FINS3623V C i lVenture Capital

Week 2 Fund Raising and Fund Structure IWeek 2 Fund Raising and Fund Structure I

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userText BoxHow VCs raise funds & relationships they have w/ their investors

userText BoxISSUES GPs / LPs negotiate on in their agreement1) what is the basis for calculating profit?2)

Lecture OutlineLecture Outline

R i f F f Fi i Review of Forms of Financing Equity Financing Debt Financing

Overview of VC FundraisingOverview of VC Fundraising What determines the inflow into VC markets?

Diffi lti f fi t ti f d Difficulties of first time funds The Limited Partnership Structurep Compensation in Limited Partnership

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userText BoxFunding a firm raises funds available to E firms at various points in life cycle and how VC fits in their

userText BoxVCs face in raising funds for 1st time

userText Boxlegal structure in which VCs raise funds ( more detail w3)

F f Fi i f P i FiForms of Financing of Private Firms

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Sources of Equity Financeq y First stage: Bootstrapping

V i f i t l it Various sources of internal equity: Own money, savings, credit cards, personal loans, family members,

tax rebates, second mortgage, etcg g Often a must before any other form of financing

A survey finds that bootstrapping contributes to about 31% f ll f f fi i31% of all forms of financing

Median startup capital in the US: only about $10,000R P t t t d EDS i 1962 ith $1000 ( b t $5000 i t d Ross Perot started EDS in 1962 with $1000 (about $5000 in todays dollars).

No real VCs at the time. Despite this EDS went public in 1968 f $ $ fshare price goes from $16 to$160 dollars in a matter of days.

In 1984 he sold a majority stake of EDS for $2.4 billion to GM ($6.5 billion in todays dollars). Today it is a division of HP.

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userText BoxE really like to hold on to ownership for as long as possible - but at some point they will need to raise SOME outside capital to fund the expansion of the firm--> restort to bootstrappingbootstrapping (aka INTERNAL CAPITAL) = efforts of E to restort to all sorts of means to minimize his/her reliance on external capital. e.g. save, use credit card, mortgage on home, family friends to raise capital- 1st form of external financing of E (31% of all firms do this 1st)- many aus companies dont actually need external capital (e.g. EDS went public without any external financing)

Sources of Equity Financeq y First stage: Bootstrapping

Problems with obtaining external funds too early Problems with obtaining external funds too early Incentives to spend, expand and squander Slower start is often a safer start Slower start is often a safer start No opportunity for correcting errors and poor decisions Venture capitalists are not that patientVenture capitalists are not that patient

They want to exit in 5 years Outside investors can hinder the entrepreneur

Outside investors often prefer the safe proven routes learnt from previous investments, while the entrepreneur may prefer experimental try-it fix-it approach in an uncertain environmenty

By bootstrapping entrepreneur can ensure very high returns Conversely, VCs will want too much ownership at early stage = little

incentive/wealth creation for entrepreneurincentive/wealth creation for entrepreneur

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userText BoxBootstrapping rationale:- dont want to introduce external capital TOO EARLY or TOO QUICKLYeven if you have a good idea, dont want to take VC or angel $ too quickly(1) --> give away too much ownership of the business- VC: this is too early, too risky, I will need much ownership in the business--> kill the return of the E, boost return of VC- limit the incentive of the E to work hard. (Moral Hazard)(2) --> once the VC's $ is in the business, they will be thinking about EXITING, MINIMIZING RISK --> not the right things to think about when starting a business

--> Introducing external capital too early may hinder entreprenrialship

userText Boxmay not be the best approach- esp if you want to be new and revolutionary

userText BoxIf you have too much capital --> VC suddenly injects heaps of $$$ --> hard to think carefully/straight/rationally of what to do --> spend too much

good dicipline to have a limited amt of capital

userText BoxWant to get the concepts right early on in the business. dont want to have too many errors.

userText BoxThey want a return from 5 years, if they dont see a return they may want to terminate

userText BoxAKA benefits of bootstrapping

Sources of Equity Financeq y Second Stage: Angel Investors/ Seed Capitalists

Professional investors investing with their own funds Often wealthy individuals, with a lot of experience:

E.g. investment bankers, lawyers, retired CEOs, retired scientists/engineers

Investment objectives: Investment objectives: Reaping the initial high returns by getting in early Reaping returns from value adding activities

P th f t it l f di Prepare the company for venture capital funding

Market for angel investments (US figures): Activity: around $12 billion in 2007y $ Number of investors: about 140,000 individuals Acceptance rate: vary from 10 to 20% of all proposed deals

Most prominent ind stries healthcare soft are and biotech Most prominent industries: healthcare, software, and biotech

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userText BoxTiming is everything - adolecent, growth stage

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userText BoxIndustry based, invest in industries...

userText Box==> once exhausted bootstrapping

userText BoxInvest own capital- likes to be very involved, mentoring, coaching, value add to the business and prepare it for funding from VC (been through it, know what an attractive firm looks like)

Sources of Equity Financeq y Second Stage: Angel Investors/ Seed Capitalists

Size of investment: from $50,000 - $100,000 Investment horizon:

Minimum 7 years to time of listing (or sale) Average 12 years

Portfolio: often less than 5 firms Portfolio: often less than 5 firms Key investment philosophies of modern angel investing:

Involvement, not just Investing Involvement, not just Investing Formal screening and selectivity Maintaining strong financial resources

Deeper pockets allow diversification, continuous funding to avoid dilution of ownership

Expertise-based investing and leveraging intellectual capitalExpertise based investing and leveraging intellectual capital

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userText BoxMENTOR, more involved than passive investor

Sources of Equity Financeq y Expansion Stage: Venture Capital

Overview of venture capital investments: Overview of venture capital investments: Raise capital and maintaining relationships with

Investors select and monitor investments and finally exitInvestors, select and monitor investments and finally exit.

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userText BoxOnce the firm grows past early stages, has a product, has a market --> full scale expansion phase- seed capitalist is not enough- once you expand you have a CAPITAL GAP --> where VC fits into the picture- Reason that VCs have much more capital than angels cuz they are a INTEMEDIATED INVESTMENT VEHICLE --> they can access the pool of investment capital in the financial system (e.g. super funds, instituional money) access that and channel that into a VC limited partnership and reach adequate scale/ amass adequate amount of cash to provide startup with amounts of capital- although Angels rich they are INDIVIDUALS and dont have the amount of capital required to fund expansion

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Sources of Equity Financeq y Overview of venture capital investments:

Flow of funds of VC/private equity investments

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userText BoxGPs manage the fund on day-day basis- contribute very small amt of capital- recieve fees for mgmting fund- recieve LARGE share of profit of fund (e.g. 30%) even if they contribute VERY SMALL AMT OF THE CAPITAL

userText BoxLP = investors- cuz they have limited liability (cant lose more than what they contribute)- contribute to 99% of the fund- recieve 70/80% of the profit- fund is then channeled through PF companies

Sources of Equity Financeq y A summary

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userText Boxfull scale --> really when VC come into the picture

- important to understand that when talking about VC/startup financing- VCs dont typically fund small projects --> step in when a firm is in its EXPANSION stage.

Sources of Debt Finance Bank Loans:

Overdrafts, commitments, term loans, etc. Contribute to about 30% of funding Difficult to obtain for start-ups as banks require

Stable cash flows Collaterals in the form of tangible assets

Moral hazard and adverse selection: Moral hazard: Borrowers have different risk appetite to lenders Adverse selection: substantial information acquisition costs The result is credit rationing (or debt gap) The result is credit rationing (or debt gap)

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userText BoxStartups can also get debt capital...

userText BoxThus the Debt that they issue is almost like EQUITY- no stable CF, no tangible assets, (cannot pay back assets, must be deferred assets), no assets to liquidate.Debt instrument is almost like equity instrument (but EVEN WORSE), Equity instrument has upside

- give rise to more serious MORAL HAZARD and ADVERSE SELECTION --> more incnetnive to use the capital on own purpose- know that the Debt providers cant do anything about it to reclaim the debt- charge really high interest rates --> adverse selection problem --> the only Es that take out the loan are the people who dont care about what happens to the loan (spend on private benefits) only attract bad E --> banks stop lending --> market breaks down --> banks stop lending

Sources of Debt Finance More exotic debt financing sources:

All it bl t l t t b id it l fi All suitable to later-stage bridge-capital firms Mezzanine funds:

P id d b fi i bi d i h i Provide debt financing combined with equity component Debt is often in the form of unsecured, long-term and less

than senior-rank instrumentsthan senior rank instruments Venture lending:

Similarly, provides debt financing with some warrant Similarly, provides debt financing with some warrant component

Often provides small debt amount that allows the firm to ti t t til th t it f di dcontinue to operate until the next equity funding round

Requires the backing/guarantee of existing venture capitalist Often requires blanket collateral over all assets Often requires blanket collateral over all assets

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userText BoxIf you see Debt funding in startup --> it is usualyl in more exotic forms

userText Box = Debt financing mixed with E financing- Hybrid D/E securities to fund Entrepreneurial ventures

userText BoxSome sort of convertibility of D to E

Guess the Venture In 1995 a 28-year-old software developer Pierre Omidyar sat

down to write a code that would enable internet users to buy and sell goods online.

Pierre decided to test the site by listing a single broken laser Pierre decided to test the site by listing a single broken laser pointer.

He was shocked when the item sold for $14.83. When he contacted the winning bidder to ask if he understood that the pointer was broken, the buyer replied: "I'm a collector of broken laser pointers". p

By 1996 the company was large enough to require the skills of a Stanford MBA in Jeffrey Skoll, who came aboard an already

fit bl hiprofitable ship. By this time the business is making $50,000 per year

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userText BoxOngoing growth of business has consistent CASH FLOWS

Guess the Venture The site went from 250,000 transactions to 2 mill transactions in

1 E ti l th i th t i d t hi1 year. Exponential growth in users that required matching growth in investments Development Expenses: $4.6 mil in 1998, $24.8 mil in 1999, $55.9

il i 2000mil in 2000 Cash investment 10 times cash flow from operation in 1998 and

1999 All earnings are put back into the business

History of external financing 1997: $5 mil from Benchmark Capital for 20% ownership 1997: $5 mil from Benchmark Capital for 20% ownership 1998: Initial public offering. Benchmark claims 49,000% return 1999: seasoned equity offer of $700 mil

Th i i ll t d d E h B T h l G The company originally traded as Echo Bay Technology Group but is now known as..........

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userText BoxProblem of transaction sky rocket:- you need funding/invest in warehouses, legal staff, servers, expansion classically is where the VC come into play- Investments 10x CF = clearly need external Financing (internal no where near nuff)-

userText Box490x return (highest return on any VC deal)

O i f VC F d i iOverview of VC Fundraising

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Overview of VC Fundraisingg The process of fund raising and fund g

structuring is complex due to the nature of VC investingg VCs invest in risky firms with moral hazard and

information asymmetry problems.information asymmetry problems. Investors in venture capital funds are investing in

investors in these types of firmsinvestors in these types of firms

Understanding fund raising and fund structuring is central to understanding the VCstructuring is central to understanding the VC cycle.

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userText BoxVCs have a complicated relationship with their Investors

userText BoxWhy complex relationship?

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userText BoxInvestors (i.e. LPs of VC funds) invest in a PARTNERSHIP which invests in these very problematic investments - DOUBLE moral hazard problem / double agency- 1) not only have to deal with the problem of investing in these really difficult to finace firms- 2) also faced with additonal agent problem of VCist behavior --> very possible for VCs to raise a lot of $$$ from LP. e.g. raise $50m fund w/ 2% fees, make $1m over life = "im set" --> agency issues --> need to make sure that the VCs work hard--> VCs can simply calim that they are working hard and leave with your

1) ageny problem b/w INVESTORS and VCists2) agency problem VCs face b/w VCs and the Entrepreneurs

Overview of VC Fundraisingg

Structure of this relationship

ff t th h laffects the whole cycle

userText BoxNB: relationship b/w VCs with investors will affect the relationship b/w VC has with the PF/Entreprenrial firm it is investing in.

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Overview of VC Fundraisingg

The structuring of private equity funds in terms of g p q ymanagement fees, profit sharing rules, and contractual terms between LPs and GPs also affects other aspects of the venture capital cycle.

For example private equity funds have a finite life of about 10 years, after which they must be terminated

How does this affect The entrepreneur seeking to raise funds? The behaviour of venture capitalists toward the

entrepreneurial firm?

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userText BoxWhy the relationship of VC and investors will also affect relationsihp b/w VCs and PF/E firms?- PE funds have finite life of 10years --> after liquidated all investments and return capital to all investors- Finite life of fund: affect E seeking funds from VC (attidue/relationship)-

userText BoxIf VC sees good venture to invest in: characterisitcs it needs to have to qualify: 1) something you must exit in 10 years time (usually actually 7)

Other way: E firm encounters some trouble, needs some time to recover, but ordinarily may recover in a few year time and get back to normal. But cuz the 10 year time frame may just terminate the investment.

- VC may also try to dress up a firm, maximise its SHORT term profits, at expense of LONG TERM GROWTH in order to EXIT the firm. e.g. 7 years into the fund, if VC makes certain amt of long term investment in R&D may be much more profitable in future.- but you know that it is exiting next year, DEFERR expenses, accelerate income, boost Short term valuation, ignore LONG TERM PROFIT potential - ultimately ST investor - only care about EXITING.

Overview of VC Fundraisingg The structuring of private equity funds can be

d d i iunderstood as a response to an uncertain environment with many information gaps

Th t t h d l d i t f These structures have developed a variety of mechanisms to ensure that value is maximized Unlike other investment funds VCs receive a very large share of Unlike other investment funds, VCs receive a very large share of

the profit of the fund (20-30%)

Other features of private equity funds can be seen as p q yattempts to transfer wealth between parties, rather than efforts to increase the overall wealth. The timing of the profit distributions to the Venture Capitalists can

vary across VC funds depending on the bargaining power of the Venture Capitalist.

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userText BoxLimited Partnership AGreements which try to contract every possible way a VC can behave opportunisticaly to rip off the LPs.- many CHARACTERISTICS / FEATURES of the LP/GP partnership agreement

userText BoxCuz so many MORAL HAZARD, RISK, INFO ASSYMETRY --> need appropriate incentive alignments1) VCs get 20% of profits - unusually high, normal fund mgmers dont receive any profit only mgmt fees- used to ALIGN LPs and GP interests

userText Boxmany contract terms - bargain over when drawing up of the partnership agreement- e.g. when EXIT when do VCs receive the PROFIT- immediately? or when all the capital contributed by the LPs are returned.-

Wh d i h i fl iWhat determines the inflow into venture capital market?ventu e capital a ket?

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userText BoxMacro level discussion (in readings)

Supply sideSupply-side Factors

Demand-side Factors

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userText BoxFactors affecting investors supplying funds to VCs

userText BoxDemand: factors effecting demand of Es for VCs in order to pursue E activities

What determines the inflow into venture capital market? Supply-side factors: related to the availability

of funds earmarked to VC/PE investments Who invest in VC and PE funds

Pension funds, insurance funds, endowment funds, wealthy individuals, governments, etc.

Why do institutional investors invest in VC/PE? Alternative asset classes that promise high potential

returnsB t t i t tl th ff l bl di ifi ti But most importantly, they offer valuable diversification opportunities when combined with traditional assets

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userText BoxNot so much in Australia

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userText BoxMACRO LEVEL

What determines the inflow into venture capital market?

Oth ifi l id f t Other specific supply-side factors: Capital gains tax:

Lower than income tax Institutional investors are tax exempt or pay low taxesClarification of Prudent Man rule Clarification of Prudent Man rule Common law countries In 1979 the US govt ruled that a small allocation into In 1979, the US govt. ruled that a small allocation into

Venture funds was not contrary to the rule Compulsory or incentivised pension contributions Performance of the public market

Encourage exit route for VC and PE investments

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userText BoxWhat affects the supply of capital to VCs?- number of factors in the reading

userCallout1) Relative level of capital gains tax and income tax- when investing in VC the most important form of gain is CAPITAL GAINS- if capital gains tax

What determines the inflow into venture capital market? Demand-side factors: demands of

entrepreneurs to obtain funds Economic growth Capital gain tax, R&D tax incentive Capital gain tax, R&D tax incentive

Determines the incentive for startup

Supply versus demand factors Supply versus demand factors Supply factor curves are much more elastic

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userText Box= more opportunities of Entrepreneurship

userText BoxBetter (than earning salary) and start own businessC.F. being employee in firm

R&D can write off R&D , rebates --> encourage to start own venture

What determines the inflow into venture capital market?

D dExpected

DemandExpected Return

Supply

Quantity of funds

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of funds

userText BoxSupply much more ELASTIC than demand factors

- supply of VC, small increase in expected return of VC asset will lead to a very large quantity of funds supplied.

However, change in Expected return in demand (Entrepreneurs) wont lead to large influx of E wanting to start own business

What determines the inflow into venture capital market?

Mi f d l l f t Micro fund-level factors: A newly established fund is like a startup firm

Incredibly difficult to raise fundy Needs to overcome substantial agency costs and information

asymmetry Needs to establish expertise and networkp

As there is no external market to trade VC fund contributions, reputation is critical in fund raisingreputation is critical in fund raising Investors in Venture Capital are hypersensitive to performance VC funds that hold larger stakes in firms that have recently gone public

raise funds with greater probability and raise larger fundsraise funds with greater probability and raise larger funds. Reputation in terms of age and size is also an important factor.

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userText BoxMICRO LEVEL

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userText BoxHypersensitvity to performance / Performance persistenceIf good performer = extremely easy to raise fund

Inadequate = money pulled away very fast

userText BoxExtremely difficult for investor to get access to top performing VC fund --> so sought after- if you take out the top quartile VC investment funds = VCs will perform VERY BADLY 0% or negative risk adjusted returnsexplaination- lot of junk VCs- not enough good entreprenurs

Importance of Reputationp pFuture-fundPerformance

Bottom Medium Top

Bottom Tercile 61% 22% 17%Past-fund

Medium Tercile 25% 45% 30%Performance

Top Tercile 27% 24% 48%

S K l d S h [2005]Source: Kaplan and Schoar [2005]

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userText BoxHigh correlation b/w past and future performance

userText BoxPast performance V.S. Future performance

userText BoxMain points- poor performing VC fund last period will also be bottom performer in next period 61% chance- poor performing fund last year only has small 17% chance of performing next year

persistence - top funds tend to be top funds, poor funds tend to be poor funds- 1st time raising funds in this kind of market = difficulty

VC skill set only certain ppl have.

userText BoxIf you perform well, more likely to attract DEALFLOWe.g. good entrerpreneur has good idea, get REFERRED to you. Good cycle --> if you do well, more good referrals

Importance of Experiencep p

IRR and Fund Sequence Number

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15

20

R

5

10

I

R

01 2 3 4 5 6 7 8 9 10 11

Sequence Number

Source: Kaplan and Schoar [2005]

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userText BoxThe more funds you raised/managed, the higher the return

userText BoxVC will raise a number funds over time- clear positive relationship b/w fund sequence and the performance of the fund- the firms that can raise the 10th fund must be sucessful in the past--> lot of junk at the start

userText BoxNB: also a graph with number of firms VS. sequence of funds- rapid decrease graph...

The Challenge of First Time Fundsg

Fundraising is particularly challenging for first time funds

Investors are reluctant to invest in an unproven teamunproven team

Then how do you raise a fund without a track record hen to obtain a track record orecord, when to obtain a track record you need to have a fund?

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userText BoxAgain infomation problems etc..., people cant verify who you are...Q: how are you ever going to raise a fund?

The Challenge of First Time FundsThe Challenge of First Time Funds

This challenge of first time funds is addressed in several waysaddressed in several ways. Identify investors who are not purely motivated by

returnsreturns Who are they?

Establish alliance ith e isting instit tions Establish alliance with existing institutions Recruit a lead investor or special limited partner

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userText Boxe.g. Green technology: investor who aint want $ but interested in innovation in Green Tech.e.g. investor who wants to support innovation in particular industry

userText BoxVCs arise from other large isntitutions e.g. arise from bank/ IB- use the name of bank as a verification of their quality

userText BoxSPecial limited partner = investor who is very EXPERIENCED who's support will certify the quality of the fund . In return = provide SLP concessions (wont charge too high fees), give them more profits

The Fund Raising Process.

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userText BoxDefining the players in the VC fund raising process

Key provision/terms in GP/LP agreement: governs their relationship

Who are the Players?y

The General Partners (The Venture Capitalists) Responsible for day-to-day management of fundy y g Usually invest a small amount of own capital For first-time funds and established funds invested For first time funds and established funds invested

amounts can be larger.

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userText Box"venture capital limited partnership" VCLP:GPs are the VCs

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userText Box1%

userText Boxinvest more to signal their COMMITMENT

NB: dont want GP invest TOO much of their own personal capital- become too RISK ADVERSE

userText BoxGPs supposedly have UNLIMITED LIABILITY - HOWEVER, in practice, GP/VCs get around this by many means- e.g. set up a company to act as a general partner.- so the company has a unlimited liablity in partnership level, they have limited liability in company level- other insuranes which indemnify them.

Who establishes private equity funds?p q y

Individuals Financial institutions

Banks Investment Banks Investment Banks Pension and other fund managers

A d th i l And their employees

Corporations Governments

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userText BoxEx- successfull entrepreneurs

userText Box"corporate Venture capital funds"

userText Boxe.g. Israel

Who are the Players?y

Limited Partners (LPs) Limited Partners (LPs) These are a wide array of individual and

institutional investors They include:institutional investors. They include: Wealthy Families Pension Funds Endowments Wealthy individuals

Established relationships are necessary to invest in top-flight fundsP t l b S i l Li it d P t Partners can also be Special Limited Partners or a Friend of the fund.

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userText Boxeven corproates

userText BoxNeed established relationship w/ GP- Top funds will be choosy who their LPs are.- Those who will be interested in investing in a SERIES of funds in future- wont hassel them to fund mgmt

userText BoxFriend = have special terms

Who are the Players?y

Investment Advisors or Gate Keepers Provide advisory services to clients. Usually set up Funds-of-Funds. Funds-of-Funds invest as a Limited Partner in many

different VC and Private Equity Partnerships. Typically major investment banks undertake this role A fund-of-funds is sometimes established to invest in a

single fund. A fee is charged to investors.

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userText BoxAgents which help LP choose which VC/GP to invest in.- provide advice

userText BoxFund that specicailly set up to invest in other VC funds2 reasons why a FoF is set up1) if you want to get access to a TOP flight fund, can invest to a fund of fund (who has access to the top fund) so you can get access2) e.g. small university (with $200m endowment) want to invest in BUYOUT fund. only a small proportion to go BUYOUT fund. $10m min. Use the FOF to SCALE UP the investment --> get EXPOSURE to the buy-out fund

3) opposite: $5b super annuation fund. Incredibly large funds --> problem these face = e.g. may have $50m allocation to VC, VC funds are only $50/$100m. Very difficult/time consuming to spread out, to find 15 funds to spend your $50m allocation- FOF can SCALE DOWN this very large fund on behalf of the super large funds.

also charge Carry e.g. 10% and MGMT fee

what you are really paying for is ACCESS to a VC who knows what to invest in

Structure of Limited Partnershipsp

Initial investors (LPs) in a private equity fund are Initial investors (LPs) in a private equity fund are anxious to avoid opportunistic behaviour by the general partners

Investors have liability limited to the extent of capital they provide. B t li it d t t b i l d i th But limited partners can not be involved in the day to day management of the firm, otherwise they lose their limited liability statusthey lose their limited liability status.

Thus, the limited partnership structure for venture capital investing is the crucial p gmechanism for limiting the behaviour of venture capitalists

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userText Boxespecially 1st time VCs- lots of scope to take your $ and simply argue that the investments were bad

userText BoxPROBLEM: investors have limited capacity to intervene with the partnership- lose LP status --> as long as they are remain UNINVOLVED with the operations of the business

==> in order to minimize their risk of this behavior must RELY on the LIMITED PARTNERSHIP AGREEMENT

-> long/complex documents which spell out the rules in which the VCs must invest-> many clauses, classifications, which try to avoid agency/moral hazard risks

Structure of Limited Partnershipsp

In U S private equity funds each LP must be an In U.S. private equity funds, each LP must be an accredited investor, which is a person or legal entity that meets certain net worth and incomeentity, that meets certain net worth and income qualifications and is considered to be sufficiently sophisticated to make investment decisionssophisticated to make investment decisions about complex securitiesGeneral Partners are responsible for the day to General Partners are responsible for the day-to-day management of the firm, and have unlimited liabilityliability.

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userText Boxaccredited = understand sohpsitcated securitiesCANNOT be retail investor

Structure of Limited Partnershipsp Oversight mechanisms found in corporations, e.g.

Powerful Boards of Directors Market for corporatePowerful Boards of Directors, Market for corporate control, powerful outside shareholders, are not in place for these partnerships.p p p

A series of contractual provisions and covenants govern the fundraising process and governance of the partnership.

No liquid market for partnership interests exists, and limited partners are frequently restricted from sellinglimited partners are frequently restricted from selling partnership interests.

Consequently the primary remedy for limited partners Consequently the primary remedy for limited partners is legal action triggered by a violation of covenants.

More on this next week.

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userText BoxNormal corporation have many mechanisms to manage many agency risks- e.g BoD, ...

userText Boxtake over market --> you get to earn good premium = implicit protection against the behaviors of mgmt

userCalloutMacqurie, large fund mgmt of IBs, exercise a lot of power in management of these firms

userText Boxnon of these mechanisms exist other than the contracts

userText BoxInvestors in regular, company --> simply Sell "wall street walk"--> partnerships NO real LIQUID market for partnership interests --> restrict protection from damages of opportunistic VCs

userText BoxLEGAL action only --> least desired way to resolve dispute

Cash Flow Schedule

CommitmentCo e Commitment refers to the maximum amount of

capital that an individual LP agrees to invest in acapital that an individual LP agrees to invest in a fund. The commitment generally includes management fees charged by the GP, as well as g g y ,other fund expenses.

But, LPs disburse committed capital in But, LPs disburse committed capital in STAGES Why? Why?

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userText BoxKEY terms in partnership agreement

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userText Box"$ committed by the LPs"

userText Boxe.g. X Ventures typical example:VC firm/partnership raises 1st fund "Vintage year" of fund (year fund made first investment) - doesnt meant that it is has $100m in its account - rather: it has $100m COMMITED by investors IF NEEDED- more fund it raises, the more committed capital it is able to raise in subsequent vintage years.

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userText BoxStages- 1) E dont need to invest all the capital up front - invest in stages- 2) effeciency perspective: inefficienct for cash sitting in VC acccount not being used --> depress IRR if they hold onto the committed capital in their bank account --> Rather: CALL the $ when needed "TAKE DOWN SCHEDULE" / ""CAPITAL CALLS"

Cash Flow Schedule

Takedown Takedown This term is used in two ways.

First, in reference to a schedule of transfer of capital in phases in order to complete a commitment of fundsin order to complete a commitment of funds.

Second, and more commonly, in reference to a single payment by an LP of a portion of a total commitment of capital. cap ta

Takedown is synonymous with drawdown and capital call.

Relatively large early payments from LPs are inefficient Relatively large, early payments from LPs are inefficient because cash waiting to be invested earns minimal interest, which depresses the funds overall returns.

Consequently, just-in-time drawdowns of capital as needed have become the norm

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userText BoxTake down refers to :- 1) Schedule of capital calls VC makes to the LPs- 2) refers to the SINGLE payment by LP to the VC ... aka. CAPITAL CALL

--> usually VC finalizes terms of investment into Entrepreurail firm, typically 10-20 LPs in the fund. LPs will wire the $ the next day and channeled into the E firm

userText Boxinefficiient --> JIT drawdowns

Compensation Structurep

Management Fee This is a fee charged by the GP to the LPs. g y

Management fees in a private equity fund typically range from 1.5% to 2.5% of committed capital, depending on the type and size of fund.

This fee structure differs from that of mutual fund managers, which invest in public markets and on average earn less than 1% of assets under

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userText BoxControversial issue: mgmt fees they charge

userText BoxGood GP: charge 2.5% of committed capital EVERY YEAR in fees- FIXED RETURN per year

Compensation Structure Carried Interest

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Carried interest is the GPs share in the profits of a private equity fund. S ti f d t t th it l i t Sometimes a fund must return the capital given to it by the LPs before the GP can share in the profits of the fundprofits of the fund.

The GP will then receive 20% of the net profits as carried interest, although some successful firms , greceive 25%-30%. This fee is also known as carry or promote.

Many funds require repayment of management fees from investment proceeds before the GP can receive any carry

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receive any carry.

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userText BoxGP shares a substantial profit of the fund

GP and LPs negotiate when this CARRY is paid --> cuz affect the wealth transfer b/w the 2 partiese.g. require to give back all the commited funds before paying the CARRY--> others dont

e.g. pay back all the MGMT fees before the GPs get CARRY--> others dont

DEPENDS ON THE BARGAINING POWER OF VC and LP

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Compensation Structurep Distributions and Clawbacks

As investments are exited funds are distributed back to As investments are exited, funds are distributed back to LPs. These are known as distributions

The Limited Partnership Agreement (LPA) specifies how The Limited Partnership Agreement (LPA) specifies how and when these distributions take place.

The timing and form of distribution (cash vs. securities) will also be defined. This includes clawback provisions, which give LPs the right to reclaim a portion of carried interest disbursements to a GP for early profitable investments ifdisbursements to a GP for early profitable investments if there are significant losses from later investments in a portfolio.

These issues can become very complex in negotiation of the partnership agreement. See examples to follow.

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Complexity of Profit Distributionsp y

The basic idea is simple:e bas c dea s s p e Investors Commit $100m Exit Proceeds are $200m Exit Proceeds are $200m Profit = $100m

A GP ith 20 t i d i t t t $20 A GP with 20 percent carried interest gets $20m and LPs get $80mSi l i ht? Simple right?

No! Many complex provision make this calculation complex.

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userText BoxOver life of fund there are EXITs of Entreprenurial firm OHHH EXIT PROCEEDS = aka "liquidation proceeds" = amt of cash/traded assets recieved upon PF company's liquidation event e.g. IPO, M&A, bankruptsy

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Complexity of Profit Distributionsp y

First, what is profit? i.e. what is the basis for , pcalculating profit? Investors Commit $100m$ Over the 10 year life of the fund they pay $25m in fees

(2.5% x 100m) x 10.( ) Therefore invested capital is only $75m If exit proceeds are $200m, is profit (1) $200-$75 or is p , p ( )

it (2) $200-$100? 70 % of funds use (1) 30% of Funds use (2) Which would a GP prefer?

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userText Box2.5% mgmt fees / year charged to LPs

userText BoxInvested Capital = how much investors commit to the fund - mgmt fees - committed capital NOT YET investedmgmt fees = mgmt fee % * investor commit to fund * No. years

userText Box1) invested capital (committed less mgmt fees) capital basis for profit2) committed capital basis for profit

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userText Boxprofit IMPORTANT to calculate CARRIED INTEREST

userText BoxCOMMON 1ST ISSUE:WHAT IS THE BASIS for calc. profit?2) COMMITTED CAPITAL; or 1) INVESTED CAPITAL?

70% of funds use (1) invested capital

userText BoxGP obviously prefer (1) profit on INVESTED funds

LOLOLOL costs = profit to the GPs- even if earn $0 still making profits

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The Timing of CarryThe Timing of Carry

Who gets what when? Who gets what, when? Approx 20% of funds require the return of committed capital

before collecting carryg y Approx 24% of funds require the return of invested or contributed

capital before collecting carryA 48% f f d i th t f ti f i t d Approx 48% of funds require the return of a portion of invested capital before collecting carry

Priority Returns or Hurdle Rates Priority Returns or Hurdle Rates Preset rate of return that the LPs must receive before GPs can

collect carry (about 45% of funds have hurdle rates) Catch-up Provision: VCs can receive a greater share of profit

once hurdle rate has been met.

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userText Boxi.e. after the mgmt fees- mgmt secure its fees

userText Boxmax security

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userText Boxpotential for greater carry

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userText BoxANOTHER ISSUE GP/LPs negotate on

userText Box20%: require GPs to return ALL commited capital

24%: require GPs to return INVESTED capital (COmmitted capital - fees - stuff not invested)

48%: only require GPs to return SOME portion of invested capital

userText Box"PRIORITY RETURNS / HURDLE RATES"- = preset rates of return that LPs have to provide to the GP before they can collect carry- e.g. 8% --> have to return committed capital AND 8% BEFORE GPs can collect CARRY

Catchup provision:- If GP gives LPs propority returns, then GPs are then allowed to collect profits to CATCH UP to CORRECT profit share AFTER the priority returns/hurdles have been met

userText BoxPriority return seems to be like a ONE OFF thing... not yearly 8%

--> TOTAL return of 8%

The Timing of Carryg y Consider a $100m fund with carry of 20% (with

committed capital being the basis for profit) Priority returns of 8% and 100% catch up y p

provisions. All Committed capital is drawn down on day 1 of All Committed capital is drawn down on day 1 of

the fund. At year 1: $108m exit proceeds At year 1: $108m exit proceeds At year 2: $2m exit proceeds At year 3: $10m exit proceeds At year 3: $10m exit proceeds

How would this profit be distributed each year?

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userText BoxTerms of partnership agreement

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userText BoxFor simplicity, NB: completelly unrealistic

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userText Boxi.e. $100m invested in DAY ONE of the fund

The Timing of Carryg y The LP agreement requires the return of committed capital + priority

returnreturn Year 1: total profit = 8m, priority return =8%

The LP receives all of $108m Year 2: total profit = year 1 + year 2 profit = 8m +2m = $10m. The

priority return has been satisfied, but GP has 100% catch-up provision:The GP can take as much as is needed to catch them up to the The GP can take as much as is needed to catch them up to the 80:20 profit split.

The GP is entitled to receive 20% of $10m, or $2 Year 3: total profit = 10+10 = $20mil, priority return and catch-up

provisions have been satisfiedThe GP gets $2m the LP gets $8m The GP gets $2m, the LP gets $8m

What happens if Year 2 distribution is $10m?

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userText Box-$100m

userText Box+ $108m exit

userText Box+ $2m exit

userText Box+ $10m exit

userText BoxGiven- Carry = 20%- Priority = 8% (100% catchup)- agree GP have to payback ALL committed capital b4 carry + 8% priority return

@ year 1- $108m exit, GP has returned ALL committed capital, additonal return required is $8m--> $108 goes ALL to the LP--> GP gets $0LP = $108GP = $0

@year 2- $2m profit- might think that now it is SPLIT cuz priority provision metNB: CATCHUP PROVISION -> GP is entitled to disprotionally collect profit to their TRUE profit/distribution RATIO- after $2m profit --> TOTAL profit = $10m (2 + 8)- out of the $10profits GP has rights to 20% (per agreement) i.e. $2m --> entitled to "Catchup" to itLP = $0GP = $2m

userText Box@ year 3- $10 exit/profitLP = $8mGP = $2m- All the priority returns have been met- usual 20/80 GP/LP split

userCallout--> GP takes $2m (from CATCH-UP) and split the rest 80/20KEY: THE REST i.e. split the $8m NOT SPLIT THE $10m 80/20

LP = $6.4mGP = $1.6m + $2m

More on Clawbacks A $100m fund has 20% carried interest, where

profit is based on committed capital. Carried interest can be collected as long as g

invested capital is repaid (no priority returns) Three years into the funds life Three years into the funds life

Contributed capital is $50m and; The fund receives its first exit of $60m The fund receives its first exit of $60m How would carried interest be distributed?

$10m profit can be divided 80/20 between LPs and GPs $10m profit can be divided 80/20 between LPs and GPs LPs get total of $58m and GP gets $2m

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userText Boxmin. amt of return???

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userText Boxc.f. invested capital

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userText BoxContributed capital = amt INVESTED by the fund

userText Boxaka. invested capital must be repaid to LPs before GPs can get CARRY

userText BoxNB: see problems

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userText Boxinvest 50m initially, invest another $50m which return is 0%

More on Clawbacks

Fast forward to the end of the funds life: There were no more exits Contributed capital is now the full $100m But the LPs have only received $58m

According to the rules the contributed capital must be repaid before carry is distributed.p y

LPs are entitled to clawback the $2m carry initially collected by GPsinitially collected by GPs

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userText BoxPROBLEM: if for the rest of the life, the investment COMPLETELY FAILS completely written off- now drawn the FULLcommitted $100 and invested - but now fund COMPLETELY written off --> LPs only recieved $58m - GP already collected $2m carry --> not fair for GP to collect $2m if fund has made substantial loss--> CLAW back agreement --> clawback the $2m carry which the GP collected-->