“But the fact that Bain Capital has amassed over $60 billion in investor capital, and the fact that there are over 2,300 private equity firms managing $2.4 trillion, suggests that this is a massive force in our global economy that attracts the best talent, capital and companies for a good reason.” – Jeff Bussgang, General Partner at Flybridge Capital Partners, a venture capital firm, and self-professed Democrat and supporter of Barack Obama (“A Democrat’s Defense of Private Equity & Mitt Romney,” BostInno, 1/18/12)

KEY FACTS

  • Private Equity = Investment of nonpublic money in mature firms with poor performance or critical problems.
  • Venture Capital = Using private money to invest in new companies; a form of private equity
  • Private Equity seeks to strengthen underperforming or failing companies and help them become profitable, permitting investors a healthy return on their investment.
  • Venture capital requires a good business plan, a clear path by which to approach the proper market segment, and often a share in company ownership.

Private Equity

What are the goals of PE firms?

Private equity investors seek out companies that either have severe financial problems or have performed poorly, with the intention of providing capital, increasing management accountability, and leading the company back to health in order to receive profits.

What strategies do PE companies employ in attempting to turn a company around?

At the heart of the PE strategy is to invest nonpublic (i.e., private) funds in a failing firm because in a privately held company management can be held accountable more effectively than in a publicly held one.  Also, some firms are unable or unwilling to go public because of the regulatory burdens that are often imposed upon publicly traded companies.  The presence of PE allows them to concentrate more fully upon their core business.

What are the potential problems associated with PE investment?

PE firms use some capital from investors, but much of the money they invest in target firms is borrowed.  This debt is added to the balance sheets of the firms they control, and critics charge that in some cases they take over a company, strip out as many of its assets as possible, and hope to sell it in a few years when the market is strong in order to repay the borrowed funds.  How often this scenario actually occurs, however, is a matter of debate, since investors typically purchase a company, especially one they will own, in order to share in its profits as it grows. 

As with publicly traded firms, it is possible that either the management will have to be replaced or a portion of the workforce will have to be laid off in order to make an inefficient firm stronger, thereby protecting the jobs of those who remain.  Also, if the investment does not succeed, then the original investors could lose their money.

Do PE firms lay off workers?

In order to restore a faltering business to health it is sometimes necessary to lay off workers, just as publicly traded companies do.  However, PE specifically targets companies that are either inefficient to begin with, and therefore at long-term economic risk already, or ones that have reached a critical point that could possibly result in the closing of the firm, with attendant job losses.  If PE investors are able to turn a firm around, the company will grow and more jobs will be created.

Isn’t it better to have strong government investment in companies, much as the federal government has invested in a number of companies since 2008?

There are several dangers with government investment in private companies.  Since governments often have a different set of objectives (e.g., political advantage, aiding particular regions of the country, satisfying political allies) than those of private investors (e.g., maximizing a firm’s value by making it more competitive, developing new products and strategies to appeal to customers), mixing the two often results in diverging purposes and a lack of accountability, since government overseers and private managers have different criteria for success. 

The expertise of politicians and bureaucrats is typically not the ability to accurately predict which market sectors will flourish and which companies will be able to take advantage of market trends.  For example, critics allege that the decision by the Obama administration to provide $535 million in loan guarantees to Solyndra, the failed solar power company, despite warnings about its grave condition, gave the appearance of poor business judgment and suggestions of favors done for political donors.  (Billionaire George Kaiser was a “bundler” of funds for President Obama’s 2008 campaign, while the George Kaiser Family Foundation, whose principal donor he is, was an investor in Solyndra.)

Venture Capital

What is venture capital?

Venture capital refers to money raised from investment banks, wealthy investors, and other financial sources that provides money to startups that do not normally have access to capital markets because of their lack of a track record.  The rewards of venture capital investments can be great, since the venture capitalist typically takes partial ownership of the new firm, and if it does well the investors can reap substantial profits.

What are the risks of venture capital investments?

For the venture capitalists, the great risk is that firm in which they invest will not succeed:  the technology it is developing will fail, the management will not properly guide the company to success, or the market will be poor at critical moments.  For the entrepreneurs, in receiving VC funds they often cede some of the decision-making to the investors.

What are the levels of venture capital investment?

In the initial stages of a business, seed money is required to fund research and development of the product or service, to maintain operations, and to attract the attention of venture capitalists.  Frequently this early funding comes from the entrepreneur’s personal assets or those of family or friends, who are called “angel investors,” but if it is provided through a venture capital fund, usually one of the conditions is that the VC firm receive an ownership stake in the target firm.

Once a new company has a solidly developed business plan, it is possible to go through various stages of financing known as alphabet rounds, i.e., A, B, or C rounds, providing progressive infusions of money to help the startup stand on its own.  The earlier venture capitalists invest in a firm, their risks are greater but so are the potential rewards.