Venture Capital and Private Equity

Session 2Professor 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”

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, multi-stage

fund• raised, closed

• vintage year• capital call = drawdown = takedown

Quick Overview of Venture Capital

Institutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement) Portfolio Company 1

Portfolio Company 2

Portfolio Company 3

…

€ € €

Advice

€+

Advice

Concerns for LPsInstitutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

VC FUND(Partnership Agreement)

€ € €

•Hand over money for 10 years – No control once committed!!!•Hard to get out mid-way

•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!

•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

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement)

Advice

•How do GPs get compensated? Carried Interest (20% of Profits)

•Reputation•Signal

Management Fee (2% of Committed Capital)

Exit and DistributionInstitutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement) Portfolio Company 1

Portfolio Company 2

Portfolio Company 3

…

€ € €

Advice

€+

Advice

€

€

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 Memorandum1. Executive summary2. Firm and Fund investment philosophy3. Investment Professionals and Advisory Committee4. Summary of GP/LP terms and agreements5. Investment track record and prior fund performance6. Legal and tax matters7. Inherent related investment risks8. Accounting and reporting standards

FUND VINTAGE

YEAR2000

Time Line For Fund Raising

1997Announcement – Plans to raise a $100 Million Fund

1998Commitments of $25 Million

1999Commitments of $75 Million

2000First Investment of $15 Million

Fund CLOSING YEAR

Final Year2009

Time Line Investment and Distribution

2000Total investment $15 Million PLUS2 Million for Management fees

2001Investment of of $65 MillionPLUS2 Million for Management fees

2008Distribution of $120 MillionStill $ 2 Million for Management fees

2009Distribution of $160 Million Still $ 2 Million for Management fees

Capital Call/Draw Down

Of $17 Million

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 lifetime of a fund

• 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

ExampleABC 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.

ProblemGiven this description, what are the lifetime fees and investment capital for this fund?

ABC VenturesCommitted Capital 100Life Time FeesYear Fee percentage Fees ($M)

1 2.00% 2.00$ 2 2.00% 2.00$ 3 2.00% 2.00$ 4 2.00% 2.00$ 5 2.00% 2.00$ 6 1.75% 1.75$ 7 1.50% 1.50$ 8 1.25% 1.25$ 9 1.00% 1.00$ 10 0.75% 0.75$

Lifetime fees = 16.25

Investment capital = 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

Fund Name Vintage Year Committed IRR Capital Fund LP

ONSET 1984 $5M

ONSET I1989 $30M 26.30% 21.72%

ONSET II 1994 $67M 15.49% 11.69%

ONSET III 1997 $100M

PAGE 20-21

Return Definitions (1)

• 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 =

– Value multiple =

– Realized Value multiple =

– Unrealized value multiple =

fees management capital invested

sinvestment unrealized of value LPs toonsdistributi Total

fees management capital invested

LPs toonsdistributi Total

fees management capital invested

sinvestment unrealized of value

(IKV)

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.

1. Calculate distributions to LPs each year. • Distributions to LPs = total distributions - carry

2. Sum them to date to get total distributions to LPs3. 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.

4. Calculate contributed capital = invested capital + fees to date.

5. Calculate

fees management capital invested

sinvestment unrealized of value LPs toonsdistributi Total multiple value

5 steps to calculating IRRs for LPsAs LPs, there are 3 components that contribute to your net cash flows: fees, new investments, and distributions.

1. Calculate fees2. Calculate distributions to LPs

• Distributions to LPs = total distributions - carry 3. Calculate net cash flows = Distributions to LPs - new

investments - fees4. 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.

• Cash flow if final year of IRR calculations = Distributions to LPs - new investments - fees + portfolio value of remaining unrealized investments

5. 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

Committed Capital 100Management Fee 2%Year 1 2 3 4 5 6 7 8 9 10Management Fee 2 2Investments 20 20Carrying Value And/or distributions ( very rare at this stage)

40

IRR -18.2%Multiple 0.90 x (40/44)

IRR 30%Multiple 4.0 x

Cash Flows to LPs -22 18

Management Fee 2 2 2 2 2 2 2 2 2 2Investments 20 20 20 20Remaining Value plus distributions 40 40 40 40 40 200

Cash Flows to LPs -22 -22 -22 -22 38 38 38 38 38 198

Committed Capital 100Management Fee 2%Year 1 2 3 4 5 6 7 8 9 10

Performance

Committed Capital 100Management Fee 2%Year 1 2 3 4 5 6 7 8 9 10Management Fee 2 2 2 2Investments 20 20 20 20Carrying Value Plus some distributions (some possible at this stage)

176

IRR 49%Multiple 2.0 x

Cash Flows to LPs -22 -22 -22 154

88

Notice it was not paid out

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.

-50

0 1 2 3 4 5 6 7 8 9 10

-50 100 80

IRR=7.87%

• What is distribution?• What is the IRR when the Fund was 4 years old?• How does the VC get paid?

Multiple 1.8x What if 100 was distributed at the end of Year 5 instead of Year 7?

Fund Description

Vintage Year Capital Committed

Cash In Cash Out Cash Out & Remaining Value

Net IRR Footnote Investment Multiple

Footnote2 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% 0.27Hellman & 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% 127.29Bridgepoint 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

CalPERS – Performance Review of Private Equity Investments

Cumulative Vintage Year Performance

Fund YearSample

SizePooled 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

VC Industry Historical Performance

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%

Year 0 1 2 3 4 5 6 7 8 9 10

Management Fee 5 5 5 5 5 5 5 5 5 5 0Investment 50.00 50.00 50.00 0.0 0.0 0.0Estimated Portfolio Value 50.0 112.5 190.6 360.4 649.4 730.5Distributions 36.0 64.9 730.5Cumulative Distributions 36.0 296.1 1026.7Distribution to Key Ventures 0.0 9.2 146.1Cumulative Distributions to Key Ventures 0.0 9.2 155.3Distribution to LPs 36.0 55.7 584.4

Cumulative Distributions to LPs

0.00.00.00.00.00.0

0.00.00.00.00.00.0

0.00.00.00.00.00.0 36.0 286.9 871.3

Portfolio value after capital returned 50.0 324.3 584.4 0.0

Contributed Capital 55.0 225.0 250.0Invested Capital 50.0

112.5110.0100.0

190.6165.0150.0 200.0 200.0

Cash Flow to Key Ventures 5.0 5.0 5.0 5.0 146.1

NPV for Key Ventures 82

Cash Flow to LPs -55.00 -55.00 -55.00

50.00288.3

0.00.00.00.00.00.0

288.3220.0200.0

5.0

-55.00 31.04

0.0 0.0 0.0 0.0405.4 456.1 513.1 577.240.5 45.6 51.3 57.776.6 122.2 173.5 231.20.0 0.0 0.0 0.00.0 0.0 0.0 0.0

40.5 45.6 51.3 57.776.6 122.2 173.5 231.2

364.9 410.5 461.8 519.5230.0 235.0 240.0 245.0200.0 200.0 200.0 200.0

5.0 5.0 5.0 5.0

35.54 40.61 46.31 52.72

250.0200.0

14.2

50.71 584.43

IRR for LPs 20.14%

Key Ventures

50+50*(1.25) 50+112.5*(1.25)

Year 9296.1-250=46.120% of 46.1=9.264.9-9.2=55.7

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

Yale Peers All UniversitiesBonds 4% 10% 12%Public equities: Domestic 7% 11% 15% Foreign 10% 15% 16%Private equity 30% 19% 16%Real assets 28% 15% 13%"Absolute return" 21% 23% 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% returnEndowment assets went up from 16.3 Billion to 16.6 Billion