7.1 Private equity: venture capital and angel investment
332. Private equity financing includes a broad range of external financing instruments, whereby the
enterprise obtains funds from private sources in exchange for an ownership stake of the firm. The capital is
provided to private companies, i.e. companies whose shares are not freely tradable in any public stock
market, across the entire life cycle, from seed financing to buyouts (OECD, 2009).
333. Through private equity, wealthy individuals, investment funds or institutions participate fully in
the entrepreneurial risk of the business, as capital is made available without provision of security.
Compared to other forms of external finance, the investor accepts more risk and expects a higher return,
typically above 25% IRR (internal rate of return) (see Table 6).
334. The investment is open-ended, though equity investors generally provide capital over a mediumto long-term horizon (3-10 years).
The objective of investors is to make profit by “exiting” (i.e. selling
their shares through an IPO, a trade sale or buyback by the other shareholders) once the firm has increased
its share value.
335. Private equity investments are less volatile than those in the stock market. Trading does not have
an impact on the asset class, as assets are held until maturity and valued on the basis of corporate
fundamentals rather than depending on market fluctuations. The lower sensitivity to market variations
provides investors a form of protection against equity market downturn and enables them to have stable
and attractive returns. For instance, in Europe, since 2001, returns in the private equity segment have
outperformed those in public equity markets by 9.4%. The 2008-09 financial crisis further widened the gap
return between these markets (Idinvest, 2014).
336. Private equity is divided into two distinct components, namely venture capital, targeted at new
and early stage companies, and other private equity, such as growth capital and buyouts, targeted at mature
businesses (see Table 6)
39. Buyouts, whereby shares are bought from existing shareholders and control of
38 Initial Public Offering: sale or distribution of a company’s shares to the public for the first time (OECD,
the company is acquired, include a number of specific types of investments, such as management buyouts
(MBOs), management buy-ins (MBIs), institutional buyouts (IBOs) and leveraged buyouts (LBOs). In
LBOs, which account for the largest proportion of private equity funds, investors and a management team
pool their own money, together with borrowed money, to buy the shares in a business from its current
owners. Usually, the assets of the company being purchased are put up as collateral for the funds
borrowed, and the cash flow of the same company is used to repay the debts. In this way, investors can
acquire a company without the need for a large business capital.
337. Private equity firms are usually structured as a limited partnership. The General Partner
(unlimited liability) receives capital from Limited Partners (e.g. pension funds, insurance companies,
hedge funds, wealthy individuals). For these investors, the key economic incentive is the opportunity to
earn a high rate of return on their invested capital through access to a portfolio of investments sourced and
managed by an investment team that is expert in the target sectors or geographies of the fund (Naidech,
2011). Contrary to stock markets, private equity is based on the principle that unlisted markets are
inefficient, due to large information asymmetry. To exploit these inefficiencies and gain returns, an indepth understanding of the opportunities available on the market is needed, based on corporate
fundamentals and assessment of growth potential. Thus, private equity managers must have access to
detailed data about potential investee companies and conduct in-depth due diligence (Idinvest, 2014).
In
this regard, for equity investors the skills and reliability of fund managers are critical.
338. Fund managers are generally rewarded with fee income and a share of other income and capital
gains. To further align the interests of investors and fund managers, fund managers must generally invest
alongside the investors, on the same terms in any fund (Gilligan and Wright, 2008).
339. Private equity companies typically focus on high growth potential or under-performing
companies that can be transformed and subsequently sold or floated, fostering rapid corporate restructuring
(Blundell-Wignall, 2007). In this regard, they differ in strategy, structure and objective compared to other
investment funds. In essence, private equity fund managers seek to control the businesses they invest in
and to choose an optimum capital structure for their investee companies. To do so, they generally operate
with better information and stronger controls and influence over management than funds holding quoted
equities. While fund managers do not exercise day-to-day control, they are actively involved in setting and
monitoring the implementation of the firm’s strategy. To achieve this, the private equity funds forego
liquidity in individual investments and take on financial risk in each investment through the use of debt
(Gilligan and Wright, 2008). Furthermore, the closed structure of the equity fund prevents fund managers
from exiting prematurely and strengthens their long-term engagement with the investee company (EVCA,
2007)40.
340. The main providers of equity finance for start-ups and SMEs are family, friends, business angels
and venture capitalists. However, interest in upper-tier SME investment by other private equity funders has
increased in recent years, as low interest rates have pushed investors to seek yields and diversification
within their portfolios.
341. In 2013, deals under EUR 500 million accounted for over 97% of the Buyout deals carried out in
Europe, while 45% of capital raised by European Buyout funds was allocated to the mid-market segment,
i.e. deals in the range of EUR 250 million - 500 million. According to a survey on 450 institutional
investors in alternative assets worldwide, conducted by Perquin in 2013, 52% of investors believed that the
mid-market segment offers the best investment opportunities. 62% planned allocations to small to midmarket buyouts for the following year, compared to 18% which planned investing in venture capital
(Figure 13).
342. Indeed, as of 2013, small buyouts (less than EUR 250 million) had outperformed larger ones
significantly, in terms of return on a 10-year horizon. The outperformance observed has been driven by the
growth of the investee companies and by operation improvements. Small and mid-market buyout deals also
benefit from low leverage and a higher share in the company’s equity, which reduces the risk profile of the
investee and increases its potential margins for external growth (Idinvest, 2014).
7.1.1 Venture capital
Modalities
343. Venture capital (VC) is equity investment aimed at supporting the pre-launch, launch and earlystage development phases of a business (OECD, 2014d). Although it is commonly assumed to be the main
source of seed and early stage financing, in fact the majority of venture capital firms intervene at a later
stage, with a typical investment size of USD 3-5 million, while the seed and early stage market is the main
target of “informal” investors, such as business angels (Table 7) (OECD, 2011a; OECD, 2013e).
344. Indeed, venture capitalists often invest in companies that have already received one or more
rounds of angel finance. They typically intervene after a business idea or product has been successfully
test-marketed, to finance full-scale marketing and production. Sometimes, however, venture capital may be used to finance product development costs when those costs are substantial, such as for clinical trials in the
biotechnology industry (Berger and Udell, 1998).
345. Venture capital involves “formal” or “professional” equity, in the form of a fund run by General
Partners, aimed at investing in early to expansion stages of high growth firms. Typically, venture capital
firms raise funds from wealthy individuals, insurance companies, and pension funds, among others. These
Limited Partners pay the General Partners to collect management fees (usually 1-2% of the capital
committed), which cover the operating costs and enable the fund to hire a group of professionals.
346. The VC fund’s investment portfolio includes various asset classes, such as stocks, bonds and real
estate. Venture capital is part of the so-called “alternative investments”, a higher risk asset class, from
which investors seek to obtain higher returns. Within this asset class, the equity fund invests in a portfolio
of companies, knowing that some will succeed, some will fail and the majority will have average or subpar performance (OECD, 2013e).
347. A venture capital fund typically has a 10-year life, at the end of which the partnership dissolves
and distributes its assets to the partners. However, an extension may be agreed upon by the Limited
Partners, so that some VC funds operate for 15-20 years. Generally, the investments in start-up companies
are made throughout the first three/four years of the fund, with follow-on investments in portfolio
companies being carried out for another few years. In fact, for early stage projects, venture capital typically
involves the provision of several rounds of finance rather than a one-off injection of funds. The VC funds
need a sufficient scale to be able to provide multiple financing rounds. At about the middle of the fund’s
life, when some early harvesting of the first successful businesses may have occurred, the General Partners
may start to raise an additional fund, recycling some of the investment success money and adding new
limited partner investors. For most of the portfolio companies, returns from the investment, through exit,
occur from years four through ten (Wright and Robbie, 20013; Hadzima, 2005).
348. VC companies are increasingly specialised by stage of development (i.e. start-up, product
development, revenue generation, profitable) or by round (i.e. seed, first, second or later stage). Usually,
the later the round, the greater the funding invested in a round. Also, the funds close to the end of their life
cycle are more likely to invest in later stage deals that are closer to exit, to gain a higher perceived return
potential rapidly (Ernst &Young, 2014).
349. Deal selection skills are crucial for venture capitalists, who perform an important screening and
signalling role in the market. In fact, they intensively scrutinise firms before providing capital, based on
objective information and analysis, as well as their intuition, “gut feeling” and creative thinking (Hisrich
and Peters, 2002; Martel, 2006). They are extremely selective in choosing their investment and are
especially interested in businesses with a very high growth potential, which may provide high yields over
the medium- to long-term investment horizon, through a successful exit.
350. Besides the funding, venture capitalists bring in technical and managerial expertise and provide
new firms with a bundle of services. These include general business strategy advice, development of a
marketing strategy, support to hire key staff, a financing plan and design for an exit, as well as advice for
scenarios in which the business does not succeed. Empirical evidence suggests that venture capitalists play
a key role in the professionalisation of the start-up companies they finance. At the same time, they may
exercise strong control on the management and even drive or impose changes in top management41.
351. On the other hand, entrepreneurs seek a venture partner that may provide expertise, experience,
contacts and reputation, alongside funding. There is a value in being associated with experienced and wellconnected venture capitalists, to rapidly gain information about markets, to attract highly skilled employees
and partners and, at the exit stage, to appeal to good IPO underwriters. Evidence suggests that
entrepreneurs are willing to accept a discount on the valuation of their start-up in order to access the capital
of venture capitalists with better reputation. In this regard, the reputation of venture capitalists, which
depends on their experience, information network, and direct assistance to the portfolio firms, is more
distinctive than their functionally equivalent financial capital (Hsu, 2004).
352. The exit prospect, i.e. the way for venture capitalists to cash out on their investment in a
company, is critical in the venture capital industry, as investment decisions are partly determined by the
exit possibility. Typically, exit takes the form of an IPO, when the company shares are sold to the public,
or, most commonly, a merger and acquisition (M&A), whereby investors receive stocks or cash from the
acquiring company (Gompers and Lerner, 2001; Pearce and Bamer, 2006; Espenlaub et al., 2009). Thus,
trends in IPO and M&A markets have an important effect on the VC industry, as in the aftermath of the
2008-09 global financial crisis, when reduced exit opportunities discouraged VC investments and increased
time to exit.
353. An acquisition often involves a sale to a “strategic buyer”, such as a supplier, distributor or
competitor in the same industry as the start-up, rather than to a “financial buyer”, who purchases
companies solely for their investment value (Vinturella and Erickson, 2013). Among strategic buyers, large
companies play an important role in screening venture capital-backed start-ups, with the aim of identifying
early-stage companies that may provide radical innovations or new business models that may be scaled-up,
or represent an interesting partner for their open innovation strategy.
