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82 Fed. Res. Bull. 26 (1996)
The Economics of the Private Equity Market

handle is hein.journals/fedred82 and id is 32 raw text is: Staff Studies

The staff members of the Board of Governors of the
Federal Reserve System and of the Federal Reserve
Banks undertake studies that cover a wide range of
economic and financial subjects. From time to time
the studies that are of general interest are published
in the Staff Studies series and summarized in the
Federal Reserve Bulletin. The analyses and con-
clusions set forth are those of the authors and do not

necessarily indicate concurrence by the Board of
Governors, by the Federal Reserve Banks, or by
members of their staffs.
Single copies of the full text of each study are
available without charge. The titles available are
shown under Staff Studies in the list of Federal
Reserve Board publications at the back of each


George W. Fenn, Nellie Liang, and Stephen Prowse

The private equity market has become an important
source of funds for start-up firms, private middle-
market firms, firms in financial distress, and public
firms seeking buyout financing. Between 1980 and
1994, the amount of private equity outstanding rose
from less than $5 billion to $100 billion. Despite the
market's extraordinary growth and its importance to
many types of firms, it has received little attention in
the financial press or the academic literature.
This study examines the economic foundations of
the private equity market and discusses in detail the
market's organizational structure. Drawing on pub-
licly available data and extensive fieldwork, it de-
scribes the major issuers, intermediaries, investors,
and agents in the market and their interactions with
each other. It examines the reasons for the market's
explosive growth over the past fifteen years and
highlights the main characteristics of that growth.
Finally, the study provides data on returns to private
equity investors and analyzes the major secular and
cyclical influences on returns.
The study emphasizes two major themes. One is
that the growth of private equity is a classic example
of the way organizational innovation, aided by regu-
latory and tax changes, can ignite activity in a par-
ticular market. In this case, the innovation was the
widespread adoption of the limited partnership. Until
the late 1970s, private equity investments were under-
taken mainly by wealthy families, industrial corpora-

tions, and financial institutions that invested directly
in issuing firms. Much of the investment since 1980,
by contrast, has been undertaken by professional
private equity managers on behalf of institutional
investors. The vehicle for organizing this activity is
the limited partnership, with the institutional inves-
tors serving as limited partners and investment man-
agers as general partners.
The emergence of the limited partnership as the
dominant form of intermediary is a result of the
extreme information asymmetries and potential in-
centive problems that arise in the private equity mar-
ket. The specific advantages of limited partnerships
are rooted in the ways in which they address these
problems. The general partners specialize in finding,
structuring, and managing equity investments in
closely held private companies. Because they are
among the largest and most active shareholders, part-
nerships have significant means of exercising both
formal and informal control, and thus they are able to
direct companies to serve the interests of their share-
holders, At the same time, partnerships use organiza-
tional and contractual mechanisms to align the inter-
ests of the general and limited partners.
The second theme of the study is that the growth of
the private equity market has expanded access to
outside equity capital for both classic start-up compa-
nies and established private companies. Some observ-
ers have characterized the growth of non-venture

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