Private Equity and Venture Capital

Conversations about private equity (PE), venture capital (VC), and hedge fund (HF) are always interesting.  One leading reason for this excitement, probably, is the tendency toward freedom and possibilities: where is the next big things? is this idea feasible? what are the strategies to conquer this industry/market?  PE, VC, and HF cumulatively operate in the widest range of the financial market, where limitations are their imagination and their own mandates.  Another leading reason for the excitement may be attributed to their relative places in the current financial market.  I don’t know what will be ahead the financial sector curve in the next 10 years, maybe a new kind of sophisticated-quasi-equity-class-no-one-understands-what-it-is; but I know PE, VC, and HF are definitely on top of the curve for now.  In addition, as their history are relatively short comparing to financial industry as a whole, their rooms for development are enormous, so go with possibilities.

Private equity basically can play in every sector and stage of the economy.  In the slide below I had already narrowed PE significantly down to the investment in the expansion stage of a (investible) company and the saving of a company from bankruptcy.  This is not exhaustive.  PE essentially can do the VC jobs if it shifts gear to invest at earlier stages or can overlap some of the HF jobs such as distressed investment or M&A speculation (even though PE and HF have a vastly different perspective in approaching M&A and distressed: PEs generally focus much more long-term perspective and value creation comparing to HFs do)  – with this in mind you can expect PE to play in every corner of the financial market.

Using a company life’s cycle to illustrate this point can be interesting.  When a group of entrepreneurs has the initial ideas, they need to make extensive studies and researches to decide whether the market is feasible and whether they have capabilities to realize that potentials.  This is seed stage, and this stage may go with a prototype product.  Financing to this stage is often made by angel capitalists and seed stage venture capitalists.  Relationships and entrepreneurial track records play a heavy role for the entrepreneurs to get financing.  After the seed, the start-up stage follows.   Start-up deals with more business related issues comparing to just product-and-market as the seed does.  I think this is the crowded place for VC to invest.  VCs suffer heavily the J-curve effect with typically low winning ratio.  Some of the most successful VCs can spend many years in their early fund-life to just invest without realizing any profit.  Thus, to reduce the risk, less aggressive VCs like to invest to investees who have spent some years (probably 2-3 years) and moved out of the seed stage.  When a company has grown dramatically and established a firm market position, it goes out of VCs’ taste and becomes a target for PEs.

In contrast to VCs, PEs are much more conservative.  PE does not like too much uncertainty as VC does, especially those who are operating in frontier/emerging markets (the fact that they are operating in frontier/emerging markets already tells that they are more aggressive than other PE firms who invest in developed market).  This tendency is also reflected through their valuation and investing methods.  VCs often employ asset replacement cost or venture capital method with a very high discount rate and real options to deal with uncertainty.  On the other hand, private equity firms often employ discounted cash flow models in conjunction with market and enterprise multiples (heavily EV/EBITDA) – these methods work well only with companies whose substantial operating history are in place.

To return to the company life-cycle story, PEs typically invest to unlisted companies, boost their growth, and end up listing them to the stock exchange.  The graph also divides the two main types of market: listed (light-yellow) and unlisted (midnight-blue).  PEs and VCs majorly operate in a highly ambiguous market where valuation faces a lot of difficulties.  First of all, the unlisted market is very illiquid; this illiquidity implies (1) the cost of a wrong-investment cannot be easily reversed and (2) the fair value of a company is very difficult to obtain.  In addition, because the ambiguity makes valuation and comparison among companies very difficult, PEs and VCs industry require a high level of expertise for anyone who wants to join.  Thus a PE firm may be very successful in investing to basic material industry may not be equally successful if it expands to invest to a law firm.  In the same fashion, a PE firm that is successful in China may not be as successful when it expands to invest in Middle East countries.  Therefore, even VCs and PEs need specialization (but they have the freedom to choose what they want to specialize).

Typically when a PE firm invests in an investee, it would get out at IPO (though not immediately because they may face to lock-up period) and leaves the listed market untouched.  This is not always the case.  PEs can still hold a portfolio of listed equity in minority interest mode and decide whether to actively manage it or not.  They can also buy a large portion of any listed company, influence the company’s direction, and do other things such as expanding the company’s business to foreign markets or accessing to international debt markets.  More spectacular, they can buy-out a listed firm, take it back to private, re-engineer it, and list it in foreign stock exchange.  The list is non-exhaustive, almost PE has the chance to do everything it wants, only competition and expertise requirements force them to narrow their scope.

There are two outstandingly hot themes currently going with PE and VC.  The first theme is to invest in high-tech in Silicon Valley and some Silicon-Valley-alike regions such as India and China.  Roughly 30% of total PE & VC’s asset under management in the US are allocating to Silicon Valley alone.  The second theme focuses on frontier/emerging markets.  The current motivation for the second theme probably started from the low yields in developed market sovereign bonds after 2001.  This low yield has created a pressure for funds and investors to seek better returns.  In early 1990s there was once a strong monetary influx to emerging countries, namely Thailand, Indonesia, Malaysia, South Korea, Russia, and Brazil.  However, the event of 1997 hurt investors’ confidence and caused them to withdraw every invested penny out of these countries.  It took several years for these investors to get over what had happened in 1997.  In 2001, 2002, and 2003 foreign investment started to return to Thailand, South Korea and other countries in the region.  I think these two themes will still be the major themes in the next at least 20 years or more.

The reason for this upbeat projection is that these two themes go logically with sources of economic development.  In order to increase total economic output (let say globally), we can increase (A) productivity and/or (B) aggregate hours of working (i.e. work more efficient and/or work longer).  In order to increase (B) aggregate hours of working, either we have (i) more working people or (ii) work longer hour.  More working people belongs to either natural population growth or employment/total population ratio, either of them is out of this discussion.  So in order to increase (A) productivity, we have to increase either these three things: (i) physical capital growth, (ii) human capital growth, and (iii) technology advance.  The first two in the list belong to PEs and VCs who invest to less developed countries (ranging from Asia, Latin America, Middle East, to Africa – i.e. room for PEs to expand geographically probably still available in the next 100 years).  The last belongs to PEs and VCs invest in high-tech industry notably in Silicon Valley, other candidates may include Japan, Taiwan, Singapore, Germany, and India.

The problem with high-tech entrepreneurs in Vietnam is that they do not have a platform to create great products and sell globally.  The platform includes not only technology capabilities but also the supporting spirit from other related sectors such as finance/investment, universities, communities, macro economic policies.  This idea I learned from a friend of mine who is managing his high-tech start-up in Singapore.  My friends who do start-up in the last 3 years in Vietnam often end up working for venture capital or aim to do so.  Sophisticated investors come to Vietnam generally not to look for young technological geniuses.  They are interested more on basic material industries, natural resources, and other industries which already establishes a sustainable competitive advantage and can join the global value chain.  This tendency can also be observed from committed capital perspective, I only know 2 or so VC funds in Vietnam (IDG Ventures Vietnam and CyberAgent Ventures) versus more than 10 PE firms (VIGroup, VinaCapital, Mekong Capital, Jaccar, Indochina Capital, Red River Holdings, Blackhorse, Dragon Capital, Aureos, and Fullerton Fund) and other less-involved investment banks/firms and ETF that hold only listed equity (Orchid Fund PTE, Citi, Deutsche, Market Vector Vietnam ETF, iShare, etc).  How about the size? the size of a PE firm is typically larger than a VC firm because PE invests in later stage and need resources to leverage.  Besides, PE’s fund managers have a tendency to increase the fund size when their earlier funds succeed because their income and prestige are directly linked to capital under management (i.e. larger the fund, higher gross management fee).  This is not the case with VCs as they don’t have a major interest in increasing the fund size.  VC fund managers’ earning often only come from carried interest.  Recently, there are efforts to build a “platform” as I mentioned above toward high-tech entrepreneurs community such as Launch (originated by IDG Ventures Vietnam) or Founder Institute.  I personally see these idea respectable.  They focus straight to the current market’s weakness; yet the road will still be long and rough.

Tri Ton

Businessperson with private equity expertise. Interested in strategy and investment.

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