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Kings of capitalismA survey of private equity November 27th 2004

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In two decades, private-equity �rms have moved from the outer fringeto the centre of the capitalist system. But, asks Matthew Bishop, canthey keep it up?

former commerce secretary under RichardNixon, private equity was a cottage indus-try that few people had heard of. Therehad always been family-owned private�rms, but family owners did not usuallyaim to sell o� the business; they passed iton to the next generation.

Until the late 1970s, the main activity inprivate equity�buying shares in privatecompanies in the hope of selling them at ahigher price later�had been carried outmostly by the investment arms of a fewwealthy families, such as the Rockefellersand Whitneys in America, and had gener-ally been con�ned to venture-capital in-vestment in small, fast-growing busi-nesses. America’s venture capitalists havebecome the envy of the world for develop-ing �rms such as Intel and Google fromnothing more than a bright idea into big,successful companies. But these days lessthan one-�fth of the money the industryraises goes on providing venture capitalfor young �rms. Much the larger part ofprivate-equity money is spent on buy-outsof established companies.

The �rst of today’s big private-equity�rms, Warburg Pincus, was formed only inthe late 1960s, and had to raise moneyfrom investors one deal at a time. By thelate 1980s private equity had grown bigenough to be noticed by the general public,but it made hostile headlines with a waveof debt-�nanced �leveraged buy-outs�(LBOs) of big, well-known �rms. The in-dustry was cast in the role of irresponsible

Pick carefullySome private-equity �rms are much more suc-cessful than others. Page 4

Highly leveragedA gravity-defying pay structure. Page 5

Small expectationsThings are likely to get harder rather than easier. Page 6

Beating the mid-life crisisWhat private-equity �rms are doing to win ina mature market. Page 8

Gut feelingJack Welch on his latest job. Page 9

Once burnt, still hopefulHas the venture-capital industry learnt itslesson? Page 11

Draw a veilThe attractions of privacy. Page 13

The Economist November 27th 2004 A survey of private equity 1

1

The new kings of capitalism

�IF YOU made ‘Private Equity: theMovie’, then Michael Douglas would

have to play Schwarzman.� The head ofone multi-billion-dollar private-equity�rm is talking about the head of another,the Blackstone Group’s Steve Schwarz-man. �I’m joking,� he adds quickly, �Steveand I are good friends.� Perhaps he realisesthat comparisons with the �ctional WallStreet banker famously portrayed by MrDouglas, Gordon �greed is good� Gekko,are not what his industry needs just now.In fact, Hollywood has already set its sightson the men who run this enormous, rela-tively unaccountable pool of capital. Thisyear, the Carlyle Group, a huge private-equity �rm, has been vili�ed in MichaelMoore’s �lm �Fahrenheit 9/11�, as well asbeing named as the inspiration for a �c-tional private-equity �rm that tries to in-stall its brainwashed candidate as Ameri-can president in the remake of �TheManchurian Candidate�.

Yet to study �rms such as Blackstone isas good a way as any to �nd out what is go-ing on at the sharp end of capitalism today.Hedge funds may be sexier, at least fornow, but it is surely Mr Schwarzman andhis peers in the private-equity industrywho control the really smart money andwield the lasting in�uence. This surveywill explain what they do, what chal-lenges they face and what e�ect they haveon the world of business at large.

In 1985, when Blackstone was foundedby Mr Schwarzman and Pete Peterson, a

Also in this section

www.economist.com/audio

An audio interview with the author is at

www.economist.com/surveys

A list of sources can be found online

AcknowledgmentsIn addition to those quoted in the text, the author wouldlike to thank many others who provided valuable insights,some of them o� the record, this being private equity. Theyinclude Alex Scott, David Williams, David Bonderman, SirJohn Craven, Sir David Cooksey, Baroness Hogg, Ken Olisa,Stuart Mills, Michael Ryan, William McCormack, NewcombStillwell, Steve Schwarzman, Kelvin Thompson, Teresa De-reniak, Diana Glassman, Charles Baillie, Christopher Flow-ers, Tim Collins, Angus Littlejohn, the Board of the TuckCentre for Private Equity and Entrepreneurship, Conor Ke-hoe, Ray Lane, John Taylor, Venture Economics and thePrivate Equity Analyst

1

2 A survey of private equity The Economist November 27th 2004

2 �corporate raider� attacking from thewilder fringes of capitalism. A bestsellingbook by Bryan Burrough and John Helyarabout the $25 billion battle in 1988 for RJR

Nabisco branded two private-equity �rms,Forstmann Little and Kohlberg Kravis Rob-erts (KKR), as �Barbarians at the Gate�.

Today, the private-equity industry hasmoved from the fringe to the centre of thecapitalist action. In the process, the leadersof private equity have earned themselvesboth wealth and respect�if not alwaysrespectability. The fabulously rich MrSchwarzman pops up in the society gossippages for such things as paying a record$37m for a Manhattan apartment and fordemolishing his Florida mansion, alleg-edly without permission. He is oftentipped as treasury secretary in a Republi-can administration.

A magnet for the bestIn the 1980s private equity was a place formavericks and outsiders; these days it at-tracts the most talented members of thebusiness, political and cultural establish-ment, including many of the world’s topmanagers. Jack Welch, the legendary for-mer boss of GE, is now at Clayton, Dubilier& Rice. Lou Gerstner, who revived IBM, ischairman of Carlyle. Even Bono, thesaintly lead singer of rock band U2, is nowin the business.

Moreover, as Hollywood has noticed,private-equity �rms have become the em-ployer of choice for politicians and gov-ernment o�cials returning to the privatesector. Blackstone has hired Paul O’Neill,until recently America’s treasury secre-tary. Carlyle has provided lucrative workfor numerous luminaries, includingGeorge Bush senior, Fidel Ramos, a formerpresident of the Philippines, John Major, aformer British prime minister, and ArthurLevitt, a former chairman of America’smain �nancial-markets regulator, the Se-curities and Exchange Commission (SEC).

Private equity’s transformation into amainstream industry has been greatlyhelped by a fundamental change in thesort of deals it does. In the late 1980s, fundsoften borrowed to the hilt to pay for buy-outs, many of which were seen as hostileby the management of the intended tar-gets. Nowadays the buy-out �rms’ deals in-volve much less debt. When KKR boughtAmerica’s Safeway supermarket chain in1986, it borrowed 97% of the $4.8 billionthe deal cost it; now a private-equity �rmwould typically have to stump up aroundone-third of the purchase price.

Hostile deals are now extremely rare.

Even Britain’s Philip Green, one of a smallband of powerful individual private-equ-ity �nanciers, declined to go hostile thisyear in his bid to buy Marks & Spencer, aBritish retailer. Indeed, big companies thatwould once have turned up their noses atan approach from a private-equity �rm arenow pleased to do business with them.Royal Dutch/Shell, a troubled oil giant, hasbeen negotiating the sale of its lique�ed-natural-gas business for $2.45 billion toKKR and Goldman Sachs Capital. Somecompanies even team up with private-equity �rms, as Sony recently did withTexas Paci�c Group (TPG) and ProvidenceEquity Partners to buy MGM, a �lm studio.

Having largely shed the image of cor-porate wreckers, private-equity �rms cannow plausibly describe themselves as pro-viding a safe haven in which �rms can pur-sue long-term growth, sheltered from theshort-term storms of the public stockmark-ets. This role is all the more important be-cause both venture capitalists and buy-out�rms work increasingly with �rms under-going big changes. Well-known �rms thathave recently been �nurtured� by privateequity include Burger King, Polaroid, Uni-versal Studios Florida, Houghton Miin,Bhs, Ducati Motor and the Savoy Group.

Private-equity �rms can also reason-ably claim to o�er a solution (though anexpensive one) to the corporate-gover-nance problems that have blighted somany public companies. �If you examineall the major corporate scandals of the past25 years, none of them occurred where aprivate-equity �rm was involved,� notedHenry Kravis, one of the founders of KKR,in a recent speech. Private-equity �rms, hesaid, are �vigilant in our role as owners,and we protect shareholder value.� On theother hand, if there were any improprietyin a private company, the public might notget to hear about it.

Clearly, private equity is now a bigbusiness. In Britain, for instance, one-�fthof the workforce outside the public sectoris employed by �rms that are, or havebeen, invested in by a private-equity �rm,according to the British Venture CapitalAssociation. Worldwide, there are morethan 2,700 private-equity �rms, reckonsGoldman Sachs (maybe many more, be-cause in this private world small �rms caneasily drop below the radar screen). Aspension funds, endowments and rich indi-viduals have become increasingly keen in-vestors, the amount of private equity hassoared. In 2000 alone, the peak year so far,investors committed about $160 billion toprivate-equity �rms (much of it to venturecapital), up from only $10 billion in 1991.

At the same time, there has been a dra-matic growth in the size of private-equityfunds, and in the size of the top �rms thatmanage them. Most private-equity �rmsraise funds as limited partnerships. The�rm is the general partner that managesthe fund and gets paid an annual fee (a per-centage of the money in, or promised to, afund) and later a large slice of any pro�ts;outside investors (who often lock up theirmoney for up to ten years) become limitedpartners who share only in the pro�ts.

In 1980, the world’s biggest fund(KKR’s) was $135m. Today there are scoresof funds with over $1 billion each. J.P. Mor-gan’s latest one is currently the biggest, at$6.5 billion, ahead of Blackstone’s (seechart 2, next page); Permira has Europe’slargest, at around $6 billion at today’s ex-change rate. A $10 billion fund can be onlya matter of time, if only for the fabulousannual fees.

Blackstone, which started life as a two-man band working from a single room,has become, in its own words, �a majorplayer in the world of �nance�. It employsover 500 people in plush o�ces in NewYork’s Park Avenue, Boston, Atlanta, Lon-don, Paris and Hamburg. The 35-40 �rmsin which it has a private-equity stake to-gether have over 300,000 employees andannual revenues of over $50 billion�which, were they lumped together as a sin-gle conglomerate, would make Blackstonea top-20 Fortune 500 company. Other bigprivate-equity �rms can point to similarnumbers. TPG’s portfolio of �rms has255,000 sta� and collective annual reve-nues of $41 billion; Carlyle’s has 150,000workers and revenues of $31 billion.

Yet the private-equity industry mustnow grapple with tough new challenges.These fall into three broad and overlap-ping categories: generating good �nancial

1Young and spikyUS private-equity fund-raisingconstant 2002 $bn

Source: Josh Lerner, Harvard Business School

0

40

80

120

160

1980 85 90 95 032000

Venture capital

Buy-out

Other


2 performance; coming up with winningstrategies in a rapidly maturing industry;and becoming more accountable to thepublic, and thus less private.

There are few industries in which thegap between the best and the rest is aslarge as in private equity. The top �rmshave delivered far better returns to inves-tors than the stockmarkets have done, butthe average private-equity fund has actu-ally produced worse results (after fees)than public equities. That includes buy-out funds as well as the venture-capitalfunds that destroyed so much capital dur-ing the tech bubble a few years ago.

In future, the industry may �nd it hardto match even this not-too-glittering pastperformance. Private equity may becomea victim of its own success. Techniquessuch as seeking to maximise cash�ow, us-ing debt astutely and paying managerswith shares, which were novel when priv-ate-equity �rms �rst introduced them inthe 1970s, have become standard businesspractice. As Mr Kravis put it in his recentspeech, �Everything we have accom-plished in driving corporate excellencemakes it harder for us to achieve the re-turns that our investors expect from us.�

A crucial factor will be whether private-equity �rms can genuinely improve thecompanies they buy. Another will be howeasily they can dispose of their invest-ments. Without an �exit�, there can be nopro�ts. Two main exit routes�selling a �rmto a big corporate buyer or �oating it on apublic stockmarket through an initial pub-lic o�ering (IPO) of its shares�have re-cently been much harder to pursue than inthe past; and increasingly popular alterna-tives, such as selling to another private-equity �rm, are becoming controversial.

Much will depend on how investors re-

spond. On one hand, many have been dis-appointed at private-equity �rms’ averagepast performance; on the other, at a timewhen bonds and public equities are de-livering historically low yields, the high re-turns generated by the best private-equity�rms look increasingly enticing. Europeaninstitutional investors, which havetraditionally invested little in private equ-ity, are beginning to show more interest. Ifinvestors pump more capital into an in-dustry that arguably already has too muchof it�especially now that hedge funds,�ush with cash, are also piling into privateequity�there is every chance of creatinganother bubble, hot on the heels of theone in venture capital.

Not only are good opportunities be-coming harder to �nd, but being a matur-ing industry throws up other tricky issues.Many of the leading private-equity �rmsare still run by their founders, who arenow getting to an age where they have toconsider bowing out. As is often the waywith charismatic founders, some may lin-ger too long. And even when they go, thehandover may prove highly disruptive assome of those passed over for the top jobleave the �rm. Nor can there be any guar-antee that the next generation, clutchingtheir MBAs, will inherit the deal-makingmagic of the founders.

Piggy in the middleWill tougher competition and increasinglydemanding investors cause the industry toconsolidate? Sir Ronald Cohen of ApaxPartners thinks that over the next decadethe private-equity industry will polarise.At one end, a few big global industry lead-ers will emerge��maybe three or fourdominant brands with high returns�; atthe other, small specialist �rms will thrive.

In the middle, however, many �rms will�nd it hard to compete. His prediction isplausible, and the losers may includesome famous names. Forstmann Little hasalready said that it will close in 2006. Itmade some awful telecoms investmentsduring the bubble and has failed to resolveits succession problem.

Some of the biggest private-equity�rms are already staking out di�erent terri-tories. KKR and Apax say they will con-tinue to concentrate on private equity. ButBlackstone and Carlyle have been addingother �nancial products to their portfolio.Blackstone, for example, which has longrun property funds, is toying with startinga hedge fund as well as bee�ng up its exist-ing business providing advice on mergersand acquisitions. Diversi�cation, these�rms hope, will help them to exploit theirexpertise and brands�and perhaps to gen-erate a more stable stream of pro�ts thatmay allow them to �oat on the stockmark-et one day. But critics ask whether there isany real synergy between the di�erentsorts of �alternative assets� they o�er.

Will private-equity �rms be able tomaintain their privacy when transparencyis increasingly expected in every walk oflife? The answer may depend on politicsas much as on economics. Most private-equity �rms �ercely oppose greater trans-parency, arguing that it will rob them oftheir magic. Many tacitly accept that theirperformance will soon become subject tomuch more intense scrutiny, and that theywill have to adopt sensible industry stan-dards for valuing their portfolios. But theyare desperate to avoid having to disclosedetails about the performance of individ-ual �rms in their portfolios. Such disclo-sure, they say, would quickly subject thosecompanies to the same sort of damagingshort-term pressures that they would facein the public equity markets.

But change is on its way, if only be-cause of the growing amount of moneybeing invested in private equity throughpublic pension funds. In America, free-dom of information acts have promptedsome public pension funds to provide de-tails of the performance of their invest-ments in di�erent private-equity �rms, tothe horror of most of the �rms concerned.Yet, as Thomas Lee, founder of the epony-mous private-equity �rm, concedes, �Weare using so much public money that wehave an obligation if not to be transparentthen to be a little less invisible than in thepast.� How much less invisible will be ex-plored later in this survey. But �rst, a quicklook at past form. 7

Year raised

Serious moneyAll-time top ten private-equity funds by amount raised, Nov 1st 2004, $bn

Source: Dow Jones Private Equity Analyst

5.00 5.25 5.50 5.75 6.00 6.25 6.50

J.P. Morgan Partners Global 2001 Fund

Blackstone Capital Partners IV

Thomas H. Lee Equity Partners V

KKR Associates 1996 Fund

TPG Partners IV

KKR Associates 1987 Fund

KKR Millennium Fund

DLJ Merchant Banking Partners III

Warburg Pincus Private Equity VIII

Goldman Sachs Capital Partners 2000

2002

2002

2001

1996

2004

1987

2003

2001

2002

2000

2

1


FROM its creation in 1976 to the end of2003, KKR invested $18.4 billion. The

�rm calculates that these investmentshave increased in value to $49.7 billion, ofwhich $39.3 billion has already beenbanked. Amid much fanfare, in the past 18months it has returned $9 billion in cash toinvestors, beating even Carlyle’s equallytrumpeted cash return of $6.6 billion.

This sort of performance makes it easyto see why investors are so keen on privateequity. Yet it has been the exception, notthe norm�which has mostly been to lagbehind even the public equity markets.And although KKR continues to proclaimthat �private equity will outperform pub-lic equity and other investments over thelong term,� even the best �rms may strug-gle to match their past success. KKR itself isnow viewed in the industry as a shadowof its old self, concentrating increasinglyon lower-risk, lower-return deals.

From 1980 to 2001, the average private-equity buy-out fund generated slightlylower returns to investors (after subtract-ing fees to general partners) than theywould have obtained by investing in theS&P 500, according to a recent study bySteve Kaplan of the University of Chicagoand Antoinette Schoar of the Massachu-setts Institute of Technology. The medianventure-capital fund also fell just short ofmatching the S&P, although an average ofventure-capital �rms weighted by howmuch capital each had invested beat it by ashort head. However, gross returns (ie, be-fore fees) on both buy-outs and venturecapital did beat the S&P during that per-iod�probably by a sizeable margin, feesbeing what they are (see box, next page),concludes the study.

Mr Kaplan and Ms Schoar also foundhuge di�erences between individualfunds. The top quartile of private-equityfunds produced an annual rate of return of23%, well ahead of the S&P; the bottomquartile earned investors only 4% (seechart 3). Other experts have come to simi-lar conclusions. Greenwich Associates, apension-fund adviser, says that typically�only the top 25 private-equity funds gen-erate better returns than the S&P.�

An even gloomier picture is painted byone of the most successful investors in

private-equity funds, David Swensen,who has been chief investment o�cer ofthe now massive Yale University endow-ment since 1985. In a classic book, �Pio-neering Portfolio Management�, pub-lished in 2000, Mr Swensen is scathingabout the performance of much privateequity�particularly as the past two de-cades may have been uniquely favourablefor private equity, with falling interestrates making borrowing cheaper, a rela-tively small number of private-equity�rms competing, lots of badly run compa-nies to improve and a sharp rise in the mul-tiple of share price to pro�ts that investorsin public stockmarkets would pay.

And even the performance of the fewfunds that did beat the S&P needs carefulexamination. Being much less liquid thanpublic equities, private-equity invest-ments should o�er a premium over theS&P to justify the extra risk. This point is

lost on some investors, who think thatprivate equity is less risky because its re-ported value is much less volatile thanpublic equities. But the main reason whyprivate equity is less volatile is that it isonly rarely revalued�and then usually inan unsatisfactory way. To say that privateequity is less volatile and thus less risky isa bit like saying that the weather does notchange much when you stay inside andrarely look out of the window.

It’s done with mirrorsBut there is a further common �aw in mak-ing comparisons with the S&P. Mr Swen-sen looked at 542 buy-out deals that werestarted and concluded during 1987-98. At�rst sight their performance looked im-pressive, with annual returns of 48%, com-pared with 17% if the money spent on eachdeal had been invested in the S&P for thesame period of time. But most of thesegains, Mr Swensen points out, came fromheavy borrowing by buy-out �rms seekingto multiply their private-equity bet.

If the same amount of debt had beenused to multiply the investments in theS&P, the leveraged portfolio of public equi-ties would have generated an 86% return,beating the buy-outs by nearly 40 percent-age points a year�or nearly 50 points afterfees. Yale took part in only 118 of the 542deals, generating gross returns of 63% ayear, comfortably beating (even after fees)comparably leveraged S&P investment re-

Pick carefully

Some private-equity �rms are much more successful than others

3Only the best will doAnnual private-equity returns, 1980-2001, %

Sources: Steve Kaplan, University of Chicago; Antoinette Schoar, MIT

0 5 10 15 20 25All privateequity

Venturecapital

Buy-outs

Top quartileMeanBottom quartile

1


2 turns of 41%. Not for nothing is Mr Swen-sen regarded as a private-equity genius.

Why did the average fund perform sopoorly? Size does not seem to have beendecisive, according to the study by Mr Ka-plan and Ms Schoar. In venture capital, thelarger funds of the 1990s tended to per-form better than their smaller counter-parts in the 1980s. But the opposite wastrue for buy-out funds, which struggled inthe early 1990s even though they had gotbigger. One possible explanation is thatventure capitalists had much better invest-ment opportunities available to them inthe 1990s, as the technology revolutiongathered speed, whereas buy-out fundswere badly hit by the collapse of the junk-bond market in the late 1980s and the re-cession of the early 1990s.

Location may also have played a part.Various studies have shown that, duringthe 1990s at least, European-based private-equity funds (mostly concentrating onbuy-outs) delivered better returns thantheir American counterparts. Possiblecauses range from less competition to bet-ter deals available because of corporateEurope’s relative ine�ciency.

Not only is there a large gap betweenthe best private-equity funds and the rest,but their respective performances havealso been remarkably consistent. Mr Ka-plan and Ms Schoar found that the win-ners in private equity tend to keep on win-ning, and the bad �rms stay bad�if theyremain in business. This is in sharp con-trast to mutual funds and, to a lesser ex-tent, hedge funds, where star performerstend quickly to return to the average. If aprivate-equity �rm’s �rst fund performs

well, its second and third will probably dolikewise�even more so in venture capitalthan in buy-outs.

Why? Some private-equity �rms mayhave better access to �proprietary� deals inwhich they are the only bidders, so theircosts will be lower than if they had to com-pete for deals. But with the increased useof auctions in sales to private-equity �rms,this has become a much less likely ex-planation for superior performance. Moreplausibly, venture capitalists with a repu-tation for successfully nurturing start-upsmay be o�ered better opportunities. Orperhaps there are simply just a few peoplein private equity who are very much betterat it than their rivals. There is, after all, onlyone Henry Kravis.

Mr Swensen argues that the deals Yaleinvested in produced better results thanthe rest of those he studied because his in-stitution took a di�erent approach to priv-ate equity. It invested in funds whose dealsinvolved much less debt and much moreattention to improving the operating per-formance of the �rms concerned.

Another explanation for the poor per-formance of many private-equity �rms

4The smarter investorAnnual performance by type of private-equity

investor, worldwide, 1991-2001 average, %

Source: Josh Lerner, Antoinette Schoar and Wan Wong

5 0– + 5 10 15 20

Endowments

Private pensions

Public pensions

Insurancecompanies

Banks

NICE work if you can get it. The generalpartners who manage private-equity

funds are lavishly paid. They receive anannual management fee, usually 1.5-2.5%of the fund’s assets, and also get a share ofany pro�ts made from the fund’s invest-ments after the initial capital has been re-paid to limited partners, a paymentknown as the �carried interest�. This isusually 20% of net pro�t, although some�rms, particularly venture capitalists, settheir �carry� as high as 30%.

As if that were not enough, some priv-ate-equity �rms levy charges for thingssuch as monitoring the �rms in a fund’sportfolio, ending the monitoring arrange-ment when the �rm is sold, and even forproviding some of the investment-bank-ing services involved in buying or selling�rms in the portfolio.

In the early private-equity funds, inAmerica at least, the carry was taken oneach deal that made a pro�t, not on theaggregate performance of a fund. So, as

long as some individual deals were pro�t-able, general partners could collect acarry even if the fund lost money overall.From the late 1980s, under pressure fromlimited partners, funds started to calcu-late the carry on aggregate pro�ts�though some �rms, including KKR, wereslow to embrace this new norm.

In practice, American private-equity�rms have often taken their carry eachtime a deal is pro�tably concluded�withthe proviso that if the fund turns out notto be pro�table overall, limited partnerscan claw back these payments. In Europe,general partners do not usually receiveany carry until a fund has repaid all of thecapital invested by its limited partners.Lately, private-equity general partnershave become jealous of hedge-fund man-agers, who also have a �2-and-20� rewardstructure, but typically get their carry atthe end of every year.

Intriguingly, private-equity �rms haverarely tried to compete for capital by low-

ering their take, perhaps because inves-tors might interpret it as showing a lack ofcon�dence. Warburg Pincus cut its carriedinterest in the early 1990s, but no one fol-lowed suit. Barry Wolf, a private-equitylawyer at Weil, Gotshal & Manges, saysthat when the tech bubble burst, manypeople expected investors to put pressureon the payment terms of new funds. Butinstead of attacking terms, they took anall-or-nothing approach to investing innew funds: those raised by �rms with agenerally good record got oversubscribed,bad performers got nothing.

If it gets harder to make pro�ts by in-vesting, private-equity �rms will proba-bly try to earn bigger management fees byraising ever larger funds at more frequentintervals. Jon Moulton of Alchemy, a Brit-ish private-equity �rm, is puzzled: �A lotof people in the industry already makeseveral million a year without having toperform. I can’t understand why inves-tors haven’t put more pressure on fees.�

A gravity-defying pay structureHighly leveraged

1


2 may be the inadequacies of their main in-vestors. The vast majority of capital goinginto private-equity funds comes from insti-tutional investors of various kinds. Somesorts of institution seem to do a consis-tently better job than others at pickingprivate-equity winners, according to�Smart Institutions, Foolish Choices?�, afascinating new study by Ms Schoar withJosh Lerner and Wan Wong, both of Har-vard Business School.

Among funds raised in the ten years to2001, those that attracted investment bythe endowments of universities and not-for-pro�t foundations did 14 percentagepoints a year better than the average fund.Funds picked by investment advisers (in-cluding funds-of-funds, which invest aslimited partners in a portfolio of private-

equity funds) and banks performed wellbelow average (see chart 4, previous page).The more endowments invest in a fund,the better it is likely to perform; the morebanks invest, the worse it is likely to do.

According to the study, these strikingdi�erences cannot be explained away bythe fact that endowments have been in-volved in private equity for longer, andthus tend to get better access to new fundsbeing raised by the leading private-equity�rms. Endowments have been just as goodat picking out new private-equity �rmsthat subsequently go on to do well.

The most likely explanation is that theleading endowments have sophisticated,relatively well-paid sta� who monitor per-formance carefully. Harvard’s endow-ment reputedly paid two of its analysts

$35m apiece last year. Advisers, banks andothers who sell funds-of-funds may have�nancial incentives to maximise sales, butmay not care how the fund itself performs.

Banks’ in-house private-equity fundsoften perform poorly because of con�ictsof interest: they may be made to invest in acompany because the bank hopes to winother banking business from it later. Theyalso pay their sta� less generously thanothers. Indeed, banks are now quitting theprivate-equity industry, both because ofpoor past performance and because oftougher rules on how much capital theymust set aside to cover the risk involved.

But even those private-equity fundsthat have done well in the past may �nd itharder to do so in the future, as the next ar-ticle will explain. 7

SOME of the ageing superstars of privateequity dismiss current predictions that

competition will drive down returns. Theyhave heard it all before. �There are still lotsof great deals out there,� says Thomas Lee.�The past couple of years have been agolden age for private equity.�

There is some truth in this. The yearsimmediately following the tech bubble,the economic slowdown, the terrorist at-tacks of September 11th 2001 and the col-lapse of Enron o�ered plenty of opportu-nities for private-equity �rms with thecourage to invest. Soon after September11th, several private-equity �rms set up aclutch of catastrophe-risk insurance com-panies based in Bermuda, which havenow been sold at a huge pro�t. �We shouldhave bought everything in sight after 9/11,�says Mr Lee. �It needed minimum brains,maximum guts to do those deals.� At thesame time, big companies such as GE andTyco, which had hitherto been competinghard with private-equity �rms for poten-tial acquisitions, backed away from themarket or even became eager sellers ofnon-core businesses.

Yet this period may prove to have beenonly a brief reprise of the high returns ofprivate equity’s early years, not a sign thatthe industry has put its troubles behind it.Nowadays even the best private-equity�rms are mostly aiming to achieve annualreturns of only 15-20% on their capital,

down from 20-25% in the 1990s and over30% in the 1980s�though in the buy-outbusiness they still hope at least to doubletheir money on every investment. Private-equity �rms now talk much less about theabsolute returns they expect to make. In-stead, they promise better returns thanthose available in public equities�which,given the stockmarkets’ miserable perfor-mance lately, may not be saying much.

Some make bigger promises than oth-ers. �We expect to do 2,000 basis pointsbetter than the market in all conditions,�says the boss of one big �rm. Carlyle isaiming for 1,000-1,500 basis points abovethe market. Most �rms, however, feel thatinvestors would settle for 600 points bet-ter than the stockmarket as su�cient re-ward for the illiquidity and, perhaps, thegreater risk of private equity.

For a variety of reasons, returns mayfall short of even these modest targets.There is already lots of capital chasingdeals: some $100 billion has been raisedbut not yet invested, hedge funds are pilingin and a new cycle of fund-raising is get-ting under way. So far, funds with a goodreputation are �nding a keen responsefrom investors, especially in Europe: Al-lianz, Germany’s biggest investor in priv-ate equity, has said that it is planning to in-vest much more. Bain Capital recentlyraised a $4 billion fund in only a few weeksinstead of the usual few months.

In the past, private-equity �rms wereable to do a fair number of �proprietarydeals� in which they had no competition.Now, even though the number of deals isincreasing, all but the smallest �rms aresold through a competitive auction organ-ised by the seller’s investment bank. Com-petition can be intense, with deals attract-ing from half a dozen to many dozens ofbidders, and auctions almost always resultin higher prices.

Pro�table ploysPrivate equity thrives on �nding ine�cien-cies to exploit. Fees aside, there are severalwell-established ways for its �rms to makemoney. The four main ones are:� Improve the pro�tability of the compa-nies they buy, so that they can sell them formore than they paid for them.� Buy low, sell high. Some companies falltemporarily out of favour with investors,so their shares trade at a low multiple oftheir pro�ts or cash�ow. Private-equity�rms can buy them and wait until the mar-ket is more bullish and multiples arehigher (though they may �nd that therewas a good reason for the low valuation).Valuation multiples also tend to rise as�rms get bigger, so simply holding a busi-ness and letting it grow may boost its mul-tiple from, say, six to eight over a few years.� Break it up. Some businesses trade at avalue that is less than the sum of their

Small expectations

Things are likely to get harder rather than easier

1


2 parts. They can be broken up and sold inpieces for more than the purchase price.Some part of the business may distractmanagement from a company’s core oper-ation or drain scarce resources from it. Sell-ing it o� not only raises money but mayalso result in a more focused and thereforemore valuable core business.� Use leverage. Borrowing can multiplyany gains made by the �rst three methods.A private-equity �rm buys a company for,say, $100m. It pays for it with $10m of itsown equity capital and borrows the re-maining $90m. It later sells it for $110m.After repaying the debt, it has doubled itsmoney even though the value of the �rmhas increased by only 10%. The risk, how-ever, is that if things go badly and the priv-ate-equity �rm is unable to service and re-pay the loan, its capital may be wiped outin the bankruptcy courts.

In practice, many private-equity �rmsdeploy all these methods. But broadlyspeaking, in the 1980s, when debt wasplentiful and target companies were nothighly leveraged in the �rst place, private-equity �rms concentrated more on �ndingundervalued assets, selling o� the piecesand greatly boosting their yield with lever-age. In the 1990s, the increasingly bullishstockmarket allowed such �rms to bene�thandsomely from rising price-to-pro�tmultiples. Today, the �rms may have toearn most of their money by improvingthe companies they own.

Standard practiceOne problem is the commoditisation ofmany of the activities that gave private-equity �rms a competitive advantage intheir early days. When people such asHenry Kravis started doing deals, the e�ec-tive use of leverage and the importance ofcash�ow was a mystery understood byonly a few; now it is taught in every busi-ness school. Private-equity �rms have be-come a huge source of business for all sortsof professionals, from consultancies, exec-utive search �rms and back-o�ce compa-nies (such as BISYS, the industry leader) tolaw �rms and investment banks (Black-stone alone paid Wall Street �rms around$700m in fees in 2003). As a result, thetechniques of doing deals have becomestandardised. That has lowered risk but in-creased competition by making it easierfor less experienced �rms to bid.

Ultimately, private equity is all aboutmaking a successful exit. The traditionalsolutions are either selling to a trade buyer(typically a company in, or trying to getinto, the same industry as the �rm being

sold) or turning the �rm into a public com-pany via an IPO. In the past two or threeyears, both of these exits have become nar-rower than they were during most of theprevious decade.

Many of the IPOs that took place dur-ing the tech boom subsequently melteddown, so now investors have little interestin buying shares in start-ups without a re-cord of pro�tability. Google’s IPO earlierthis year may have attracted a lot of atten-tion, but it has not made investors muchkeener on other tech IPOs. Most private-equity �rms believe that it will be years be-fore the IPO market returns to the levels of2000�if indeed it ever does.

At the same time, corporate buyers re-main reluctant to make all but the most ob-viously sensible acquisitions. Under pres-sure from shareholders, their boards havecome to regard the large number of ill-ad-vised takeovers and mergers during the

bubble years as evidence of corporate-governance failure during that period.

Helpfully, two new exit routes haveopened up in the past few years. The �rst isrecapitalisation. Recently a few second-tierbanks have become much keener on lend-ing to �nance private-equity deals. Theyare now willing to value �rms at muchhigher multiples of pro�ts than even 12months ago, and to lend against those val-ues. Many private-equity �rms have takenadvantage of this to �recap�: increasing theamounts borrowed by the �rms in theirportfolios, then using the extra moneyraised to make dividend payments that thefund distributes to its limited partners.

Will this exit stay open for long? Thereare only so many times a �rm can be reval-ued and recapitalised. Recaps are anywayonly a partial solution, for the �rm still re-mains in the hands of its private-equityowner. And it may not be prudent forbanks to lend at such high multiples. Itwould not be the �rst time that their pur-suit of loan origination fees has led to lax-ity in their credit judgments. When they ortheir regulators notice how lax they havebecome, this particular door may slamshut just as suddenly as the IPO one did.

The other currently fashionable exitstrategy is for one private-equity �rm tosell to another, a technique known as a�secondary buy-out�. (This should not beconfused with the �secondary market� inwhich one investor can sell its limited part-nership in a fund to another investor. Thismarket is also growing fast.) Over the pasttwo years, secondary buy-outs have ac-counted for a rapidly rising proportion ofsales by private-equity �rms.

Some observers view these �buy-outsof buy-outs� as evidence of the growingmaturity and specialisation of the indus-try. Others wonder what they will get outof this game of �pass the parcel�. �The re-sults of these deals may prove most disap-pointing,� says Michael Stoddart, a Britishprivate-equity veteran at Fleming Familyand Partners. Anything the buyer could doto improve its acquisition may alreadyhave been done by the seller. And what isthe bene�t to the limited partner who hasinvested in both the buying and the sellingprivate-equity �rm and thus ends up stillowning the �rm that has been sold, minusthe fees for the general partner of the sell-ing fund? Some limited partners evenworry that such deals may involve somemutual back-scratching, in which one �rmbuys from another on the understandingthat the seller will later return the favour.

There is another exit that private-equity

5

*As of Sep 30th

A narrower exitWorldwide initial public offerings

Source: Dealogic

0

500

1,000

1,500

2,000

Number of deals

1994 96 98 2000 02 04*0

50

100

150

200

Value, $bn

1


2 �rms are increasingly having to thinkabout: that of their top brass. As the indus-try has matured, so has its pioneering gen-eration of leaders. The duo in charge ofKKR, Mr Kravis and George Roberts, arearound 60, as is Mr Lee. Teddy Forstmannof Forstmann Little is 64. Increasingly, lim-ited partners�who, after all, must lock uptheir cash with private-equity �rms formany years�want to know who will suc-ceed the current bosses, and when. So, too,do the candidates who might take over.Lionel Pincus, now 73, lingered so long atWarburg Pincus that when he �nally gaveup operational responsibility, a wholegeneration of heirs apparent had left.

Some �rms have embraced successionplanning more willingly than others. Thefounder of Apax, Sir Ronald Cohen, set amandatory retirement age of 60 long be-

fore he himself reached it. Apax now has anew chief executive, Martin Halusa, 49. AtPermira, power has passed smoothly to anew generation. Mr Lee has delegated day-to-day responsibility for his �rm to others.TPG’s David Bonderman now describeshimself as more a chairman than a chiefexecutive. Blackstone has recruited anemerging next leader, Tony James.

The long goodbyeBy contrast, Forstmann Little, which hasfailed to develop any potential successorsto Mr Forstmann (and has also put in anabysmal performance recently), recentlyannounced that it will go out of businesswhen Mr Forstmann retires in 2006. MrKravis, for his part, plans to stay at thehelm for many more years. He says thatKKR has a deep bench of talent, so there is

no doubt that the �rm will thrive after him. What should a founder be paid for giv-

ing up his partnership? Founders tend tohave a large stake in their �rms, so buyingit could be a serious drain on the �nancesof the remaining partners. Apax’s partnershad a meeting to agree on what they re-garded as a reasonable price. Other strate-gies for cashing in the founders’ stakes,much discussed in private-equity circles,include selling the �rm to a bigger �nancialinstitution, or �oating it.

The trouble with replacing a set ofhighly charismatic founder-leaders is thattheir successors may seem less inspiring.As one limited partner put it, they will cer-tainly �all be very bright and numerate,with MBAs, very analytical. But I worrythey may be more like bank o�cers thandeal-making geniuses.� 7

�PRIVATE-equity �rms are only nowstarting to do aggressive branding,�

says David Rubenstein, boss of the CarlyleGroup, a top private-equity company thathas probably devoted more thought to itsbrand strategy than anyone else in the in-dustry. This task has been complicated byCarlyle’s recent elevation to public enemynumber one, on �lm by Michael Mooreand, more thoughtfully, in Dan Briody’sbook, �The Iron Triangle�.

Carlyle’s critics note that many formerpoliticians have taken the company’s shil-ling, and that some members of the binLaden family and other Saudis not only in-vested in the �rm but were attending itsannual investors’ meeting on September10th-11th 2001. This, they aver, shows thatCarlyle is at the heart of a worrying globalmilitary-political-industrial complex.

The company �ercely rejects suchcharges. It says that hiring politicians wasnot meant to secure deals; it was a market-ing initiative intended to �help people getto know us�. This approach has beenwidely imitated, says Mr Rubenstein: �Ev-ery private-equity �rm now has its formersenior government o�cial hangingaround, but it got identi�ed with us.� Hesays that, contrary to the �rm’s (un)popu-lar image, �we are as ethical as any busi-ness in the world, and are proud that inover 17 years no government agency has

ever �ned us for anything.� The bad press,he says, seems to have had no e�ect onprivate-equity investors, a smallish groupwho hold the �rm in high regard. �We areraising more money than ever, recruitingmore people than ever, doing more deals.�

For what it’s worth, Carlyle’s rivals inthe private-equity business also dismissthe conspiracy theories and, in a back-handed way, pay tribute to the �rm’s mar-keting prowess. Wooing the people in pub-lic-pension funds who invest in privateequity may well be good policy. They tendnot to be high-�yers, and may be in�u-enced by rubbing shoulders with the greatand good in a luxurious venue.

�Carlyle is the McDonald’s of the in-dustry�big, everywhere, schlocky,� saysone well-known deal-maker. Carlyle, henotes, is always on the road drumming upmoney to �ll the constant stream of newfund �franchises� it opens. The companycurrently manages 22 funds of varioussorts; the industry norm is to start one newfund every few years, typically involving alaborious fund-raising process that oftenlasts the best part of a year. �Carlyle isabout as in charge of the world as McDon-ald’s is,� concludes the rival deal-maker.

Just like Carlyle, other leading private-equity �rms now hope that establishing astrong brand will give them an edge. Asprivate equity matures, they think, it will

become like many other industries, with afew leaders that can use their strongbrands to charge higher prices, launch newproducts more easily, recruit top talent andattract the best business partners. Impres-sive past performance is likely to be a pre-requisite for becoming a strong brand. Butin an industry once dominated by look-alike generalists, the top �rms are now pur-suing very di�erent strategies.

The main variables are the size of theirfunds and the degree of specialisation.Some have established a niche in particu-lar kinds of deals or industries or geo-graphical regions; others cover the wholerange of private equity, or are even movingbeyond private equity into other assetssuch as hedge funds. The market seemswell aware of these distinctions. Increas-ingly, limited partners �divide funds intoparticular categories, sectors, types ofdeals, then go to the best of breed in eachgroup,� says David Thomas of CitigroupVenture Capital (a global technology-ori-ented buy-out �rm, despite its name).

One crucial strategic choice is the sizeof deal to be pursued. It is fashionable toargue that competition is �ercest�andthus returns likely to be lowest�in the big-gest deals, of $1 billion and up. These are inrelatively short supply. All of them involveauctions among the largest, most competi-tive funds. Mid-sized deals are often seen

Beating the mid-life crisis

What private-equity �rms are doing to win in a mature market

1


2 as a better bet�more common and morediverse, and thus providing more opportu-nities for specialist private-equity �rms.

Yet mid-sized deals are increasingly al-located by auction, too. The poorest per-formers in private equity are concentratedin this part of the market. �A lot of �rms inthe mid-market know they are never goingto be able to raise another fund, so they’rethrowing their money around,� says theboss of one of the �rms that concentrateon bigger deals. Mid-sized auctions tend toinvolve many more bidders, perhaps doz-ens. Bigger deals are often fought out by nomore than three funds or consortia.

Consortium deals�known as �clubdeals��have become increasingly com-mon. A recent example was the joint pur-chase in July by KKR, Blackstone, TPG andHellman & Friedman of Texas Genco, anenergy �rm, for $3.65 billion. Some clubs

include non-�nancial �rms: TPG and Prov-idence Equity Partners recently teamed upwith Sony to buy MGM.

But club deals are controversial. On theplus side, a consortium can do biggerdeals. Most funds have an upper limit onhow much of their capital they can putinto any one deal, typically around 10%. Soeven a $5 billion fund, assuming it couldborrow, say, three times the equity it putsin, might not be able to bid more than $2billion for any target �rm on its own.

On the minus side, some sellers suspectbig private-equity �rms of forming (loose)cartels to make bidding less competitive.There is also the practical question ofwhich member of the club will be in con-trol of the company after it has beenbought. Jack Welch, the former boss of GE,who now works for Clayton, Dubilier &Rice (CDR, see box), worries about what

happens when the purchasers disagreeabout what needs to be done to improvethe company, or when to sell it. But thatrisk does not trouble Mr Lee, whose �rm isinvolved in lots of club deals. �All the toppeople in the big private-equity �rms haveknown each other for years, and it is un-likely we are going to disagree funda-mentally,� he says. �Put the chance of a dif-ference of opinion versus the opportunityto make lots of money, I’m prepared totake the chance.�

Many of the most upbeat people inprivate equity today concentrate on smalldeals, not least because in this area there islittle competition from thebig funds. Thefunds pursuing small deals tend them-selves to be small. �There is a stark contrastbetween small private-equity funds�maybe $10m-50m, truly lean, often largelyfunded by the general partners, who have

�IWAS looking for work,� jokes JackWelch, explaining why he agreed to

become a partner at Clayton, Dubilier &Rice (CDR). The much-admired formerboss of General Electric surely had noshortage of job o�ers after he steppeddown in 2001. But, he says, �today I seeprivate equity as about as much fun asyou can have if you like managing, im-proving assets, building leadershipteams�which is what we do at CDR.�

Mr Welch, one of several formerbosses of big global public companies tomove into private equity, was hired byDon Gogel, CDR’s boss, to help get thevenerable private-equity �rm back ontrack after a few disappointments, nota-bly an investment in Fairchild Aerospace.Mr Welch’s main activity in his part-timerole at CDR is to conduct in-depth quar-terly reviews of all the �rms in the CDR

portfolio. He treats each managementteam to three hours of intense question-ing and inspiration�a personal tutorial inthe applied management philosophy de-scribed in his bestselling autobiography,�Straight from the Gut�. The o�er of regu-lar meetings with a business legend mayalso help CDR clinch deals with manag-ers of �rms that have a choice of prospec-tive owners. A call from Mr Welch can

convince executives to work for, or jointhe board of, a �rm that CDR owns.

Mr Welch used to conduct similarquarterly reviews of the �rms within GE’sdiverse portfolio of businesses, helping tomake the �rm the exception to the rule

that conglomerates underperform. �Wedo all the same things we did at GE�sitdown with the CEO, look him in the eye,go over performance in the past quarterand plans for the next,� says Mr Welch.�The only real di�erence between hereand GE is we aim to sell the �rm one day.�

CDR is probably the most hands-on ofthe leading private-equity �rms in itsdealings with the companies it owns. Itbelieves it can still add value, especiallywith Mr Welch’s extra clout. Without thepressure most public companies feel un-der because they have to publish their re-sults every few months, companiesowned by private-equity �rms can pur-sue longer-term strategies, says Mr Welch.CDR combines this long-term perspectivewith a strong emphasis on corporate gov-ernance. �If you don’t bring governance,you are not going to be able to make itwork.� That is why CDR does not takepart in club deals, he says.

Mr Welch’s biggest challenge so far? AtGE, he wanted to buy only good busi-nesses. At CDR, he has had to �reset mybrain to buy broken businesses and �xthem�. This has not been easy. �It takes ayear to get into the right way of looking atthese businesses. Your �rst reaction is, ‘Je-sus. Why would I want to get into that?’ �

Jack Welch on his latest jobGut feeling

1


2 often been successful managers�and big�rms that are really asset managers whosemain expertise is fund-raising,� says RoyBingham of Health Business Partners, aninvestment banking �rm specialising insmall health-care-related deals.

Sentinel Capital, based in New York,goes for �rms in the $25m-125m range.There are lots of them, the scope for re-medying ine�ciencies is much greaterthan in medium-sized and large �rms, andcompetition for deals is less intense�though that may change as the mid-mar-ket funds become more desperate for pro-mising opportunities. Indeed, says DavidLobel of Sentinel, mid-market �rms are al-ready keen buyers of companies that Sen-tinel has acquired and knocked into shape.

The leading private-equity �rms havelong claimed to add value to the compa-nies they have bought. As the industry ma-tures, they say, operational improvementswill become the main source of pro�ts, sothey are upgrading their methods. CDR

hired �Neutron Jack� to add rigour to theoversight of �rms in its portfolio. KKR nowdraws up a detailed �100-Day Plan� (�notthree pages, a line-by-line blueprint�) for a�rm immediately after its acquisition, inwhich its in-house consulting �rm, Cap-stone Consulting, plays a crucial part.

The rise of the specialist�From now on, specialists will outperformgeneralists,� says Glenn Hutchins of SilverLake Partners, an American private-equity�rm specialising in large, mature technol-ogy companies, a sector in which �youreally have to understand the companiesyou invest in�. Increasingly, all but the big-gest �rms are claiming to be specialists inparticular sorts of deal.

And even some big �rms are claimingto specialise in several things: for example,Apax says it has built expertise in six care-fully selected industries. Electra Partners, abig British private-equity �rm, says it spe-cialises in �nding �rms with low growthand complex challenges that it thinks it canclean up and put on a faster growth track.Elevation Partners was launched in Juneby Roger McNamee, formerly of SilverLake, and Bono, a rock star, to seek outdeals in the media and entertainment in-dustry. But specialisation itself is no guar-antee of success: a private meeting withBono persuaded investors to stump up $1billion, but can his fund do better than ex-perienced and equally specialised rivals?

Some �rms are trying to di�erentiatethemselves by aiming for a wider geo-graphical spread. For most American priv-

ate-equity �rms, �going global� is short-hand for bee�ng up their continentalEuropean operations. Several have nowestablished a foothold in Europe, havingtried but failed a decade ago. This timeround they have realised that to succeed inEurope, with its many languages, culturesand legal systems, they need a strong localpresence, mostly of local sta�. Conversely,European private-equity �rms are not seri-ously trying to crack the American market.

Europe has seen far more buy-out dealsthan other parts of the world in recentyears, a trend that is widely expected tocontinue. �In Europe, unlike America,there will be opportunities to exploit in-e�ciencies for years,� argues GraemeJohnson, European head of DeutscheBank’s private-equity-funds group. Onereason, says Damon Bu�ni of Permira, isthat whereas America has already unbun-dled most of its badly run conglomerates,Europe is only now starting to do so. Buteven in America, there are still a fewopportunities to be found. Wilbur Ross, ofWL Ross, for instance, made a remark-able�and remarkably lucrative�job ofrationalising America’s steel industry andshepherding it through the bankruptcycourts in 2002-03.

Asia has mixed appeal for private-equ-ity �rms. Most think that it has huge poten-tial but are uncertain about their ability totake advantage of it. Many are now look-ing hard at Japan, following the success ofRipplewood and Christopher Flowers inbuying Shinsei Bank out of bankruptcy,

cleaning it up and �oating it. Gillian Tett’sgripping book about the deal, �Saving theSun. How Wall Street Mavericks Shook UpJapan’s Financial World and Made Bil-lions�, makes it clear that foreign private-equity �rms with brains, patience and con-nections can make a fortune in Japan.

Private equity is growing in India too.Gaurav Dalmia of First Capital India, aprivate-equity boutique, says this rangesall the way from big foreign funds negotiat-ing equity stakes in large Indian publiccompanies to Indian entrepreneurs return-ing from Silicon Valley to put their moneyinto tech start-ups. �India is one of the fewmarkets in the world that o�ers opportuni-ties to deploy large amounts of privateequity,� says Mr Dalmia. Private-equity in-vestment in India this year is expected toreach $1.3 billion, up from $800m in 2003.

China, which has no lack of capital anda tendency quickly to create overcapacityin any successful business, still has manyforeign private-equity �rms wonderinghow to make money there. General Atlan-tic Partners, long one of the savvier andmore globally oriented American private-equity �rms, has astutely teamed up withAIG, an insurer with great connections inAsia, and particularly in China. �We preferto �nd partners in those parts of the world,as we would otherwise spend years tryingto understand local conditions,� says SteveDenning, General Atlantic’s boss. Havingstarted to invest in China and India threeyears ago, the �rm this year �oated one ofits Indian �rms, Patni Computer Systems,

1


2 and recently bought a stake in GE’s busi-ness-process outsourcing unit in India.

Carlyle and Blackstone, with TPG andBain Capital following close behind, havedecided to diversify well beyond privateequity. This strategy is not entirely new.Many private-equity �rms have long hadmezzanine or distressed-debt funds. Black-stone has run a property fund since 1992.One reason for branching out is to providea �one-stop shop� for limited partnerssuch as big pension funds, which nowwant to reduce the number of private-equ-ity �rms they deal with, but without nec-essarily making their investments less di-verse. Carlyle says it allows investors topick and move among di�erent marketniches, and allocate capital across manyfunds without being charged the doublefee that a fund-of-funds would incur.

Yet as �rms concentrate on expandingtheir assets under management, they maystart to care less about performance�which may anyway be a�ected by thesheer di�culty of evolving from �craft�businesses into huge institutions. And,

say, Carlyle’s 1-2% annual fees on the $18billion it manages add up to more thanenough to provide its team of 280 invest-ment professionals with a comfortable liv-ing even if their results are mediocre�which, to be fair, so far they have not been.

Is there any synergy between di�erentsorts of so-called alternative assets? Black-stone, which tries harder than Carlyle toget its di�erent sorts of fund managers toexchange ideas, says that, for example,during the tech bubble sceptics in its priv-ate-equity group saved its property groupfrom investing in o�ce space intended ascheap �telecoms hotels� for internet �rms.

Yet even as Blackstone, Carlyle and TPG

diversify, private-equity �rms are com-plaining that hedge funds are moving onto their turf. Mr Kravis, noting that in theauction for Texas Genco the KKR club hadonly narrowly defeated a rival one madeup of hedge funds, observed that �hedgefunds know how to pick stocks and make alot of money. But that is not the same thingas creating value through ownership of anasset over the long term in a hands-on

way.� Nor do hedge funds have the rightvaluation skills, say other private-equitybosses. One of them competed unsuccess-fully for a stake in Air Canada against Cer-berus Capital, a big hedge-fund �rm. Hereckons that, at $185m, �Cerberus paidthree times too much.� Yet Cerberus is thehedge-fund �rm most admired, andfeared, by private-equity rivals.

Compared with private-equity funds,hedge funds are short-term vehicles fromwhich investors can readily withdrawtheir capital, usually at least once a year.There is a risk that in the event of a run onthem (and private-equity folk all agree thatthere is now a hedge-fund bubble), hedgefunds might have to sell fairly illiquid priv-ate-equity investments fast. On the otherhand, private-equity �rms, with their long-term perspective, have no obvious claimon the short-term trading skills needed tosucceed in the hedge-fund business.

But if the buy-out side of private equityfaces big challenges, much of the venture-capital business is having an even toughertime, as the next article will show. 7

THE contrast between the dream andthe often disappointing reality of priv-

ate equity shows up most clearly in the re-cent history of venture capital. Investorspoured their money into the industry, cer-tain that venture capitalists had discov-ered a corporate alchemist’s stone, a quickand reliable way of turning bright ideasinto valuable �rms. For a while the indus-try’s success seemed to prove them right.

Paul Gompers and Josh Lerner, in theirin�uential 2001 book, �The Money of In-vention�, calculate that over the years,�venture capitalists have created nearlyone-third of the total market value of allpublic companies in the United States.� In1999-2000, more venture capital wasraised than in the entire previous life of theindustry, stretching back to the 1940s. Butwhen the resulting bubble burst, it wipedout investments of billions of dollars andkilled o� thousands of young companies,not all of them daft dotcoms.

Even so, the dream lives on, in Americaat least. Although investment in venturecapital is well down from its peak, manyexperienced venture capitalists think it is

still far too high. This means that many in-vestors will probably be disappointed bythe returns on their money. And the task ofinstitutionalising and professionalisingthe erstwhile craft business of venture cap-ital has become much harder.

Some of the investors who rushed intoventure capital in the late 1990s haverushed out again, dismissed by ventureveterans as �tourists and day-trippers�.

Most of the big industrial �rms that set upventure-capital arms have either prunedthem or lopped them o� altogether. Manyof the wealthy individual �angel� inves-tors who provided seed �nance for young�rms have, in industry parlance, �gone toheaven�: a lot of them were bubble entre-preneurs who thought they were richerthan they proved to be.

Likewise, most buy-out �rms haveended the �irtation with venture capitalthat led some to invest their funds directlyin start-ups (as Hicks, Muse, Tate & Furstdid, badly, in telecoms) and others to setup venture funds, such as KKR’s joint ven-ture with Accel Partners, a leading venture-capital �rm. Conversely, the long-termtrend for �rms that started in venture capi-tal (such as Apax, 3i and Warburg Pincus)to move into buy-outs has reasserted itself.

Even so, venture-capital �rms mayraise as much as $25 billion this year, com-pared with only $11 billion in 1997. �Theamount of capital raised has come down,but it is still high by historic standards,�says John Jaggers of Sevin Rosen, a long-es-tablished venture �rm that helped to bring

Once burnt, still hopeful

Has the venture-capital industry learnt its lesson?

6Volatile ventureUS private-equity returns, %

Source: Josh Lerner, Harvard Business School

25

50

0

25

50

75

100

125

150

–

+

1974 80 85 90 95 2000 03

Venture capital

Buy-outs

1


2 on Compaq, among others. �At this level,the industry as a whole will not makemoney. It needs to be $10 billion or less toget decent returns.� At $25 billion, he reck-ons, the industry as a whole may do nomore than double its money, rather thanmore than trebling it, as it would usuallyhope to do. Given that top-quartile �rmsusually far outperform the rest, for the av-erage �rm an industry-wide doubling ofthe money invested, spread over the typi-cal ten years, would represent a disap-pointing annual rate of return.

Certainly the in�ux of capital hasbrought much more competition to thoseparts of the economy that innovatethrough start-ups. For example, around 50venture-funded �rms are now said to bedeveloping products to improve internetsecurity, compared with the pre-bubblenorm of 10-15 �rms per sector. Clearly thisis a recipe for many more corporate fail-ures�yet many investors appear to haveconcluded that the bubble period is over,and that venture capital is likely to returnto its former pro�tability.

European chillEuropean venture capital got going prop-erly only in the late 1990s and was justshowing signs of becoming a serious in-dustry when the bubble burst. Thatstopped it in its tracks. Biotech has been hitespecially hard. �The biotech businessmodel is changing here. A lot of VCs aremoving away from early-stage investing tolater-stage, near-market opportunities,�says Sir Chris Evans of Merlin Biosciences,a venture �rm that specialises in biotech inEurope. With �rms like his now con-centrating on investments likely to makemoney within one or two years, he says, �itis really hard for new, young companies toget early-stage funding in Europe now, andthis is having a knock-on e�ect all the wayto the universities, from where innova-tions usually arise.�

Perhaps the bubble in Europe did notlast long enough. �It was only really sixmonths, much shorter than in America,�says Anne Glover of Amadeus CapitalPartners, a British venture-capital �rm.This meant that �venture �rms in Americawere able to get a lot more of their �rmsinto the public markets and returned a lotof money to investors. Europe’s didn’t.�That di�erence may help to explain whycon�dence in America’s venture-capitalindustry has rebounded, whereas Eu-rope’s remain depressed. More broadly,says Mr Lerner, Europe lacks an �entrepre-neurial infrastructure��everything from

law �rms that specialise in venture to sea-soned entrepreneurs and a liquid publicmarket for young �rms.

Will European governments try tocounter the setback by stimulating domes-tic venture-capital industries? Some ofthem have tried before. Between 1965 and1995, Germany launched over 600 govern-ment programmes to encourage ventureactivity, without obvious success. �The ex-perience worldwide where governmenthas tried to encourage venture capital hasnot been good,� says Colin Blaydon of theTuck Centre for Private Equity and Entre-preneurship. That is true nowadays evenfor America’s initially useful Small Busi-ness Investment Company scheme, intro-duced nearly half a century ago to provideloans funded by the taxpayer. It becameentangled in red tape, but has lingered on.

As new money �oods into the industry,a disproportionate amount of it is going tothe leading �rms. In the buy-out business,well-known �rms such as Forstmann Littlethat went awry have been punished by in-vestors. By contrast, big names in venturecapital that performed badly during thebubble period are still able to raise newfunds; indeed, some have been turningaway would-be investors. The latest fundsraised by leading �rms have all beensmaller than their previous ones, and havebeen heavily oversubscribed, often two orthree times. Kleiner Perkins Cau�eld &Byers raised $400m, compared with $1 bil-lion last time; Sequoia Capital raised$395m, down from $695m. The only $1 bil-

lion venture fund raised lately was byNEA, which does a lot more late-stage in-vesting (and is thus closer to buy-out in-vesting). But that fund, too, was only halfthe size of the previous one.

After a period when �epiphany re-placed rigour�, the leading American ven-ture �rms are going back to basics, saysScott Meadows, a former venture capitalistwho now teaches at the University of Chi-cago. They are more disciplined in whatthey will �nance, and try to ensure thatthey can walk away without a huge bill ifthe venture is not working, he says.

They are also rediscovering how im-portant it is for venture general partners tomentor the entrepreneurs they �nance, in-cluding taking seats on the boards of �rmsin their portfolio. The popular bubble-eraidea of setting up �incubators� to bring onlots of companies fast and cheaply hasbeen abandoned in favour of more tried-and-tested venture concepts. The best�rms are becoming increasingly carefulabout what they invest in, and are doingmore research before committing them-selves. At the same time, some of themhave become much more secretive aboutwhat they have invested in, in the hope ofkeeping down the number of imitators.

The top �rms are bene�ting from a vir-tuous cycle. Those venture capitalists withthe best record of nurturing successful�rms tend to attract the best ventures. A lotof entrepreneurs were badly treated afterthe bubble burst: venture capitalists allo-cated what money they had left to those

1


2

OVER the years, big �nancial institu-tions have replaced wealthy individ-

uals as the most important category ofcompany owner. With the rise of privateequity, they now have two main ways ofacquiring their stakes. They can buy sharesdirectly in public stockmarkets, or they caninvest in a private-equity fund that will, ontheir behalf, buy shares in private �rms, orin public companies that they then takeprivate. But which model is best?

Institutional investors typically investwell under 10% of their money in privateequity, and some still steer clear of it alto-gether. But to hear people in private equitytalk, its superiority over public equities isnow overwhelming. Private-equity �rmso�er the best solution to the biggest pro-blem facing institutional owners: how toensure that their companies’ bosses act inshareholders’ best interests. With theirhands-on corporate governance�fromclose but unbureaucratic monitoring atboard level to carefully designed incen-tives for the bosses�they reckon they candeliver a better performance and steerclear of scandals. Corporate governance inthe public equity markets remains notori-ously weak, despite the increase in activ-ism in the past decade, and particularlysince the collapse of Enron in late 2001.

Indeed, the private-equity folk thinkthat recent attempts by politicians and reg-ulators to improve public companies’ cor-porate governance have further strength-ened their hand. KKR’s Henry Kravis hasgone on record as saying that America’s

Sarbanes-Oxley legislation to tighten uppublic companies’ corporate governancewas a �positive development for share-holders. Today directors are taking theirresponsibilities to shareholders more seri-ously.� But, he continued, �they are alsobeing more conservative and risk-averse,�and �to the extent that Sarbanes-Oxleycauses public companies to be less com-petitive, there is an opportunity for theprivate-equity industry in taking thesebusinesses private and putting some en-ergy back into growing them.�

There is no doubt that Sarbanes-Oxleyand other legislation and regulation onboth sides of the Atlantic have raised thecost of running a public company. Smaller�rms, in particular, may feel that an extra$1m a year in compliance costs, say, isenough to tip the cost-bene�t analysis infavour of going private. Moreover, arguesLarry Harris, who until recently was chiefeconomist at the Securities and ExchangeCommission, that is �not a bad thing�.After all, if you take a �rm public, �youhave a high responsibility to the peoplewho are trusting you with their money.�The most expensive aspect of the Sar-banes-Oxley legislation, he says, is certify-ing �nancial results, which requires sys-tems of accountability in public �rms:�You need accountability if you are tohave publicly distributed capital.�

Mr Harris does not think that there willbe any macroeconomic cost if there is ashift away from public to private equity. �Ifyou can’t raise money for a business idea

in the private domain, given how muchcapital there now is in private equity, theidea probably isn’t any good.�

Yet it would be premature to celebratethe inevitable triumph of private equity. Ifmost private-equity �rms fail to improvetheir performance, investors may put theirmoney elsewhere. And private-equity�rms need healthy public markets as anexit route from their investments. Someleading private-equity bosses even hope totake their own �rm public one day. Theydislike private equity’s long, secretive, inef-�cient fund-raising process, and the con-straints imposed by each fund having alimited lifespan. They admit that the per-formance of publicly listed private-equity�rms (such as Britain’s 3i) has often beendisappointing, but point to GE and WarrenBu�ett’s Berkshire Hathaway, both ofwhich have permanent capital and pro�tby doing lots of what are, in essence, priv-ate-equity deals.

And even if good exits are available, lifeis likely to remain tough for private equityas a whole, even as a few big �rms and alarger number of niche operators do well.As Mr Kravis has said, many of the tech-niques that private-equity �rms pio-neered�paying managers with shares,concentrating on shareholder value, mak-ing good use of debt, maximising cash-�ow�are now standard practice in public�rms, making it hard for private equity tooutperform public equities. As they grow,private-equity �rms may also su�er fromdiseconomies of scale, becoming more bu-

Draw a veil

The attractions of privacy

�rms in their portfolios nearest to achiev-ing an exit, even if others had better long-term prospects. The idea was that if theventure �rms returned at least somemoney to investors, they could quickly geton with raising a new fund. Even the bestventure capitalists have upset entrepre-neurs with their exit strategy; for example,Google’s founders would have preferredto wait longer to do their IPO, but had torush it because venture capitalists, includ-ing Kleiner Perkins, wanted to cash in.

The only serious threat to the growingdomination of the leading �rms is succes-sion at the top, a problem discussed earlierin this survey. This is arguably even more

critical for venture-capital �rms than forbuy-out �rms, because the personalityand involvement of the venture capitalistmatters far more to a start-up than to a buy-out. Entrepreneurs increasingly want toknow which particular partner will workwith them before agreeing to a venture�rm taking a stake in their business. Yetmany leading venture �rms, such asKleiner Perkins and Greylock, have al-ready made a number of successful inter-generational shifts, so the problem may beless pressing than in buy-outs.

Limited partners in venture �rms arealso becoming increasingly assertive.Kleiner Perkins, for instance, decided to let

its limited partners o� paying some of thecapital they had committed to its worstbubble fund. �Over the next few years,limited partners are likely to be much morerigorous in holding general partners’ feetto the �re,� reckons Chicago’s Mr Mead-ows. �They are not any more going to in-vest in funds where the general partnergets a distribution of cash before 100% ofthe limited partners’ capital has been re-turned.� During the bubble years, limitedpartners had to claw back a lot of distribu-tions made to general partners when theirfunds proved to be less pro�table than ex-pected. It is all part of a broader attempt tomake private equity more accountable. 7

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Previous surveys and a list of forthcoming surveys can be found online

2

www.economist.com/surveys

reaucratic and risk-averse. So institutional investors should look

beyond the hype and question whetherprivate equity really is a better bet than thealternatives. They are surely right to wantto make private-equity �rms more ac-countable, because they are not �nding iteasy to get general partners to acceptresponsibility when things go wrong. In2002, the state of Connecticut’s pensionfund sued Forstmann Little for mismanag-ing its investment. The pension fund won,but was awarded no damages. It appealed,and Forstmann Little settled out of courtfor $15m in September this year. Yet thiswas a pyrrhic victory. In the words of oneprivate-equity veteran, �The only fundsthat will take Connecticut’s money in fu-ture will be those that can’t raise moneyfrom anyone else.� That is quite a penaltyin an industry where the best funds faroutperform the rest and are able to picktheir investors.

A similar punishment was meted out tosome public pension funds, notablyCalPERS, which last year published the re-sults of the private-equity funds in whichthey invested. They were only trying tocomply with the disclosure requirementsof freedom-of-information legislation, butseveral funds�led by Sequoia, a top ven-ture capitalist�said they would no longeraccept money from public pension funds.Some states have since modi�ed their lawsto limit the need for such disclosure.

Limited partners are trying to exercisemore clout by setting up organisations torepresent their collective interests�thoughthe people heading such groups are habit-ually poached by private-equity �rms justas they start to �nd their voice. Some pen-sion-fund managers responsible for invest-ing in private equity hope to go on to muchbetter-paid jobs in private-equity �rms, somay be slow to criticise them for fear ofmarring their prospects.

Perhaps the growing fund-of-funds in-dustry, led by �rms such as HarbourVestand Parthenon, will eventually make abetter job of holding general partners toaccount, not least by encouraging the de-velopment of a liquid secondary market inlimited partnerships. So far, however,funds-of-funds have stood out mainly fortheir additional fees.

More accountability will require betterinformation about the performance ofprivate-equity portfolios. As things stand,valuations are a shambles, says Colin Blay-don of the Tuck Centre for Private Equityand Entrepreneurship. Valuation method-ologies are not standardised and tend to be

overly conservative, using historic costrather than current market value; and val-ues are rarely reduced when they shouldbe, and are easily manipulated by generalpartners. But industry groups are slowlymaking progress with standardising valua-tion methodology. Herman Daems of theEuropean Private Equity and Venture Capi-tal Association (EVCA) points out that Eu-rope is now well ahead of America onstandardising valuations and reporting.

The age of transparencyGovernment, too, is getting more involvedin trying to make private equity more ac-countable and transparent, either throughfreedom-of-information legislation or viaattempts by watchdogs such as the SEC toregulate the industry. The SEC has hintedthat, having started to regulate hedgefunds, it may turn to private equity next.

Even with the lobbying expertise of in-dustry groups such as the EVCA, the Brit-ish Venture Capital Association and Amer-ica’s National Venture Capital Association,it is hard to believe that private equity will

be able to escape the growing pressure forinstitutions of every kind to be transpar-ent. In many respects, greater transparencyshould improve the performance of priv-ate equity by making such �rms more ac-countable to institutional investors�who,in turn, should then be more easily held toaccount for their investment choices by thepublic whose money they invest.

Yet transparency can go too far. Private-equity �rms may be wrong to oppose at-tempts to make them disclose the perfor-mance of a fund as a whole at frequent in-tervals. But they are surely right to resistdisclosure of the performance of each �rmin a fund’s portfolio. The one big advan-tage that private equity still has over publicequities is that it can transform �rms awayfrom the public gaze and from the short-term pressures of the stockmarkets. Impos-ing full transparency on the kings of cap-italism would destroy this advantage. AsWalter Bagehot, a great early editor of The

Economist, famously observed about theBritish monarchy, �Its mystery is its life.We must not let in daylight upon magic.� 7

Future surveys

Countries and regionsIndonesia December 11th 2004Taiwan January 15th 2005New York February 19th 2005India and China March 5th 2005Turkey March 19th 2005

Business, �nance and economicsNanotechnology January 1st 2005Corporate social responsibility January 22nd 2005The rise of the consumer April 2nd 2005

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