THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 339

CHAPTER 12

Nonbank Financial Institutions

307

U.S. banks and investment banks have clear guidelines on the amount of lending
they can provide to hedge funds and require that these institutions get the appropriate amount of disclosure from hedge funds as to the riskiness of their positions.

PRI VAT E EQ U I TY AN D VE NT U RE CAP I TA L FU N DS
Another type of investment fund is the private equity fund, which makes longterm investments in companies that are not traded in public markets and has a similar structure to hedge funds. In a private equity fund, investors who are limited
partners (e.g., high-wealth individuals, pension funds, financial institutions, and
university endowments) place their money with the managing (general) partners
who make the private equity investments. Private equity funds are of two types.
Venture capital funds make investments in new startup businesses, often in the
technology industry. Capital buyout funds instead make investments in established businesses, and in many cases buy publicly traded firms through a so-called
leveraged buyout (LBO), in which the publicly traded firm is taken private by
buying all of its shares, while financing the purchase by increasing the leverage
(debt) of the firm.
Private equity has several advantages over investing in publicly traded companies. First, private companies are not subject to controversial and costly regulations. Second, managers of private companies do not feel under pressure to
produce immediate profits, as do those at publicly traded companies, and thus can
manage their company with their eyes on longer-term profitability. Third, because
private equity funds give managers of these companies larger stakes in the firm
than is usually the case in publicly traded corporations, they have greater incentives to work hard to maximize the value of the firm. Fourth, private equity overcomes the free-rider problem that we discussed in Chapter 8. In contrast to
publicly traded companies, which have a diverse set of owners who are happy to
free-ride off of each other, venture capital and capital buyout funds are able to garner almost all the benefits of monitoring the firm and therefore have incentive to
make sure the firm is run properly.
In both venture capital and capital buyout funds, once the startup or the purchased company is successful, the fund earns its returns by either selling the firm
to another company or by selling it off to the public through an initial public offering (IPO). The managing partners of private equity funds are well compensated
for their activities: Like hedge funds, they typically earn around a 2% fee for management of the equity fund investments and earn 20% of the profits, which is
called carried interest.

Both venture capital and capital buyout funds have been highly profitable.
Venture capital firms have been an especially important driver of economic growth
in recent years because they have funded so many successful high-tech firms,
including Apple Computer, Cisco Systems, Genentech, Microsoft, and Sun
Microsystems.

GOVE RNM EN T F I NA NCI AL I N TE RM EDI AT IO N
The government has become involved in financial intermediation in two basic
ways: First, by supplying government guarantees for private loans, and second by
setting up government-sponsored enterprises that directly engage in financial
intermediation.