Monday, December 12, 2016

Interview with Josh Lerner: Venture Capital and Private Equity

David A. Price has an "Interview" with Josh Lerner in the Econ Focus magazine published by the Federal Reserve Bank of Richmond (Second Quarter 2016, pp. 26-30), with a focus on topics involving entrepreneurs and new firms, along with method of financing them like venture capital, private equity, and crowdfunding. There's lots of interest in the interview, but here are a few of Lerner's comments that caught my eye:

On the level of fees charged by venture capitalists and private equity:
"An interesting thing is that fees in private equity and venture capital are remarkably sticky. The compensation structures don't look that different in today's era of $10 billion-plus funds than they did back in an era of $10 million funds. They've come down somewhat, so instead of 2 percent committed capital, it's more likely to be 1.5 percent. But given the economies of scale of running a larger fund, it means the profits per partner can be staggering. If you look at the history of financial intermediation, you see in general that as more competition has arrived, prices have come down. I anticipate venture capital and private equity will follow that pattern, but it's been surprising how leisurely the adjustment process has been."
On the potential for conflict in crowdfunding because of disclosure requirements: 
"I myself am a little bit in the skeptical camp on crowdfunding per se. A lot of my doubts have to do with the inherent contradictions between the entrepreneurial process and disclosure requirements. When you think about what have been the guiding principles of securities regulation, a big part has been based on disclosure: "Sunlight is the best disinfectant." But if you think from the perspective of an entrepreneur, it's very important to keep information close to the chest rather than tipping off competitors early as to your business model. When Google filed to go public, people were shocked by how profitable the search business was for them. Yet at that point, they had already established themselves and had an insurmountable lead that Yahoo and the others haven't been able to catch up to. The natural tendency is to say, "Let's just make everyone disclose everything," but the very process of disclosing things is likely to destroy a lot of the competitive advantage that the entrepreneurs might have. That's a tough conundrum to solve.
"Moreover, when you look at attempts to create entrepreneurial finance models with crowdfunding-type flavors to them, the outcomes have not been great. For instance, there was an effort in Europe during the 1990s to create a whole series of small capitalization models where riskier young companies could list and so forth with relatively lax regulations. They ended up with a phenomenon where the bad drove out the good. All it took was a few scammers to come in and undertake "pump and dump" schemes, and the interest in those markets declined precipitously. And I think some of the same danger lurks here."
On the question of whether being surrounded by entrepreneurs encourages entrepreneurship: 
"Ulrike Malmendier and I tried to find a setting where one could look at this question where there was an element of randomization. We ended up looking at the impact of how students spent their first year at Harvard Business School. In particular, what we have here is a system where people spend the first year with a section of 90 people and they take all of their classes together. These sections tend to be powerful connecting devices for people, still binding them together when they come back for their 25th reunion. So we can ask, does having in one's section fewer or more entrepreneurial peers — people who were entrepreneurs prior to business school — end up affecting the willingness of people who didn't have an entrepreneurial background to start a new venture themselves after school?
"When we ran the analysis, we were shocked because we got exactly what we thought was the wrong answer: Having more entrepreneurial peers makes people less likely to start businesses. When we broke it down, however, we discovered that the individuals who had lots of entrepreneurial peers were less likely to start unsuccessful businesses but were as likely or lightly more likely to start successful businesses. So it seemed that having the entrepreneurial peers was scaring people away from doing ideas that subsequently turned out to be unsuccessful, but if anything, encouraging people to go out and start businesses that proved to be successful. That suggested that peers really do matter, but in perhaps a more complicated way than we would initially anticipate."
On venture-backed firms taking longer to go public: 
"For instance, among venture-backed firms today, the average company going public was 12 years old at the time of IPO last year. Historically, it was around four or five years old. And so you've got all these companies that are privately held sitting there raising money but staying private. They're getting funded not just by venture capitalists, but also by sovereign wealth funds and family offices and even mutual funds. What's the ultimate implication of this trend? Is being private, sheltered from financial markets, actually good because a lot of people do more long-run things? Or do these arrangements simply allow management to perpetuate poor decisions?"
On the sources of gains from private equity involvement: 
"One of the advantages of buyouts is that because you've got such detailed financial information, you can see often the way in which value is created: How much is real operational improvements, how much of it is the market timing, and how much of it is the financial engineering or the use of debt? A number of papers have done this to try to divide the share of value being created into these three broad buckets. If you asked the private equity guys, many would say, "Oh, 90 percent of it is us going in and adding value to the operations of companies." If you look at the academic evidence, you'd probably say the operational improvements are a lot closer to 30 percent than 90 percent. Not to say that it doesn't happen, but it's only one of a number of levers that the private equity groups are pulling to create value."