Some thoughts on VC and PE funds

Private equity is a type of investment strategy, consisting, among other things, of venture capital and leveraged buyouts, which are considered among the most impactful innovations of financial intermediation. Much of this owes to the spectacular success of firms in the information technology sector.

Venture capital (VC) works on the principle that there are promising ideas and dynamic entrepreneurs out there who are short of capital. If they can be identified, funded and provided light-touch portfolio support (mainly in the form of forging connections), a few among them will hit the bulls-eye and generate windfall returns that more than make up for the failure of the majority.

The central assumption is that of identification. This, in turn, has two parts. One is the belief that venture capitalists have acquired some form of prescience to spot great ideas in their nascent stages, well before their commercial potential becomes evident. Second, they are also able to identify the great entrepreneurs who are behind those promising ideas.

I’m not sure about the former at all in any credible enough manner that can justify investing tens, even hundreds, of millions of dollars in them. The strategy of making ten such bets in the hope that one or two will hit big appears closer to gambling than a strategy grounded on some sophisticated skills. If confined to a promising technology sector in its emerging phase, then the context itself dictates that some firms must succeed, and if you have large pots of money, you are more likely than not to hit some bulls-eye. This raises questions about the value proposition of the venture capitalist, certainly enough to question their outsized rewards.

The second part about the identification of entrepreneurs raises even more troubling questions. It’s hard to believe even the shrewdest brains can spot great entrepreneurs with a few interactions, with enough confidence to be able to make the kind of large financial bets made by venture capitalists. Except, if they are friends or friends of friends, or part of a connected closed network.

This raises concerns of cronyism and exclusion bias. Wouldn’t there be perverse incentives, especially given that venture capitalists are investing others’ money, and also the moral hazard afoot from the fact that most or many of these bets will fail? What about the inefficiency arising from the exclusion of those several others outside the network?

Given the aforesaid, there are some fundamental questions that one could be asking. How can we say that burning several hundred million dollars to generate one or two unicorns or decacorns is an efficient use of capital? What if, instead, investors should be more discriminating and do rigorous due diligence before investing? What if there is a model whereby the high-risk assuming angel and seed stage investors, including governments, are compensated by the later-stage investors who have a less risky pool to choose from?

It’s not that such questions are not asked elsewhere. In fact, industrial policy is subjected to this scrutiny continuously and has been declared an inefficient and wasteful pursuit by the same set of experts. For example, in the context of the Chinese government’s massive Made in China 2025 campaign to boost strategic industries and achieve technological self-sufficiency, which involved Big Funds picking sectors and firms and pouring hundreds of billions of dollars, experts have been quick to castigate it for its colossal waste.

But they conveniently overlook the same portfolio aspect of these investments. Who can deny that these investments have resulted in a portfolio which is the Chinese economy that utterly dominates the world across several sectors and technologies? Just in terms of the incremental output, jobs created, surpluses from exports, not to mention the geopolitical power conferred, these investments appear to have generated returns in multiples. In narrower terms of sectors – electric vehicles, EV batteries, critical minerals refining and processing, solar panels, wind turbines, electronics components and products, etc. – the success of those sectoral funds is spectacular.

Admittedly, in all these cases, the successes have come at a very high cost in terms of the amounts spent. But the logical conclusion from this line of reasoning is that wastage and losses are fine as long as the portfolio generates a high net return.

If experts can question the collateral wastage associated with the emergence of this portfolio, why are they shying away from scrutinising the VC industry’s capital deployment efficiency on similar lines?

Leveraged buyout (LBO) is different in an important way. LBO funds identify industries and firms that have promise but are now operating far below their potential, either due to poor management or deficient enterprise or some other factor that can be worked upon. If these firms can be bought out and their operational efficiencies improved or business models modified through very active portfolio management, most likely by replacing the entire senior management, then there might be large efficiencies to be realised. LBO funds use significant leverage to supplement investor equity in purchasing firms, and place the debt on the balance sheets of the firms being bought.

The critical assumption here is that of very active portfolio management. This would include the PE LBO fund changing the management, and in general, necessarily getting into the nuts and bolts of the firm’s business, from the high-level business model to the granular unit economics and small operational details.

There’s no quibbling about the value of this model. In simple terms, it’s about identifying firms that are not managed well (and there are several out there), buying them, and addressing their inefficiencies to unlock the hidden value. Who could dispute this proposition?

Two things follow from this model. One, the PE LBO firm must have the internal domain expertise to be able to do this effectively. There are hard limits to the use of outsourced expertise. But acquiring in-house domain expertise of the quality required to do such portfolio management effectively across several sectors is very difficult. Two, since it demands proficiency and intense engagement, there are binding bandwidth constraints on how many firms, even a large PE fund with several teams can manage.

Taken together, there ought to be a self-limiting (in terms of size) nature inherent to the PE business model. This also means there’s only so much that the fund can generate as returns and pay the General Partners (GPs).

In this backdrop, it’s natural that problems start when PE LBO funds try to scale beyond a certain level in the quest to amplify and expedite returns and payouts. The incentive distortions and inefficiencies surface at multiple levels. Each team is now stretched over far more projects than they can effectively manage, leading them to follow a light-touch portfolio management. Further, as the fund size increases, it becomes increasingly difficult to identify good investment opportunities.

Leverage is attractive, especially when rates are low, to make investors’ equity go further, besides also amplifies the GPs’ returns. The period of the PE industry’s growth coincided with that of ultra-low interest rates in advanced economies. Now that rates are normalising, the PE/VC industry faces serious vulnerabilities.

The use of leverage also expands the envelope of sectors that become attractive for LBO firms. In fact, LBO firms come to believe that they have a model that can achieve high returns even with low-risk assets. So, they buy out low and stable return assets like those in infrastructure or affordable/public housing, load them up with debt, strip assets, and pay out large dividends and pass the parcel along.

This creates problems and externalities that are borne by society and taxpayers. The British water and sewage sector, specifically Thames Water, is a classic example. The same logic makes similarly boring, low-return and mass-market assets like kindergartens, salons, gyms, laundromats, vape shops, and so on attractive to LBOs, but with large negative externality risks. Is this practice of amplifying risks by using leverage to increase returns on low and stable return mass market assets desirable?

Finally, the incentive to indulge in financial engineering – excess leveraging, skimping on investments, sale and lease back, raiding pension chests, etc. – and strip assets has become pervasive. The squeeze in exit options has led to PE LBO funds indulge in practices like selling to another fund managed by it at a higher valuation to reset the clock, continuation funds, strip sales of part of a fund’s assets, net asset value borrowing, defer interest payments and add them to debt, transfer the best companies across funds, and so on to raise money to pay LPs and kick the can down the road.

This article is about how PE funds have come to see insurance premiums as an attractive source of credit to finance their activities and have therefore created a financial model where they encourage the securitisation of insurance premiums and then buy those securities. The model gets strained once the insurance companies face a liquidity crunch or when the LBO fund is unable to exit its investments.

All this raises concerns about the negative externalities inflicted by LBO funds when the cost of capital becomes normalised. See this, this, this, this, and this. It is especially important since LBO funds now attract investments from pension funds, insurers, sovereign wealth funds, and public endowment funds, thereby raising questions on how private (and therefore lightly regulated) these funds actually are.