Secrets of Private Equity

Private equity firms stay in business by launching new funds every three-to-five years. If a firm's previous funds have been successful, it can generally earn higher revenues with the new one by setting higher fees, demanding more variable compensation and raising more capital.

But there are striking differences in strategy and practice between venture capital and buyout funds -- the principal components of the private equity industry. To begin with, Yasuda notes, the study confirms what many investors already sense -- that the economics of venture capital and buyout firms are different, even though both depend upon fixed management fees for the preponderance of their revenues. The differences lie not only in the superior scalability of buyout versus venture capital funds, but also in the fundamental skill sets required.

Early-Stage Investing

Venture capitalists tend to be scientists and engineers by training, with the necessary experience in operations, marketing, management and related skills to help small companies grow. Early-stage investing is time- and labor-intensive, notes Yasuda, and even experienced VC professionals have difficulty overseeing more than five companies at once.

The typical venture capital firm has five partners and invests in five companies per year over the first five years of a fund's 10-year life, with the value of each early-stage investment rarely exceeding $100 million. On average, each VC professional is apt to be responsible for one new investment a year during the fund's first five years -- for an aggregate investment of $350 million to $500 million. That professional typically spends the fund's second five years aggressively fostering and monitoring those five companies.

VC funds tend to derive the bulk of their revenues from just 20% of their investments. They depend on hitting a "home run" -- a return five times greater than invested capital -- with one in every five investments. Another 20% of VC investments can be expected to fail or achieve minimal returns, with the remaining 60% returning an average 2.5-to-3 times invested capital -- not a fabulous result, considering the risks, but one most firms can live with.

Larger, more successful VC firms -- like Kleiner Perkins Claufield & Byers, known for such home runs as Amazon (AMZN Quote), Compaq [acquired by Hewlett-Packard (HPQ Quote)], Genentech (DNA Quote) and Netscape [acquired by AOL (TWX Quote)]; and Sequoia Capital (Google (GOOG Quote), Yahoo! (YHOO Quote), PayPal [acquired by eBay (EBAY Quote)], Apple (AAPL Quote) and YouTube [acquired by Google]) -- can raise substantially more capital in launching new funds, but they, too, are constrained by the time-consuming nature of VC work. To invest in more small companies with outsized potential, they must hire more VC professionals. Thus, in the world of VC firms, larger scale does not necessarily mean greater profitability.