Editor’s Letter

The U.S. economy continues to grow at a faster pace in terms of real GDP than other major industrial economies. Although this bodes well for venture capital and private equity activity in 2016, several developments require careful monitoring. Preliminary evidence is that the rate of job turnover is being shortened to about three to five years, especially in the middle-market sector of the economy. This development could be destabilizing to consumer spending and to labor productivity. Additionally, analysts have identified the need for higher levels of education in the increasingly technology-driven economy. Anyone with only a high school education faces dire job prospects unless they pursue additional skills training at community colleges or technical colleges. Even students that graduate from college with a Bachelor’s degree are strongly urged to pursue additional education.

The emergence of online learning has enabled new workforce entrants to gain further education while earning a living working in their current job. Nevertheless, the persistent drive for more education to supply the future workforce needs of the middle-market economy is complicated by at least three factors. First, demographic factors have contained the growth in the number of students enrolling in high schools for about the next eight years. This absence of growth in the number of potential new workers in the United States will continue to persist through college and into graduate studies, limiting skilled workforce growth in the future. Second, the passion to go to school and achieve higher levels of education and increased standards of living is adversely confronted by a widening wage gap, the rising costs of traditional education inflating student debt levels, and a lack of certainty about the future cost of living. Increasing immigration of well-educated and driven workers has been the response to meet the growing demand by companies to remain competitive.

The continued decline in the U.S. labor participation rate since 2008, the growing wage gap, and the widening education gap will likely have a negative or constraining effect on the demand for goods and services in the United States in the future. Both middle-market and larger companies will be adversely affected, and underemployment and labor participation rates may suffer further, slowing the pace of economic activity until a new equilibrium between the growth of supply and demand is achieved. The outcome is a greater emphasis on substituting technology for the shortage of education to keep the economy growing; however, this too requires a more-educated labor force. Private equity is a possible vehicle for capitalizing on this shortage of education.

In 2015, private equity activity was heavily concentrated in the middle market, which remains relatively strong although somewhat down from 2014. The focus of the articles in this issue is diverse but continues to be on analyzing the factors and strategies influencing successful private equity and venture capital performance. Adrian Ng begins this issue with “Evaluating the Private Equity Investment Process: Performance Attribution.” Although performance attribution is seldom used in private equity, by employing this flexible framework, all types of private equity investors can evaluate how they achieve their performance and fine tune their investment decision process to improve future results.

Gianfranco Gianfrate and Simone Loewenthal, in “Private Equity Throughout the Financial Crisis,” investigate private equity funds’ financial crisis performance by studying 358 U.S.-based funds with vintage years between 2002 and 2007. Not only did private equity obtain higher returns than the public market and prove to be persistent (differently from mutual funds), it also constituted a safe harbor during the financial crisis because of its low correlation with market swings and its focus on companies’ operating growth. The authors find, throughout the crisis, a positive relationship between fund performance and size and experience and a negative relationship between performance and fund duration measured as in fixed-income investments.

Looking ahead, Joseph Calandro writes about “The ‘Next Phase’ of Strategic Acquisition.” He suggests that we may be entering a new buyout phase that takes strategic targets to the “next level” of performance. This supposition is based on select recent deal activity as well as investor observations regarding the growing need for more integrated levels of operational, investment, and financial competencies that, at times, must be deployed simultaneously to identify, close, and profit from strategic acquisitions in today’s marketplace. He profiles the phase-by-phase progression of buyouts and implications of a “next phase,” the integrated and interactive nature of post-acquisition management, and the competencies required to successfully compete in the next phase of strategic acquisition.

Harry Gray, Chad Greenway, and Robert Feeney, in two articles, focus on portfolio company best practices. In “Portfolio Company Best Practices—Post-Acquisition Transition: Preserving Customer Relationships when Company Founders Depart,” they explore methods for private equity investors to mitigate revenue leakage and customer risk when company founders transition away from a middle-market business. In their second article, “Portfolio Company Best Practices—Focusing on the Most Important Controls: It’s about Operations First, Finance Second,” they draw on their experience to suggest that too often managers and business owners prefer to focus their attention on financial control. The authors argue that in high-growth and distressed environments, it is far more prudent to lock down and institutionalize operating controls.

David Sonius, Uwe Kehrel, and Rustin Yerkes examine “The Effects of Call Options on Exit Strategies in Private Equity Shareholder Agreements.” Private equity financing is a primary source of funding for new ventures, but forfeiting ownership and control may deter entrepreneurs. They show how recapitalizations are viable exit strategies that allow founders to maintain control. Growth rates are a major factor in option exercise, and the authors illustrate how only modest rates are necessary for a company to satisfy relatively high private equity investor return requirements. This suggests that barriers to this important source of capital may be lower than commonly perceived by startup companies.

Vincent Jocquet, Sven H. De Cleyn, Frank Maene, and Johan Braet examine pivoting as a critical success factor in “Product Iterations in Venture Capital Funded Technology-Based Start-Ups: Pivoting as Critical Success Factor?” Companies developing new products often end up addressing different customers in other markets with products they didn’t envision when the original product development began. The authors find the impact of venture capital funding on product iterations is diverse, and the sooner product iterations happen (if needed), the better. VC funding usually provides adequate financial tolerance to explore multiple options toward ultimately validating a tangible product market-fit that enables scaling and potential high growth.

Paul Asel, Haemin Dennis Park, and S. Rama-krishna Velamuri explore “Creating Values through Corporate Venture Capital Programs: The Choice between Internal and External Fund Structures.” The authors examine the appropriateness of structuring corporate VC units internally (the corporation makes investments off its own balance sheet) versus externally (the corporation, acting as a limited partner, endows a separate legal entity managed by general partners with capital to invest on its behalf). They study the implications of this structural choice on the scope of investments, balance between strategic and financial objectives, performance measurement, deal sourcing and due diligence, post-investment involvement of the corporation, human resource issues, and exit considerations.

Manu Sharma, in “Asset Pricing: Valuing Venture Capital Investments,” focuses on building an asset pricing theory for venture capital investments. He argues that the value of venture capital investment over the life of an investment holding period is the value of business/venture for seed funding. The entrepreneur and venture capitalists can use this theory to determine the right amount of capital required for each round of financing and how in subsequent rounds the percentage share of each venture capitalist can be determined.

Monica Singhania, Neha Saini, and Puneet Gupta examine “Foreign Ownership and Indian Firm Performance: A Dynamic Panel Approach.” Foreign capital invested in developing countries has been increasing at a greater pace since the last decade of the 19th century because of liberalized capital inflow policies and increasingly favorable macro-economic conditions. They explore the importance of the firm’s ownership on company performance using data from Bloomberg for the 2005–2014 period for 254 firms. They confirm that foreign ownership in emerging countries contributes to firm performance, thus confirming the knowledge-transfer process of foreign private equity investment.

TOPIC: Private equity

F. John Mathis

Editor

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