Venture capital funds are an important segment of the private equity fund sector which invests in the equity of private businesses and the securities of public companies. The financial activities of private equity funds are spread over a variety of fields, including derivatives, real estate, commodities, and emerging markets. Conservative estimates indicate that more than $100 billion are invested annually by private equity funds registered in the United States. While the numbers declined sharply in 2001, they are still above the amount in the years prior to 1999. It is important to point out that the figures are only approximates, since funds are not subject to public disclosure requirements with respect to their private equity investments. Some funds may choose to publish their investments and size in order to demonstrate their own financial ability and to enhance their own ability to raise capital, and gain access to attractive investments. Other funds, on the other hand, prefer to stay away from the limelight.
Private equity funds usually have a pre-defined model of their field of investment. For instance, many funds specialize in investing in companies which are experiencing financial difficulties by buying the securities of such companies (distressed securities); various hedge funds invest in securities, commodities, and/or currencies, often through financial leverage (i.e., using debt to "leverage" the equity).
As mentioned above, venture capital funds are part of the private equity fund sector. It is interesting to note in this context that with the development of the high tech industry in recent years, many private equity funds which were once identified with other investment fields, started investing considerable amounts in fields which are associated with "classical" venture capital funds. Kohlberg, Kravis, Roberts and Co. (the KKR fund), for instance, which was known for years for its investments in leveraged buyouts (LBOs) and in companies undergoing restructuring, has in recent years been investing considerable amounts of money in high tech companies.
The Main Types of Private Equity Investments
Although the different fields of activity of private equity funds do overlap, they may be classified into several main categories, according to their specialties.
Venture capital funds A venture capital fund is an entity which amasses money from investors in order to invest it in companies which are in the early phases of developing their products or services (startups). An investment in a startup is made in several stages, starting in the seed stage and ending in the last stages before the IPO. The investment is usually made by buying preferred shares which are convertible into ordinary shares, shares which provide some protection in the form of preference in the distribution of dividends and upon dissolution. The main method by which venture capital funds exit their investments is by selling shares after the company in which they invested goes public or is bought out by another company (for a discussion of investment milestones, see the section on stages in raising venture capital). Venture capital funds often define their area of activity for their investors, as well as the profile of the companies in which they intend to invest. The entities which invest in such funds are usually various institutional investors, corporations, and high net-worth individuals.
Leveraged buyout and merchant banking funds These funds invest in acquiring all or most of the shares of different companies, usually in financial distress. Such acquisition is usually made by a company which is established for this purpose, with the funds investing some of the capital, and the majority of the acquisition being financed by loans, many of which are provided by the funds' institutional investors. Historically, the companies bought by such funds were companies which had demonstrated economic stability in the past but found themselves facing operating difficulties at a certain period of time, particularly companies in areas which could generate stable free cash flows. Following operational improvements, the companies are able to derive cash from operations and that cash is used to pay the interest on the large debt undertaken by the companies to finance the acquisition (known as "serving the debt"). The acquisition is often made in cooperation with the company's management, which gains a substantial part of the equity of the new company.
Hedge funds The term "hedge" is derived from the original goal of these funds: to generate risk-free returns by buying assets (long positions) by using proceeds from the sale of assets carrying the same return profile (short positions) and which, according to the investors' estimate, will bear a lower return. In other words, these funds aim to hedge the risks involved with holding the assets and retain the difference between the projected returns on these similar assets. However, over the years, most of the funds in this category have become funds which have net positive position and are not necessarily maintaining a non-exposure (i.e., hedge) status.
Hedge funds include various types of funds which usually define their field of activity for their investors. In practice, hedge funds operate as mutual funds, but they are not subject to the reporting and management rules which apply to mutual funds, particularly the obligation of disclosing their investments, and the prohibition of receiving revenues which are contingent on profits. Hedge funds usually make extensive use of loans to leverage their returns. They are active in all fields in which mutual funds operate, alongside fields which are almost free of mutual funds, including fields such as (1) financial derivatives, i.e., investments in options and financial contracts while taking advantage of projected return differences between similar assets; (2) investments in shares and debentures of companies which are expected to be bought out, and the sale of the shares of the companies which are about to buy them (risk arbitrage funds); and (3) investments in commodities and currencies (commodities and currency funds).
One of the most famous hedge funds was Long Term Capital Markets (LTCM). This fund was managed by a team of famous experts, including Robert Merton and Myron Scholes, Nobel Prize laureates in economics. LTCM received broad attention from the media due to its remarkable success, as well as its collapse in 1998. A main component of its business was the investment in and sale of bonds while taking advantage of small interest gaps between similar assets and using highly leveraged investments. Successful hedge fund managers, such as George Soros and Michael Steinhardt, frequently appear in the media even though the investments made by their "macro funds" (funds investing in a broad selection of securities) generally remain concealed. Many of the hedge funds had invested in startups and, in particular, technology startups in the last few years, but significantly reduced the level of investment in the area from mid-2000.