From a tiny 1970s fringe industry comprising a handful of talented venture capitalists, private equity management in the 1990s has developed into a permanent fixture of the institutional investment landscape. In 1997, over $50bn was raised by private equity partnerships - almost as much in one year as in the whole of the 1980s. What caused US institutional investors to begin investing in the first place, and what has transformed the industry into such a powerhouse?

In the 1970s, a reduction in capital gains taxes motivated entrepreneurs to leave their secure career jobs for small start-up firms, taking on greater risk for the chance to accumulate significant wealth. At the same time, the prudent man" investment rule of the Employees' Retirement and Income Security Act (ERISA) was clarified, allowing pension plans to invest a portion of their assets in higher-risk, illiquid investments.

By the end of the decade, the contrast between the abysmal performance of the US public markets and the success of several high-profile, venture capital-backed companies set the stage for pension plan investments in private partnerships.

By the early 1980s, NASDAQ was already a deep public market for small companies. With a robust IPO market generating more venture-backed successes (such as Apple and Genentech), institutional money started to flow more freely into venture capital investment. Then in the mid 1980s, the first major LBO success, Gibson Greeting Cards, focused attention on buyout investing. Though often lumped together, it is important to note here that venture capital and buyout are distinct sub-sectors of private equity. Each represents a different stage of investing, demands a different skill set for success, and has a different risk/return profile.

In the late 1980s and early 1990s, severalother factors combined to provide even more legitimacy to private equity as a di stinct asset class:

q increasingly sophisticated portfolio modeling of risk and return;

q the realisation that significant portfolio impact requires a meaningful allocation of capital;

q the formation of the Institutional LP Association, a group of 40 major pension plan private equity investors;

q consultant sponsorship of private equity;

q the evolution of performance history; and

q concern that the extraordinary public market returns would regress to the mean.

These elements raised the curtain for further expansion.

During the 1990s, significant inflows to public equity markets, combined with fabulous public equity market appreciation, provided the underpinning for an explosive IPO market. IPO growth has resulted in an almost geometric increase in partnership distributions and exceptional internal rates of return. This, in turn, has further strengthened institutional investors' commitment to private equity. Asset allocation practices have been crucial in this chain reaction; in order simply to maintain target portfolio allocations, pension managers have to recycle distributions, which in effect makes the industry self-funding. Magnifying the deluge of money is the tendency among many institutional investors to raise their target allocations, since they have accepted as gospel the notion that over the long term, private equity investments will outperform public market investments. Even if (or rather, when) performance turns down, the curtain is unlikely to be rung down. Private equity has found its audience, and is here to stay.

Increased appetite for private equity investing is at odds with the ability of pension plan managers to effectively oversee a portfolio comprised of multiplying partnerships. For this reason, many large pension plans are consolidating their private equity allocations by making fewer but more significant investments ($50m-300m) in partnerships that can accommodate that level of commitment - the eye-popping, multi-billion-buyout partnerships.

Venture capital funds, by contrast, are typically only $50m-250m in size and cannot accommodate these large investments. This is a major reason why the growth of buyout commitments has dwarfed that of venture capital commitments. One can therefore question whether the inherent cyclicality of the private equity market will have a greater impact on buyout funds than on venture capital funds.

Make no mistake about it, private equity has been a cyclical business. As the accompanying chart shows, both venture capital and buyout investing have had their periods of spectacular and below-expectation returns. (Significantly, their cycles have been at odds with each other - a persuasive reason to include both in a diversified private equity programme.) Prior cyclical corrections in these illiquid investments have resulted in overcorrections. The reason, quite simply, is that the long-term nature of private equity investing almost guarantees that improvements in internal rates of return don't materialise until after the market equilibrium has been restored. By that time, the cycle has already begun its reverse.

Thus, a key consideration for any investor is, "Will the cycle happen again?" Perhaps. Perhaps not. Several factors supporting a cyclical repeat are:

q the sheer enormity of the commitments - over $100bn in the last three years;

q massive competition for deals, forcing up entry valuations and minimising the time allowed for due diligence;

q the historical cyclicality of the IPO market; and

q the apparent increase of late in the correlation between public and private market performance, which implies the probability that exit valuations will decline if the public market declines.

On the other hand, several structural changes may serve to counteract the historical pattern and smooth the cyclicality.

First, the industry is far more mature than it was 10 years ago, fed by more continuous funding by institutional in-vestors and stabilised by the greater ex-perience and discipline of seasoned ven-ture capitalists and buyout specialists.

Second, the global public capital markets have grown and should continue to grow as a percentage of total global financial assets, which in turn should increase the appetite for venture and buyout-backed IPOs.

Third, a plethora of talented senior managers are cashing in their stock options at established firms to become entrepreneurs, often moving on to build their second or third successful company.

Fourth, rapid growth is continuing in broad, fertile fields of opportunity, such as biotechnology, multimedia, healthcare, information technology, wireless, and the Internet. Finally, the scope of investment opportunities is expanding quickly around the world.

The verdict of the marketplace has yet to be delivered. Warren Buffet often said, "Price is what you pay, value is what you get." Only time - a long time - will tell if the money committed today will be worth the price.

Todd Ruppert is managing director of T Rowe Price Associates in Baltimore"

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