the period of December 1994 to February 2006. Out of the 552 IPOs, 472 were non - venture capital backed IPOs and 80 venture capital backed IPOs. The research included details of board size, board composition, CEO characteristic such as age, tenure and etc, ownership, and firm characteristics such as size, risk, PPE intensity and cash flow to sales (Suchard, 2009).
The findings of the research showed that venture capitalists own, on average, 33.79% of the venture capital backed firm before IPO. The cross-sectional results suggest that venture capital backed IPOs have better corporate governance, has an impact on overall board composition, boards are more independent and have more independent directors with industry experience than non-venture capital backed IPOs (Suchard, 2009).
Investment characteristics
Suchard, 2009 pointed out the Australian board structures and mechanisms are more similar to those in the US and United Kingdom, but market activity characteristics are more similar to Japanese and German systems.
In addition, there are differences in the behaviour of US and Australian institutional stockholders in solving corporate governance issues. Further, the Australian private equity market differs from the US market. It has a legal and institutional structure similar to most common law countries where private equity markets have been the subject of much study (including Canada, the United Kingdom and the US), but it is a relatively younger market. Private equity markets are influenced by many factors, including a country's legal and institutional structure, liquidity and stock market performance, investor sophistication, and ability to provide value-added assistance to entrepreneurial firms. Recent studies have demonstrated international differences in financial contracts, syndication, and exits (e.g., Barry et al., 1990; Megginson & Weiss, 1991; Cumming and MacIntosh, 2003).
Private equity and venture capital have many common investment characteristics despite the different development stages of the businesses invested in. Both involve: Equity investment typically over a 3 to 5 year investment period in unquoted companies considered to have significant growth potential and active involvement by the investor in the governance and management of the investee business considering, at the time of investment, the subsequent sale of the investment rather than the indefinite retention of it (AVCAL, 2008).
However those venture capital funds invested in the start-up companies have a clear target to exit after 4-7 years. Since most high-tech start-ups initially do not generate profits to pay dividends or buy back shares, the exit route is the primary way the venture capitalist can realise a positive return on the investment. Exit conditions are therefore crucial for financing. The type of exit is an important issue not only for the venture capitalist but also for the entrepreneur (Schwienbacher, 2008).
One of the investment characteristics is when the owners of private businesses seek for venture capital. They increasingly see private equity funds as an attractive source of expansion capital and management expertise that is needed to grow the business to a level where it will be suitable and ready for a trade sale or IPO. In such cases, the private equity manager invests capital for a stake in the business and also provides ongoing advice to management.
Many business owners who are looking to retire, after building up a business over many years, are selling to private equity managers. In Australia today there are a higher than ever number of business owners approaching retirement. For many of these owners, private equity offers the only possible exit and realisation of the capital they have built up in their business.
Another investment characteristic is purchase of a publicly listed company. Although a handful of recent acquisitions suggest otherwise, only about a dozen publicly listed companies in Australia have ever been taken private by private equity. Nevertheless, it is instructive to consider the benefits reported by publicly listed companies locally and offshore that have been taken private by private equity. These include: a board less driven by process and better able to make decisions on a timely basis; a chief executive who is able to devote to the business valuable time that was previously spent representing the company to the investor community; a board and management team that is no longer fixated on meeting short-term profit expectations of the public market, analysts and the media is instead able to concentrate fully on what will be of most long-term benefit to the business and its shareholders; a business now with an ownership and governance structure more conducive to resolving structural or strategic issues that may have troubled the business previously and which can only be solved by initiatives that may adversely affect profits and/or cash reserves in the short term; and fresh capital for investment.
An alternative investment characteristic is purchase of a division of a publicly listed company. Similar characteristics as described above in the public company taken private, but in this instance private equity fund purchase part of the business rather than the whole of a listed company. Often the listed company concerned describes the division being sold as non-core and has, for some years, concentrated its attentions and capital investment on other divisions. Analysts have, from time to time, described such business divisions as unloved or as orphans. New private equity owners of such businesses are better equipped than the previous publicly listed company owners, to unleash their entrepreneurial spirit and provide them with the additional resources and capital investment that they require.
A conclusively characteristic is sale of business by private equity. All businesses bought by private equity are sold, generally via either a private sale or an initial public offering on the ASX or, in a small but growing percentage of cases, to another private equity fund.
As private equity strengthens its significance in capital markets, the importance of style drift for private equity investors has attracted increasing attention. For example, Coller Capital, a leading institutional investor in private equity, conducted a survey, the '2008 Global Private Equity Barometer', which identifies style drift as one of the most important issues facing institutional investors. [1] Coller Capital reports that style drift by private equity investors is perceived negatively by 84% of fund limited partners. Since private equity investors are active in their portfolio companies, it is important that investments match the fund objectives at the time of investments. The Coller Capital report confirms that 75% of respondents, who are predominately institutional investors, view style drift as important, because to them, style-inconsistent investments could lead to underperformance, and could indicate that the private equity managers lack the necessary knowledge and skills to successfully manage these portfolios. In this paper we introduce the concept venture capital and private equity.
Role of portfolio management
Portfolio fund management looks at the best interest of earning profit through diversifying institutional investor wealth into private equity funds.
The legal documentation governing each fund reflects that all investments of the fund will have been realized and the funds returned to the investors within a particular time-frame, usually 10 to 12 years. After a fund has closed (i.e. raised the funds that will be managed), the managers invest the fund's capital across a set of investments that fit the fund's investment mandate or focus. Once this process is complete, typically after 3 to 5 years, the fund is said to be fully invested (AVCAL, 2008).
Before deciding to invest in a fund, the institutional investors undertake detailed due diligence on the fund manager, often over a number of years, during which the manager's prior investment performance is monitored and assessed. The investors also rigorously review the fund documentation and have sufficient bargaining power to negotiate terms with the managers of the fund. These investors include superannuation funds, insurance companies, banks and university endowments (AVCAL, 2008).
These expert advisers carry out a level of scrutiny and due diligence akin to that carried out by agencies such as Standard & Poor's and Moody's in other sectors of the economy (AVCAL, 2008).
Funds adopt a detailed and disciplined approach to matters such as the stage of the investments that are targeted, industries (and countries) that can be invested in, and the percentage of fund assets that can be allocated to any particular investment (AVCAL, 2008).
Over the life of a fund, the managers will assess hundreds of potential investments, conduct detailed due diligence on perhaps 10% of these but only actually invest in a small number, usually around 10 to 15. Competition for investments is fierce and a fund manager's bid will not always succeed, in which case the time and money expended on assessing an investment and preparing an offer is lost. Additionally, owners and managers of companies may reject approaches from private equity, as is their right. Fund managers receive a management fee based on the size of the fund and also receive a share in the capital gains delivered to the fund's investors. The management fee is usually calculated as a percentage of the funds originally invested in the fund. The percentage is negotiated between the investors and the manager at the time the funds are raised. An indicative figure is 2 to 2.5% p.a. for smaller venture capital funds and 1 to 2% for larger private equity funds. This figure covers the overheads of the business including salaries and the costs of conducting due diligence on investments (AVCAL, 2008)..
The manager's share of capital gains is around 20% in most funds globally and is calculated after all fees and expenses paid by the fund have been returned to the investors. The private equity manager only receives a share in capital gains if the fund has delivered a minimum return known as the preferred return. If the capital gains do not exceed the preferred return then the private equity manager receives no share in capital gains. The preferred return is usually similar to the long term bond rate, currently about 8% p.a. (AVCAL, 2008).
