Venture capitalists invest in firms which do not have access to public equity markets. They may be new, unproven enterprises, or businesses which are seen as troubled or high-risk. Or they may not yet exist as independent firms at all - for example, venture capitalists may be involved in restructuring privatised organisations or business lines divested by existing conglomerates into new entities.

In the popular imagination venture capitalists are dashing piratical individuals. Eg, in the UK TV series 'Dragons Den', entrepreneurial hopefuls line up to pitch business ideas to a panel of hardboiled venture capitalists wach with a large stack of fifties on the table in front of them.

While there does seem to be a lot of swagger and ego in this field, VCs in reality are just another niche in the financial markets, and analysable in the same terms. In general, they are Funds - pools of investors' financial capital. They are a variety (though sometimes used a synonym?) of Private Equity Funds. That is funds investing in equity, but through private deals with company managemnent rather than in publicly trading markets.

Types of ventures:

  • start-ups. eg. VC buys a share of new enterprise.
  • privatisations. eg. state organ auctions off a business line or pool of assets.
  • deconsolidations. eg. large conglomerate looking to re-structure for efficiency, or simply to raise capital, sells off a business unit.
  • takeovers.

Venture capitalists often don't work alone. More commonly they will be partners in a firm - eg. as large shareholder in a startup. Or eg. in a privatisation or takeover they may form a consortium with other VCs and perhaps an existing business working in the relevant industry. Or eg. in a deconsolidation they may support a management buyout of a business unit. Also, the capital they are investing is unlikely to come just from their own fund - often they will bring in InvestmentBanks to provide the bulk of the financial capital needed to buy and grow/restructure the venture.

The key to analysing VCs is that they are (usually) short-termists. VC is an investment strategy: raise financial capital, buy in to venture, grow or restructure venture to make quick bucks, refinance or sell-on and get out.

They say: venture capital is always looking for 'the exit.'

This makes perfect sense in terms of VCs' place in the financial markets. They are providing an investment channel for high-risk investments. High risks must be compensated by high potential gains. The risk is only worth taking if it is possible to make a large profit in a short period. (In this context note that in general expected utility theory implies that even mild risk aversion means heavy discounting of future against immediate gains ...)

NB: Because of this you might think of VC as standing somewhere in between 'investors' and 'financial intermediaries' in a schema of FinancialMarketAgents: from the outset, they are looking to turn their investments into opportunities for more standard longer-term investment funds. But they also fall somewhere in between financial agents proper and corporate players - they are involved both in raising finance and in managing/restructuring/spotting potential of businesses. This is where the markets get very muddy - eg. international investment banks actually running pubs, housing estates or utilities through their own venture capital units.

Leverage

VC strategies typically involve the use of Debt Leverage.

To simplify: suppose that, in making an investment, a VC may have a target Return on Equity (ROE) of eg. 25%. Within a given period - eg. 3 years - the VC is setting out to make 25% profit on the equity put in to the venture.

For example, suppose the VC needs to put in a total capital of 100 mE - the total it will spend on buying the venture, then restructuring or growing it. But the VC, an established financial agent, has access to the debt markets (perhaps unlike the existing owner). So there is no need for the VC to put 100 mE of its own funds in - it puts in a percentage and borrows the rest. The relationship between debt raised and own equity put in is called 'leverage'. It can be expressed in these ratios:

'equity ratio' E = equity put in / total capital

'debt ratio' F = debt raised / total capital

Though often these figures are expressed as percentages. So if the VC puts in only 10 mE of the total 100mE then E = 0.1 (or 10%); F = 0.9 (or 90%). These are fairly typical figures for a venture capital fund today.

The other factors determining the VC's return are: the rate of return on capital r (i.e., how much the venture actually makes as a return on the total capital put in); and the interest rate i at which the VC can borrow.

The VC's total profit is then (over one year for simplicity):

return = requity + (r - i)debt

If you divide this through by equity you get the crucial Return on Equity (RoE) figure:

RoE = r + (r - i)*(debt/equity)

which is sometimes expressed:

RoE = r + (r - i)*F/E

For example if r = 7% and i = 5% then:

RoE = 7% + 2%*(9) = 25%.

Currently (June 2005) VCs are doing particularly well - debt is very cheap. But if interest rates go up, they will have to try and crank up leverage, or find higher return (riskier) ventures to meet the same RoE targets.

Exits

It is not enough just for the venture to be making a good return on capital (r). The VC has to realise its return - get out, collect its RoE, and - most crucially of all - pay back the highly leveraged debt it borrowed. Eg. the venture might be making a whopping 10% profit after three years; but if the VC can't pay back the 90% it borrowed on time it will be hit with penalty charges and suffer a damaging loss to its reputation as a debtor. In order to get a good interest rate, it will have borrowed on a short time scale. The pressure is on to find an exit.

There are different exits it can look to, including:

  • Selling out to other private equity investors.
  • Launching an IPO (Initial Public Offering). I.e.: listing the company on a public stock market.
  • Asset stripping - eg. splitting the venture up into component assets and selling these on to appropriate markets.
  • Refinancing. Replacing the initial short term borrowing with a long term debt. Eg. a securitisation (see OnSecuritisation).

Adding value

Advocates of financial markets often tend to stress purportedly long term, stabilising forces within markets. Capitalism offers sober steady growth paths rather than boom and bust - the gordon gecko-esque speculators being just the inevitable few bad apples. But there is no getting away from the fact that venture capitalists are quick buck merchants. To justify their place within finance capital, the argument is that they perform emergency surgery, cutting out inefficiencies in corporate marketplaces.

The concept is 'added value'. VCs identify sources of value that are overlooked by markets, and inject capital to realise them. The high returns are justified by the riskiness of the operation - some of the patients die. Stories are:

  • Startup. Business has potential for growth that is unrecognised by financial markets. VC injects capital. Startup proves itself, lists on public mkt with IPO. VC moves on, another job well done.
  • Privatisation. Everyone knows that states and municipalities are inefficient managers of services. Yes we agree there are genuine public goods, or there are real welfare concerns in sectors where we want poor people to have access to services they might not be able to afford without state support. But the efficient thing then is to have private companies provide these goods and services, with regulation in the case of public goods, and the state can subsidise the disadvantaged to buy them.

Governments understand this today. Unfortunately voters and sometimes noisy minorities often do not. But as state budgets squeeze ever tighter and tighter, the pressure to realise capital on saleable assets becomes more urgent than lobbyists' squeals. Investors have to move with caution, eg. writing in 'social' clauses in purchase agreements to protect things like tenancy agreements and patients' rights. But remember that contracts are living documents - when VCs move on in a few years, structures will have to be reassessed anyway. And now politicians will not be directly responsible for the privatised entities. Out of my hands, guv.

DariusSokolov