When most people hear the term “investment”, they think of stocks listed on the New York Stock Exchange, NASDAQ, and others.  However, private equity funds—generally, limited partnerships that create a fund in which private firms and individuals of high net worth invest—actually manage upwards of one trillion dollars out of a total 36 trillion dollars invested worldwide.  Despite this sizeable chunk of capital, relatively little research has been conducted about the organization of the private equity industry. To address this conspicuous absence of reliable research and data, Andrew Metrick of the Yale School of Management and Ayako Yasuda of the Wharton School of Business at the University of Pennsylvania published a paper entitled “The Economics of Private Equity Funds” in September 2008.The immediate and intuitive effect on those graduating from college in a stagnating economy is obvious: they are less likely to be hired, especially for the most desirable jobs. However, how do those who graduate during a recession fare over the course of their careers compared to graduates during periods of economic growth? Yale School of Management Professor Lisa Kahn addresses this question in her October 2007 paper titled “The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy.” Relying on detailed year-by-year occupational and educational information from the National Longitudinal Survey of Youth (NLSY) for white males who graduated from college between 1979 and 1988, Kahn followed participants for 14 to 23 years after college graduation to study the effect on employment status, occupational attainment, job tenure, wages, and enrollment in graduate schools as a function of economic conditions.

     There are two basic types of private equity funds: venture capital funds and buyout funds. Buyout funds, as their name suggests, use money from their wealthy investors to purchase struggling companies, restructure their management, and then return the resulting profits to their investors, often at a ratio close to 20/80. By contrast, venture capital firms invest the money in small, up-and-coming businesses such as Google, which seem like they could become profitable over the medium term.

     The authors developed a model of expected revenues of both types of private equity funds using data from a large limited partnership that started 238 funds between the years 1993 and 2006.  The authors found that managers of buyout funds typically earn less revenue per dollar invested than do venture capital funds, but they are able to build on their prior experience and increase the size of the fund at a faster rate than venture capital funds.  For example, if a manager of a buyout fund successfully restructures and profits from the buyout of a 100 million-dollar company, the same skills can be applied to billion-dollar companies. Thus, they can drastically increase the size and scope of their fund in a relatively short period of time.

    The reason why venture capital funds cannot replicate these results owes to the typical size of venture capital firms.  While buyout funds often take over large, mature corporations with market capitalizations in the hundred millions or billions, venture capital firms typically invest in firms that are valued in the tens of millions.  The skills needed to develop small, young firms are not the same skills necessary to handle bigger, more mature firms who already have developed management.  Whereas buyout funds can sharply increase their profits by handling firms with larger asset valuations and still maintain a constant number of firms in their portfolios, venture capital fund managers possess  skill sets that are specific to firms in their infancy. Thus, they cannot simply take on larger firms because larger firms do not need the same type of services.

     What all this suggests to the investor is that while venture capital funds are reputed to earn high returns on their investments right away, buyout funds tend to perform well in the long run because of their unique ability to build off of prior success and handle increasingly larger and more lucrative firms. While these conclusions may seem modest to the sophisticated investor, it is precisely this type of financial demystification and sourcing of returns that could prevent future investors from being duped by the opaque workings of the private equity markets.