Brady Lipp of Warburg Pincus explains how US institutional investors met the challenges of this exciting asset class

The private equity market has been the fastest-growing market for corporate financing in the US for two decades now. Despite this, the market has received relatively little attention from the financial press, and statistical profiles of the asset class are less than complete. These investments are exempt from registration with the Securities and Exchange Commission, and thus any market study must contend with limited data and rely significantly on anecdotal evidence. Over the past few years, however, some fairly comprehensive reports regarding the private equity market have been published (The Economics of the Private Equity Market, by George W Fenn et al, Federal Reserve Bulletin, January 1996). Herewith, we draw upon those studies as well as our own insights to highlight the key elements of the private equity market.

Prior to 1980, the private equity market in the US was characterised primarily by wealthy individuals and financial institutions investing directly in issuing companies. As such, the market, fraught with uncertainties, remained small and rudderless. Holding back the growth of private equity as an asset class was a lack of highly skilled intermediaries, ones that could more closely align the interests of investors and issuers. That began to change however, and change rapidly in the early 1980s. Spurred by favourable tax and regulatory changes (for example, changes permitting greater private equity investment by pension funds), limited partnerships (LPs) became heavily involved in private equity investing. As a result, the market ex-perienced tremendous growth: capital under management in the private equity market rose from about $4.7bn in 1980 to more than $200bn by 1998.

Market Structure: The three chief players in the US private equity market are issuers, investors and intermediaries. In brief, issuers receive financial backing they are unable to obtain elsewhere, from large (primarily institutional) investors seeking high levels of risk-adjusted return as well as diversification away from more traditional investments. Intermediaries, acting as professional equity managers, typically enter partnership arrangements with private equity investors and take large ownership stakes in issuers. Intermediaries often have specialised areas of expertise, which they draw upon to provide oversight and advice to their targeted investments.

Issuers: Issuers in the private equity market include not only 'start-up' firms in their early stages of development, but also more-mature private firms and even, in certain cases, public companies. What unites firms seeking private equity is their inability (or reluctance) to raise capital from traditional sources, such as bank loans or the public equity market. These firms therefore turn to the private equity market. Though one of the most expensive forms of finance, the market provides these issuers with much-needed financial and intellectual capital.

One significant group of private equity issuers, and one that has been the particular focus of Warburg Pincus for 26 years now, consists of firms seeking venture capital. In broad terms, these can be separated into 'early-stage' and 'later-stage' firms, with firms in each group varying somewhat in terms of age, size and need for external capital. Early stage firms range from entrepreneurs seeking to finance feasibility studies to more-mature firms beginning to market a product or service, perhaps even profitably. Regardless, early stage issues are high-risk, illiquid investments, with investors often committing their capital for many years in expectation of potentially substantial long-term returns (as high as 50% or more on an annual basis).

Firms receiving 'later-stage' venture financing are generally more stable than their early-stage brethren. They typically offer viable products and services, display rapid growth and generate profits. As a result, they are perceived to be closer to going public or being sold to another firm. Given these attributes, later-stage issuers may command higher investments (sometimes as much as $50m to $100m) than early-stage issuers (which typically receive investments in the $500,000 to $20m area). Likewise, expected returns are generally lower, though still high compared to more-standard investment fare.

Another group of private equity issuers-one made up of 'middle-market' private firms-differs from the traditional venture group in several important aspects. For one, middle market firms are usually well-established; in some cases, they have been in operation for decades. These firms also typically exhibit greater revenues and more-stable cash flows compared to venture issuers. Why, then, the need for private eq-uity? In general, these firms represent family-owned businesses (that wish to remain so) seeking to fund either a recapitalisation or an expansion but have limited access to bank loans or bond placements.

There are several other noteworthy sources of private equity issuance, including firms in financial distress, which quite often are simply overleveraged and display profits before interest and taxes. Such firms are typically targeted by LPs that specialise in 'turnaround' stories. Other issuers of private equity include public firms that enter the market for cost and/or efficiency reasons, such as to raise funds quickly with minimal paperwork.

Investors: As noted above, wealthy individuals no longer dominate the investment side of the private equity market. In fact, they comprise only a small share of it, with pension funds now accounting for about half of all outstanding private equity capital. One particularly notable development here has been the phenomenal growth of public pension funds in the private equity arena. These funds recently surpassed corporate pension funds as a percentage of total private equity holdings. Other major investors in private equity include endowments, foundations and insurance companies. Although the range of investors has broadened over the past two decades, only a minority of institutions hold such investments at present.

Intermediaries: More than 80% of private equity investments are now professionally managed by intermediaries, primarily through LPs. In practice, institutional in-vestors enter agreements with professional private equity managers, with the former serving as limited partners and the latter as general partners. These partnerships are typically committed to set life spans-often 10 years-over which investors relinquish almost all control of the management of the partnership.

In this light, it is incumbent upon private equity managers to continually monitor the quality of their investments. Central to this process are close working relationships with firm managements. More specifically, intermediaries can add value to a firm by formulating strategy and reviewing performance; recruiting senior management talent; providing access to better technologies and systems; assisting in the negotiation and implementation of complex corporate transactions; and, in general, by supplying advice based upon an intermediary's experience working with similar firms.

Along the same lines, intermediaries use their skills and experience to manage the risk/reward profiles of their funds' overall portfolios. One way to do this is to maintain broadly diversified portfolios of private equity investments spread across a variety of industries. Managers can also attempt to control risk by limiting the size of individual portfolio investments, for example by not allowing any position to exceed 10% of a fund's subscribed capital. Another risk/ reward-management technique involves being opportunistic by making portfolio adjustments based on shifting macroeconomic factors. During the early 1990s, for example, the financial markets witnessed significant dislocations. Some intermediaries used this as an opportunity, from a risk-vs-re ward perspective, to increase their stakes in technology companies as well as in early-stage companies in other sectors.

In conclusion, we are excited about the ex-plosive growth experienced by the private equity market over the past 20 years. The surge in capital flows from institutional investors to entrepreneurs, facilitated great-ly by intermediaries, has played no small role in the US economy's sustained growth and global competitive advantage. All told, the reputation of private equity as an asset class has been greatly enhanced. Going forward, we believe that institutional investors' participation in private equity will only expand as a result.

Brady Lipp is managing director of Warburg Pincus

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