Academic journal article Yale Economic Review

Demystifying Private Equity

Academic journal article Yale Economic Review

Demystifying Private Equity

Article excerpt

WHEN MOST people hear the term "investment", they think of stocks listed on the NewYork 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 entided "The Economics of Private Equity Funds" in September 2008.

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. …

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