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Venture Capital and Private
Equity
Session 2
Professor Sandeep Dahiya
Georgetown University
This Course
• No easy answers – Boot Camp (Up to
100+pages of reading before class!!)
• Main Perspective
– Key aspects and practices of industry
– How these key features are a response to
the difficult environment
– Constant comparison of the US and
European experience
We will follow the “Venture Capital
Cycle”
Investing Capital
Fund
raising
Exit
and
returning
capital
3
Course Road Map
• What is Venture Capital - Introduction
• VC Cycle
– Fund raising
– Investing
– Exiting
• Time permitting – Corporate Venture
Capital (CVC)
Some Important Terms
•
•
•
•
VC firm
general partner (GP)
VC fund
limited partner (LP)
• committed capital
• early-stage, mid-stage, late-stage fund, multistage fund
• raised, closed
• vintage year
• capital call = drawdown = takedown
Quick Overview of Venture
Capital
Limited
Partners
(LP)
Institutional
Investors
(Pension Funds/
Endowments etc)
€
Advice
General
Partner
(GP)
VC Fund
Management
Company
Individual
Investors
Family Offices
Fund of Funds
(FOF)
€
€
VC FUND
(Partnership
Agreement)
Advice
Portfolio Company 1
€
Portfolio Company 2
+
Portfolio Company 3
…
Concerns for LPs
Limited
Partners
(LP)
Institutional
Investors
(Pension Funds/
Endowments etc)
€
•Hand over money for 10
years – No control once
committed!!!
•Hard to get out mid-way
Individual
Investors
Family Offices
Fund of Funds
(FOF)
€
€
VC FUND
(Partnership
Agreement)
•Restrictions on size of fund, size and type of investment, and use of debt
•Restrictions on co-investments with earlier funds
•Pre Agreed “Take Down” Schedule – will give money when “Capital Calls”
are made
•Fund Life restricted to 10 years (may be extended by additional 2 years)
•Compensation Structure of GP!
Compensation of VCs
Management Fee (2% of
Committed Capital)
•How do GPs get
compensated?
Carried Interest (20% of Profits)
•Reputation
•Signal
Advice
General
Partner
(GP)
VC Fund
Management
Company
VC FUND
(Partnership
Agreement)
Exit and Distribution
Limited
Partners
(LP)
Institutional
Investors
(Pension Funds/
Endowments etc)
€
Advice
General
Partner
(GP)
VC Fund
Management
Company
Individual
Investors
Family Offices
Fund of Funds
(FOF)
€
€
VC FUND
(Partnership
Agreement)
€
Advice
€
Portfolio Company 1
€
Portfolio Company 2
+
Portfolio Company 3
…
Who are the LPs?
• Historically, just under half of all committed
capital comes from pension funds.
• The next two largest groups are financial
institutions and endowments/foundations,
each with about 1/6 of the total.
• Individuals/families and corporations make
up the remainder, and are more fickle than
the other types.
Fund Raising Process
• Private Placement Memorandum
1. Executive summary
2. Firm and Fund investment philosophy
3. Investment Professionals and Advisory Committee
4. Summary of GP/LP terms and agreements
5. Investment track record and prior fund
performance
6. Legal and tax matters
7. Inherent related investment risks
8. Accounting and reporting standards
Time Line For Fund Raising
FUND VINTAGE
YEAR
2000
1997
Announcement
– Plans to
raise a $100
Million Fund
1998
Commitments
of $25 Million
1999
Commitments
of $75 Million
Fund CLOSING
YEAR
2000
First
Investment of
$15 Million
Time Line Investment and
Distribution
Final Year
2009
2000
Total
investment $15
Million PLUS
2 Million for
Management
fees
Capital Call/
Draw Down
Of $17 Million
2001
Investment of
of $65 Million
PLUS
2 Million for
Management
fees
2008
Distribution of
$120 Million
Still $ 2
Million for
Management
fees
2009
Distribution of
$160 Million
Still $ 2
Million for
Management
fees
The key terms in VC
partnership agreement
1. Compensation structure
• Management fees
• Carried interest
2. Covenants
• Activities of the fund
• Activities of the individual General
Partners
Fees: definitions
•
Annual management Fees
– Level:
– Basis: committed capital or net invested capital
•
lifetime fees = The total amount of fees paid over the
•
investment capital = committed capital - lifetime fees
•
invested capital = cost basis for the investment capital
of the fund that has already been deployed at a given
point
•
Net invested capital = invested capital - cost basis of
all exited and written-off investments
lifetime of a fund
Example
ABC Ventures has raised their $100M fund,
ABC Ventures I, with management fees
computed based on committed capital.
These fees are 2 percent per year in the first
five years of the fund, then fall by 25 basis
points per year in each of the subsequent
five years. The fees will be paid quarterly,
with equal installments within each year.
Problem
Given this description, what are the lifetime
fees and investment capital for this fund?
ABC Ventures
Committed Capital
Life Time Fees
Year
Fee percentage Fees ($M)
1
2
3
4
5
6
7
8
9
10
Lifetime fees
Investment capital =
2.00%
2.00%
2.00%
2.00%
2.00%
1.75%
1.50%
1.25%
1.00%
0.75%
=
$
$
$
$
$
$
$
$
$
$
100
2.00
2.00
2.00
2.00
2.00
1.75
1.50
1.25
1.00
0.75
16.25
83.75
Carried Interest: definition
•
Definition: % of the realized fund profit, defined as
cumulative distributions in excess of carry basis, that gets
paid to GPs
– Level
– Basis: committed capital or investment capital
– Timing
– Priority return
– Catch-up
– Claw back
Carried interest
• Contributed capital = invested capital + management fees
that have been paid to date
– For a fully-invested and completed fund, contributed capital =
investment capital + lifetime fees = committed capital
• Carried interest timing
– Return all call carry basis (committed or investment capital)
first (25%)
– Return all contributed (or invested) capital plus priority return
first (45%)
– Return only part of contributed/invested capital
• Often distinguishes between realized and unrealized
investments
• Fair value test (14%)
– Other (16% of sample)
ONSET Ventures
PAGE 20-21
Fund Name Vintage Year Committed
Capital
ONSET
1984
$5M
IRR
Fund
LP
ONSET I
1989
$30M
26.30%
21.72%
ONSET II
1994
$67M
15.49%
11.69%
ONSET III
1997
$100M
Return Definitions (1)
(IKV)
• Internal rate of return (IRR) = a rate of return that implies an
NPV of 0 for a given cash flow stream
• Value multiple (TVPI)* = Total Value Paid In= investment
multiple = multiple of money =
T otaldistributions to LPsvalue of unrealizedinvestments
investedcapital managementfees
T otaldistributions to LPs
– Realized Value multiple = investedcapital managementfees
– Value multiple =
value of unrealizedinvestments
– Unrealized value multiple =
investedcapital managementfees
5 steps to calculating value
multiples
There are 3 components that contribute to value
multiples: Total (cumulative) distributions to LPs, value
of unrealized investments, and contributed capital.
Calculate distributions to LPs each year.
1.
•
2.
3.
4.
5.
Distributions to LPs = total distributions - carry
Sum them to date to get total distributions to LPs
Get value of unrealized investments (after exits) =
portfolio value (before exits) - total exits in year t. This
is an estimate value of illiquid investments and not a
market/transaction value.
Calculate contributed capital = invested capital + fees to
date.
Calculate value multiple T otaldistributions to LPsvalue of unrealizedinvestments
investedcapital managementfees
5 steps to calculating IRRs for LPs
As LPs, there are 3 components that contribute to your
net cash flows: fees, new investments, and
distributions.
Calculate fees
Calculate distributions to LPs
1.
2.
•
3.
Calculate net cash flows = Distributions to LPs - new
investments - fees
For the IRR of a fund that is T years into its life and is
still alive, the value of unrealized (i.e., remaining)
investments at the end of year T is counted as if it is a
positive cash flow. This is an estimate value of illiquid
investments and not a market/transaction value.
4.
•
5.
Distributions to LPs = total distributions - carry
Cash flow if final year of IRR calculations = Distributions
to LPs - new investments - fees + portfolio value of
remaining unrealized investments
IRR(year 1,…, year X) = IRR(CF1, …, CFT)
The IRR is not perfect
• Cannot be compared to time-weighted
returns
• Compounding of periodic returns
• Realized vs. unrealized investments
• Difficult to make risk adjustments
Performance
Committed Capital
100
Management Fee
2%
Year
1
Management Fee
2
Investments
20
Carrying Value
And/or distributions ( very rare at this stage)
Cash Flows to LPs
IRR
Multiple
-22
IRR
Multiple
-22
4
5
6
7
8
9
10
Notice it was not paid
out
18
2
2
20
3
2
20
4
2
20
176
-22
-22
154
2
2
20
3
2
20
4
2
20
5
6
7
8
9
10
88
49%
2.0 x
Committed Capital
Management Fee
Year
Management Fee
Investments
Remaining Value plus distributions
100
2%
1
2
20
Cash Flows to LPs
-22
IRR
Multiple
3
-18.2%
0.90 x (40/44)
Committed Capital
100
Management Fee
2%
Year
1
Management Fee
2
Investments
20
Carrying Value
Plus some distributions (some possible at this stage)
Cash Flows to LPs
2
2
20
40
30%
4.0 x
-22
-22
-22
5
2
6
2
7
2
8
2
9
2
10
2
40
40
40
40
40
200
38
38
38
38
38
198
Example of a J-curve
Some Basics
• How is return of a fund measured?
• Consider a fund that raised 100 million – Drew down 50
million at start of year 1 and Year 2. Distributed 100 million
at the end of year 7 and 80 million at the end of year 10.
0
-50
1
2
3
4
-50
5
6
7
8
100
IRR=7.87%
Multiple 1.8x
• What is distribution?
• What is the IRR when the Fund was 4 years old?
• How does the VC get paid?
9
10
80
What if 100 was
distributed at
the end of Year
5 instead of
Year 7?
CalPERS – Performance Review of Private Equity Investments
Fund
Description
Vintage Year Capital
Committed
Cash In
Cash Out
Cash Out &
Remaining Value
Net IRR
Footnote
Investment Footnote2
Multiple
RV/Cash In RV
Permira U.K.
Venture III
1991
12,700,000
13,262,655
37,161,145
37,428,531
31.1
2.80x
2.02%
0.27
Hellman &
Friedman Capital
Partners II
1991
100,000,000
87,335,732
239,071,996
239,128,430
22.5
2.70x
0.06%
0.06
Welsh, Carson,
Anderson &
Stowe VI, LP
1993
50,000,000
50,000,000
97,922,237
100,214,581
12.9
2.00x
4.58%
2.29
Blackstone
Capital Partners
II, L.P.
1994
75,000,000
78,946,963
170,188,559
176,592,301
37.4
2.20x
8.11%
6.40
FS Equity
Partners III, L.P.
1994
75,000,000
75,000,000
164,794,231
164,813,795
16.4
2.20x
0.03%
0.02
Green Equity
Investors II, L.P.
1994
75,000,000
72,453,008
151,988,178
151,988,178
13.9
2.10x
0.00%
0.00
Aurora Equity
Partners I, L.P.
1994
25,000,000
27,227,117
33,799,938
37,078,086
7.7
1.40x
12.04%
3.28
TPG Partners VI,
L.P.
2008
855,000,000
162,853,206
261,044
127,551,734
-26.8
N/M
0.80x
N/M
78.16%
127.29
Bridgepoint
Europe IV, L.P.
2008
406,373,559
56,266,433
0
40,177,347
-48.4
N/M
0.70x
N/M
71.41%
40.18
Candover 2008
Fund, L.P.
2008
39,629,686
25,528,038
462,069
18,295,919
-19.0
N/M
0.70x
N/M
69.86%
17.83
CVC Capital
Partners Asia
Pacific III, LP
2008
150,000,000
52,426,802
344,567
34,904,220
-27.6
N/M
0.70x
N/M
65.92%
34.56
VC Industry Historical
Performance
Cumulative Vintage Year Performance
Sample
Size
Pooled Average
Maximum
Upper Quartile
Median
Lower Quartile
Minimum
1990
21
28.47
74.94
29.29
14.25
0.31
-7.63
1991
17
19.39
61.34
25.25
14.10
4.43
-0.57
1992
27
36.43
116.35
38.89
13.34
11.00
-17.13
1993
42
37.32
98.55
38.90
12.37
0.75
-25.01
1994
36
47.00
107.72
43.90
23.75
3.03
-47.88
1995
49
59.49
220.09
61.14
19.27
2.38
-36.14
1996
39
84.26
454.91
94.47
37.73
1.19
-13.59
1997
65
48.16
295.97
59.56
19.97
-0.58
-21.63
1998
78
17.23
721.01
10.48
1.91
-3.10
-44.77
1999
109
-4.18
140.02
1.91
-4.95
-12.54
-100.00
2000
124
1.44
21.98
1.95
-1.89
-5.77
-37.35
2001
63
5.45
26.94
6.47
1.03
-3.51
-20.68
2002
18
-1.79
13.72
1.63
-1.11
-3.65
-13.83
2003
19
4.60
18.43
8.71
1.88
-0.65
-10.74
2004
26
4.07
81.86
4.63
0.41
-4.08
-13.77
2005
22
7.57
54.43
6.82
3.08
-3.46
-18.65
2006
43
4.75
21.50
6.37
-0.71
-5.97
-35.25
2007
23
14.29
80.48
18.63
2.37
-4.15
-16.84
2008
16
6.38
29.15
16.50
4.90
-7.25
-22.00
2009
12
11.55
45.30
10.55
5.26
-9.11
-42.44
2010
5
-15.18
2.71
-4.24
-22.30
-32.29
-57.79
Fund Year
Review of Important Terms
•
•
•
•
•
•
•
•
•
•
VC firm
General partner (GP)
VC fund
Limited partner (LP)
Capital call = drawdown = takedown
Committed capital
Early-stage fund, late-stage fund, multi-stage fund
Vintage year
Management Fees
Carried interest
Basics of Fund Performance
• Simple calculations have ignored
fees/expenses to be paid
• We shall see a more realistic example
in Key Ventures
Key Ventures
• Size is $250 million, life 10 years
• Management Fee 2% collected at start of
each year. (2%x250 = 5 million each year)
• Lifetime fees = 10x5=50 million
• Investment Capital = 250-10x5= 200
• Assume 4 equal take downs (200/4=50)
• Assume gross return is 25%
• 10% of portfolio value is distributed every
year starting in Year 4 (end of year).
• No carry till the entire 250 million is
returned to investors – Carry is 20%
Key Ventures
50+50*(1.25)
0
1
5
5
Management Fee
50.00 50.00
Investment
50.0 112.5
Estimated Portfolio Value
0.0
0.0
Distributions
0.0
0.0
Cumulative Distributions
0.0
0.0
Distribution to Key Ventures
0.0
Cumulative Distributions to Key Ventures 0.0
0.0
0.0
Distribution to LPs
0.0
0.0
Cumulative Distributions to LPs
50.0 112.5
Portfolio value after capital returned
55.0 110.0
Contributed Capital
Invested Capital
50.0 100.0
5.0
5.0
Cash Flow to Key Ventures
82
NPV for Key Ventures
-55.00 -55.00
Cash Flow to LPs
20.14%
IRR for LPs
Year
Year 9
296.1-250=46.1
20% of 46.1=9.2
64.9-9.2=55.7
50+112.5*(1.25)
2
5
50.00
190.6
0.0
0.0
0.0
0.0
0.0
0.0
190.6
165.0
150.0
5.0
3
5
50.00
288.3
0.0
0.0
0.0
0.0
0.0
0.0
288.3
220.0
200.0
5.0
4
5
0.0
360.4
36.0
36.0
0.0
0.0
36.0
36.0
324.3
225.0
200.0
5.0
5
5
0.0
405.4
40.5
76.6
0.0
0.0
40.5
76.6
364.9
230.0
200.0
5.0
6
5
0.0
456.1
45.6
122.2
0.0
0.0
45.6
122.2
410.5
235.0
200.0
5.0
7
5
0.0
513.1
51.3
173.5
0.0
0.0
51.3
173.5
461.8
240.0
200.0
5.0
8
5
0.0
577.2
57.7
231.2
0.0
0.0
57.7
231.2
519.5
245.0
200.0
5.0
9
10
5
0
0.0
0.0
649.4 730.5
64.9 730.5
296.1 1026.7
9.2 146.1
9.2 155.3
55.7 584.4
286.9 871.3
584.4
0.0
250.0 250.0
200.0 200.0
14.2 146.1
-55.00 -55.00
31.04
35.54
40.61
46.31
52.72
50.71 584.43
HOME WORK 1
• Accel VII – ANSWER ALL STUDY
QUESTIONS
Yale University Investments
Office August 2006
A Clear Philosophy
Focus on Equities--public or private.
Avoiding market timing.
Focus on inefficient markets.
Pick investment managers rather than
investments.
• Focus on incentives.
•
•
•
•
An Unconventional Mix
Bonds
Public equities:
Domestic
Foreign
Private equity
Real assets
"Absolute return"
Yale Peers All Universities
4%
10%
12%
7%
10%
30%
28%
21%
11%
15%
19%
15%
23%
15%
16%
16%
13%
21%
Picking the Pickers…
Source: Yale Endowment Report 2010
Strong Track Record
• 1980-2010 year return of 14.6%:
–
–
4.1% above S&P 500
4.7% above all universities
Can PE
returns be
compared to
other asset
classes?
Private Equity is an Important
Element
• Investor since 1973.
• Repeated investments in partnerships
formed by a select group of
organizations.
• Emphasis on value-added strategies.
• Focus on incentives.
How easy it
is to invest in
top PE funds?
But Worries About Future
• Recent fund influx:
–
–
–
–
Private pension funds in 1980s.
Public pension funds in 1990s.
Private equity pool--from $4B in 1980 to
~$300B in 2004.
“Virtual overhang.”
Implications of fund Influx
• Alteration in incentives.
• Relaxation of covenants.
• Concerns about within-fund
compensation.
• Quality of deals.
But ...
• Good returns during last fund influx.
• Inter-quartile spreads:
–
–
3% in public equities.
12% in private equity.
• Private equity small relative to
potential: $1:$30.
Swensen’s Dilemma
• Is private equity still viable for Yale?
– If so, where?
– If not, what other asset classes should
they pursue?
• How far can it go in pursuit of returns?
• How dangerous is it to be different?
Yale Investment Office 2008
•
•
•
•
Domestic Equity 10%, Bonds 4%!!!
Private Equity 20%
Real Assets 29%
Beat S&P 500 in every year since 2002
by Wide margins!! Endowment size
$22.8 billion
But what about 2009!
Future of Swensen Model
•
•
•
On December 16, President Levin delivered a message to Yale’s
faculty and stated that : “Our best estimate of the Endowment’s
value today is $17 billion, a decline of 25 percent since June 30,
2008.” President Levin’s estimate incorporated returns on
marketable securities through October 31 and projections of write
downs on illiquid assets. Based on marketable security returns
through December 31 and illiquid asset projections, the estimated
investment decline remains at 25 percent
Salary and hiring freeze instituted (Endowment had provided 37% of
Yale’s operating budget in 2008!)
Context –Domestic Equity fell 30%, Foreign Equity fell 47%
2010 Yale Endowment had 8.9% return
Endowment assets went up from 16.3 Billion to 16.6 Billion
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