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Ebook UK Venture Capital and Private Equity as an Asset Class for Institutional Investors

The terms venture capital and private equity describe equity investments in unquoted companies. In the UK and much of continental Europe, venture capital is synonymous with the term private equity. In the US, however, venture capital usually refers to the provision of funds for young, entrepreneurial businesses whereas private equity is mainly associated with the financing of leveraged management buy-outs and buy-ins.

This report has been written as a result of the declining share of UK institutional investors among the providers of funding of the UK venture capital and private equity industry. It has a dual objective: Its first part will explain the concept of private equity finance and the fundraising and investment processes of venture capitalists. The second part will examine the characteristics of venture capital and private equity. We will analyse the returns, the risk and the cash-flow implication of venture capital investments in order to assess the suitability of this asset class for institutional investors. From an investor's perspective, the characteristics of venture capital and private equity are very similar, i.e. investments in this asset class are predominantly handled by limited partnerships operating fixed-life funds. We will therefore use both terms interchangeably during this report.

The key findings of the report can be summarised as follows: The long-term performance of the UK venture capital industry since 1980 stands at 14.2% per annum. Over the period between 1987 (the first year for which individual fund valuations are available) and 1998, its cumulative returns have outperformed all principle UK comparators.

The analysis of annual returns revealed a movement parallel to public equity return indices. However, the spread of returns of individual funds is quite large. Diversification is therefore of utmost importance when investing in this asset class. Finally, private equity investments have particular cash-flow properties. Individual funds start making net contributions to investors after between three and five years. An appropriately structured private equity portfolio will finance itself after an initial net investment period and continue to generate substantial positive cash-flows for several years. This characteristic of private equity can be attractive for pension funds irrespective of their maturity.

Contents

Executive Summary
1. Introduction / Objective of the Report
2. Venture Capital and Private Equity

    2.1. Debt versus Equity
    2.2. Types of Venture Capital and Private Equity by Stage of Investment
    2.3. Institutional / Organisational Aspects of the Private Equity Industry
    2.4. Operation of the Fixed-Life Investment Fund
      2.4.1. Involved Parties
      2.4.2. Fundraising
      2.4.3. The Venture Capital Investment Process
      2.4.4. Remuneration of General and Limited Partners.

3. History of the Investment Activity of the UK Venture Capital Industry

    3.1. Fundraising
    3.2. Investment Activity
    3.3. New Areas of Private Equity Activity

4. Venture Capital and Private Equity in the United States

    4.1. Regulatory Influences
    4.2. Fundraising and Investment Activity

5. Assessment of the Suitability of UK Private Equity as an Asset Class for
Institutional Investors

    5.1. Methodology
      5.1.1. Description of the Dataset
      5.1.2. Methodological Aspects of Assessing Private Equity
      5.1.3. Methods of Performance Measurement: The Internal Rate of Return (IRR)
      5.1.4. Average IRR versus Pooled IRR
      5.1.5. Defining Fund Maturity: Convergence of Interim IRR and Definitive IRR
      5.1.6. The Drivers of the IRR:
      5.1.7. Individual Fund Performance versus Industry Performance
      5.1.8. Internal Rate of Return versus Time-weighted Rate of Return

    5.2. Performance Assessment of Private Equity

      5.2.1. Assessment of Private Equity Returns: Industry IRRs
      5.2.2. The Returns of the British Venture Capital Industry compared to its US and European Counterparts
      5.2.3. Performance of Private Equity Relative to other UK Asset Classes
        5.2.3.1. Private Equity compared to Public Equity
        5.2.3.2. Private Equity compared to Small Cap Stocks
        5.2.3.3. Private Equity compared to Bond Returns
        5.2.4. Private Equity Realisations in relation to Paid-in Capital (Absolute Returns)

    5.3. Private Equity and Risk

      5.3.1. The Spread of Private Equity Returns
      5.3.2. Analysis of Absolute Returns
      5.3.3. Private Equity Risk and Diversification

    5.4. The Cash-Flow Implications of Private Equity

      5.4.1. Cash-Flow Profiles of Private Equity Funds
      5.4.2. Long-Term Cash-Flow Pattern of a Portfolio of Private Equity Participations
      5.4.3. Secondary Markets

    5.5. Additional Aspects

      5.5.1. Carried Interest
      5.5.2. The Impact of the Minimum Funding Requirement (MFR)

6. Industry Outlook: Is there "too much money chasing too few attractive deals?"

    6.1. External Factors influencing Private Equity Returns
    6.2. Cyclical Aspects: The Relationship between Public Equity and Private Equity Returns

7. Recommendations

    7.1. Recommendations for Institutional Investors
    7.2. Recommendations for the Venture Capital and Private Equity Industry
    7.3. Recommendations for Government and Regulators

Acknowledgements
Bibliography
Glossary
Appendix

    Appendix 1: The IRR Formula
    Appendix 2: A Numerical Example of calculating the IRR net of Carried Interest
    Appendix 3: Alternative Criteria to define Fund Maturity
    Appendix 4: A Method for comparing Private Equity Returns to the Returns
    of other Asset Classes

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