Decision maker. Chapter 1. Business Model. Private equity/public equity

Transcription

1 Chapter 1 Disruption - disturbance or problems that interrupt an event, activity, or process Dislocation - disturbance from a proper, original, or usual place or state innovation - a new method, idea, product, etc The Venture Capital Industry 1-1 Public Equity Private Equity Decision maker Top Management entrepreneur founder portfolio Co. IDEA General Partners (GP) Venture Capitalist Active Contribution agency cost Investors Information IAsymmetry Limited Partners (LP) 1-2 Business Model Assets Liability & Equity Goods investment financing Services Cash Flows operations Debt Equity cost of capital sales revenue > $$$ Investment required rate of return expected rate of return Private equity/public equity Public equity Agency relationship Top management and equity investors Information asymmetry Public investors liquid SEC regulations

2 Chapter 1: Introduction WHAT ARE THE KEY THEMES Illiquidity Uncertainty and Information Gaps Cyclicality Certification Incentives Deal Context LLH 2: The Private Equity Cycle What is a VC? Players in Venture portfolio companies Entrepreneur Deal People & Resources Competitor Opportunity Strategic Partner Lender, etc. Venture Capital Investors in Venture Capital Context

3 What is a VC? THE FLOW-OF-FUNDS IN THE VENTURE CAPITAL CYCLE (1) A VC is a financial intermediary, meaning that they take the investors capital and invest it directly in portfolio companies. (2) A VC will only invest in private companies. This means that once the investments are made, the companies cannot be immediately traded on a public exchange. (3) A VC takes an active role in monitoring and helping the companies in his portfolio. (4) A VC s primary goal is to maximize his financial return by exiting investments through a sale or an initial public offering (IPO). (5) VCs invest in order to fund the internal growth of companies. VC Funds Managed by General Partners ( VCs or GPs ) Limited Partners (Investors or LPs ) Portfolio Companies Exits : Sale of Portfolio companies to public markets (IPOs) or to other companies ALTERNATIVE INVESTMENTS What is a VC? Concept of FIT Venture Capital Private Equity Mezzanine Buyout Distress People & Resources Experience Skill Contacts Attitude Knowledge Favorable Sociological Factors Opportunity Appropriate Knowing & Being Known Context Macroeconomy Tax Regulatory Sociopolitical Appropriate Risk/Reward Allocation & Incentives Investor Value-Added Hedge Funds Favorable Technology Macroenvironment Favorable Rules of the Game Opportunity Entry Barriers Customers Suppliers Substitutes Rivalry Economics Project Appropriate Financing Option Preservation Deal Allocation of Risk/Reward Incentives Signals Sorting Consequences

4 Why now? Who s watching? Dislocation? Regulation? Context Opportunity Market Size Who is Customer? Compelling Value? 10X? Proprietary Advantage? Competition Cash Flow Characteristics Sources of Entrepreneurial Opportunities Research (J. Case) suggests 12% of Inc. 500 success is due to extraordinary idea 88% due to exceptional execution of ordinary idea Trends suggesting possible entrepreneurial innovations Societal changes Demographic changes Technological changes 1-15 Societal Changes Naisbitt s reflections still relevant! (Megatrends,1982) 1. Industrial Society to Information Society - Suggested focus on human response to information 2. Global economy - Awareness of international innovation and sourcing 1-16

5 Demographic Changes Dent s Generations The Baby Boom 1. Spending wave (1990 s) - Behind the stock and bond market booms 2. Power wave (to peak in the 2020 s) - Aging baby boomers with great business influence - Aging baby boomers provide business opportunities creating them, financing them, using them Technological Changes Information Age Internet Wireless Artificial Inteligence (AI) Robot Cross-functionality Truly global in reach and competition People Experience (vs the ideal ) Know and Known Ambition/Objectives Commitment Attract Who? Entrepreneurship Fundamentals Entrepreneurship: process of changing ideas into commercial opportunities and creating value Entrepreneur: individual who thinks, reasons, and acts to convert ideas into commercial opportunities and to create value

6 Entrepreneurial Traits or Characteristics A successful entrepreneur Sees and seizes a commercial opportunity Tends to be doggedly optimistic (perhaps even to a fault) Plans to obtain the physical, financial, and human resources needed for the venture to succeed Non-Entrepreneurial Traits or Characteristics Success is unlikely if you are seldom able to see an opportunity, until it ceases to be one (Mark Twain) view the glass as being half empty instead of half-full (unknown) are paralyzed by a fear of failure Deal Concept of FIT Simple? Fair? Durable? Reward the Right Behavior? Opportunity Appropriate Knowing & Being Known People & Resources Experience Skill Contacts Attitude Knowledge Favorable Sociological Factors Context Macroeconomy Tax Regulatory Sociopolitical Appropriate Risk/Reward Allocation & Incentives Investor Value-Added Favorable Technology Macroenvironment Favorable Rules of the Game Opportunity Entry Barriers Customers Suppliers Substitutes Rivalry Economics Project Appropriate Financing Option Preservation Deal Allocation of Risk/Reward Incentives Signals Sorting Consequences

7 Stages of Financing 1.Seed-Money Stage: Small amount of money to prove a concept or develop a product. 2.Start-Up Funds are likely to pay for marketing and product refinement. 3.First-Round Financing Additional money to begin sales and manufacturing. 4.Second-Round Financing Funds earmarked for working capital for a firm that is currently selling its product but still losing money. 5.Third-Round Financing Financing for a firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing. 6.Fourth-Round Financing Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing

8 VC Investments Investment, Pre-Boom In 1979; Reinterpretation of Prudent Man Rule in the Employee Retirement Income Security Act of 1974 (ERISA) Preboom ( ) Boom (1994) Postboom period (1995- ) Investments by Stage Industry Region VC Investment ($billions) Investment, Boom and Post-Boom Stages of Growth Early-Stage VC Investment ($billions) Seed Startup Other Early-Stage Mid-Stage (expansion) Late-Stage Generic Late Stage Bridge/Mezzanine

9 100% 80% 60% 40% 20% 0% Investment by Stage Investment by Industry Industrial/Energy Business/Financial Media/Retail Late Expansion Other Early Seed/Startup postboom boom preboom Other Healthcare Biotech Hardware Semiconductors Software Communications % 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 1-34 Investment by Region NE 11% NY 8% TX 6% SE 7% LA 6% DC 5% Midwest 5% Other 20% SD 3% CO 3% NW 4% PH 3% Other 7% SV 32%

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11 Chapter 2 Private Equity Cycle VC Players The Private Equity Cycle WHO ARE THE LPs? Angel Investors Endowments Pension Funds Corporations Sovereign Wealth Funds Intermediaries

12 Who are GPs?

13 Some Important Terms EXHIBIT: EARLYBIRD VENTURES (EBV) Portfolio firm VC fund vintage year early-stage fund, late-stage fund, multi-stage fund general partner (GP) limited partner (LP) capital call = drawdown = takedown committed capital raised, closed Management fees carried interest Fund Name Vintage Year Committed Capital EarlyBird Ventures I 1994 $100M EarlyBird Ventures II 1998 $250M EarlyBird Ventures III 2000 $1B Early Bird Ventures IV 2005 $300M management fees lifetime fees investment capital invested capital Fees Example 1 ABC Ventures has raised their $100M fund, ABC Ventures I, with management fees computed based on committed capital. I.These fees are 2 percent per year for all 10 years. II.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 for (i) and (ii)?

14 Q solution Carry capital raised ($M) $100 Year Fee percentage Fees ($M) 1 2 $ $ $ $ $ $ $ $ $ $0.75 Lifetime fees = $16.25 carried interest = carry carried interest basis committed capital (70 percent of sample) investment capital (30 percent of sample) Investment capital = $ Example 2 A VC firm is considering two different structures for its new $100M fund. Both structures would have management fees of 2.5 percent per year (on committed capital) for all ten years. Under Structure I, the fund would receive a 25 percent carry with a basis of all committed capital. Under Structure II, the fund would receive a 20 percent carry with a basis of all investment capital. Problems a) Suppose that total exit proceeds from all investments are $150M over the entire life of the fund. How much carried interest would be earned under each of these two structures? b) For what amount of exit proceeds would these two structures yield the same amount of carried interest?2-15 Q: Solution b) For what amount of exit proceeds would these two structures yield the same amount of carried interest? 25% * (z - 100) = 20% * (z - 75) Solve for z. Z=200M 2-16

15 Example 3 A VC firm is considering two different structures for its new $100M fund. Both structures would have management fees of 2.0 percent per year (on committed capital) for all ten years. Under Structure I, the fund would receive a 25 percent carry with a basis of all committed capital. Under Structure II, the fund would receive a 20 percent carry with a basis of all investment capital. Problems a) Suppose that total exit proceeds from all investments are $160M over the entire life of the fund. How much carried interest would be earned under each of these two structures? Q1 b) For what amount of exit proceeds would these two structures yield the same amount of carried interest? A. 180M B. 200M C. 220M D. 240M b) For what amount of exit proceeds would these two structures yield the same amount of carried interest? Carry Carried interest timing Return everything first (20% of sample) Return all contributed capital first (24% of sample) Return part of contributed capital (48% of sample) Often distinguishes between realized and unrealized investments Other (8% of sample) Carried interest timing Real estate model return the total base first Deal-by-deal model return the base corresponding to each deal Carry, continued Priority returns = preferred returns = hurdle returns (45% of sample, more common among late-stage funds) Catch-up provision (73% of those with priority return) Clawback - in case of deal-by deal model

16 priority return comitted 100 capital carry 20% carry basis committed capital priority return 8% catch-up no catch-up exit GP LP GP LP 1 $108 $108 $108 2 $ $1.6 3 $ $8.0 total $120 $4 $116 $2.4 $ clawback carried interest is paid as long as contributed capital is returned committed 100 capital carry 20% carry basis committed capital contributed exit capital exit GP LP 1 $50 60 $2 $ $ total $100 $108 $1.6 $ VC COMPENSATION COMMITTED CAPITAL % BY LP TYPE Salary Bonus Carry Total Salary Bonus Carry Total Managing GP Senior Partner Partner Principal/VP Senior Associate Associate Analyst Venture Partner NA NA NA NA % 60% 50% 40% 30% 20% 10% 0% Year Pension Funds Endowments & Foundations Individuals and Families Financial & Insurance Corporations

17 Restrictive Covenants GP vs. LP Incentive Problems Management of funds Max % to be invested in any one portfolio firm Taking debt Coinvestment from GPs GP Activities Raising another fund Types of investment Other investment, LBO, distressed firm, etc. The Private Equity Cycle THE LIMITED PARTNERSHIP AGREEMENT Characteristics of the Fund Management of the Fund Activities of the General Partners Types of Investments The Private Equity Cycle ALIGNMENT OF INTERESTS: FEES AND CARRY Management Fees Carried Interest Other Fees Capital Calls

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20 Return Definitions Chapter 3 VC Returns periodic returns compound returns annualized return gross returns net returns realized returns = historical returns expected returns Periodic return = R t = (P t + D t ) / P t-1 1, where R = return, P = portfolio value or price, t = period, and D = dividend. For multi-period returns, multiply the periodic returns to arrive at the compound return: Compound return = (1 + R 1 ) * (1 + R 2 ) * * (1 + R N ) 1 To translate multi-period returns into annualized returns use the following formula: Annualized return = (1 + compound return) (1/T) 1 Gross returns are before subtracting fees and carried interest Net returns are after subtracting fees and carried interest LARGECO PENSION PLAN, VC PORTFOLIO

21 Realized or historical return Expected return

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23 Industry Returns Cambridge Associates (CA) the most comprehensive net-return index During the 20-year period from 1988 to 2008, the CA index earned an annualized return of 16.2 percent Sand Hill Econometrics (SHE) industry s primary gross-return index From December 1988 to December 2008, the SHE index s annualized return was 12.8 percent. How and Why: CA return > SHE return? Venture Economics (VE) 3-15 reports fund-level return data 3-16

24 CA INDEX VERSUS NASDAQ SAND HILL INDEX VERSUS NASDAQ % 1, 16.2% % 1, 7.9% CA index Nasdaq Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 Note: Q1 to 2008 Q Q4 to 2008 Q Quantitative measures of fund performance: IRR the rate of return that implies an NPV of zero for a given cash flow stream value multiples for LPs the ratio of dollars received to dollars given gross value multiple (GVM) for GPs unlike the value multiple, does not account for fees and carry Quantitative measures of fund performance (for LPs): IRR it does not distinguish between realized and unrealized investments value multiples unrealized value multiple uses the value of unrealized investments as the numerator. The realized value multiple uses the total distributions to LPs as the numerator How well did you do with my money while you had it? Overall, how much money did you make for me? 3-20

25 Exercise 1: $200M fund is 7 years into its 10-year life. IRR, VM, realized VM, unrealized VM at the end of year 7 year 1 year 2 year 3 year 4 year 5 year 6 year 7 investments portfolio value total distributions carried interest distributions to LPs cumulative distributions to LPs port value after capital returned year 1 year 2 year 3 year 4 year 5 year 6 year 7 investments portfolio value total distributions (to LPs) carried interest distributions to LPs cumulative distributions to LPs port value after capital returned management fee cash flows to GPs cash flows to LPs (24.0) (34.0) (44.0) if ending year (4.0) NOTE: DO NOT FORGET TO ADD THE "PORT VALUE" AT THE END OF EACH YEAR AS A TERMINAL CASH FLOW MANY PEOPLE FORGOT TO DO THIS management fee At year end % At year end 2 $ (24.0) $ % At year end 3 $ (24.0) $ (34.0) $ % At year end 4 $ (24.0) $ (34.0) $ (44.0) $ % At year end 5 $ (24.0) $ (34.0) $ (44.0) $ 21.0 $ % At year end 6 $ (24.0) $ (34.0) $ (44.0) $ 21.0 $ 3.6 $ % At year end 7 $ (24.0) $ (34.0) $ (44.0) $ 21.0 $ 3.6 $ 35.1 $ % If we count year 0 as "zero" then this is an example of a J curve If we count year 0 as "zero" then this is an example of a J curve

26 Value Multiple = (total distributions to LPs + value of unrealized investments) / (invested capital + management fees) = (total distributions - carried interest) / commited capital = 1.84 Realized VM = 0.97 Unrealized VM = IRR: J-Curve carried interest and GP%. For a fully-invested fund at the end of its life, Carried interest = carry% * (GVM * investment capital carry basis) To calculate the fraction of the investment exit value that we expect to be paid to the GP as carried interest: GP% = carried interest / total distributions = carry% * (GVM * investment capital carry basis) / (GVM * investment capital). Exercise 2: VM, GVM, GP% *use graphical analaysis committed capital $100 mgt fee 2% Carried interest (committed capital) 20% lifetime 10 years GVM 2.5 VM? GP%?

27 Committed Capital Total Distribution VM(to LP) = Distribution to LP + value of unrealized investment Committed Capital Total Distribution GVM(to GP) = Investment Capital GP(Carry) GP% = Total Distribution VE MEDIANS AND TOP-QUARTILE BY VINTAGE YEAR KLEINER PERKINS CAUFIELD & BYERS FUNDS

28 Venture Finance Risk and expected return Expected return vs. realized return Expected return and cost of capital Chapter 4 The Cost of Capital for VC Capital-Asset-Pricing Model (CAPM) Risk r i = R i = R f + β(r m R f ), where r i is the cost of capital for asset i, R i is the expected return for asset i, R f represents the risk-free rate for borrowing and lending, R m is the return on the whole market portfolio, and β, pronounced as beta, is the level of risk for asset i. The difference (R m R f ) is called the market premium. Beta risk = market risk = non-diversifiable risk = systematic risk = covariance Idiosyncratic risk = diversifiable risk = firmspecific risk = residual risk = variance

29 Performance Evaluation Regression CAPM Estimation results R it -R ft = a + β(r mt R ft ) + e it, where β, R it, R mt, and R ft are defined similarly to the earlier slide, except that previously the return variables represented expected returns, while here they represent realized returns for period t. The new elements in this equation are α, pronounced as alpha, the regression constant, and e it, the regression error term. ***, **, and * Indicates statistical significance at the 1, 5, and 10% level, respectively.. Two data sources Beta is smaller than 1 here, but CAPM is not perfect, and we will make 3 further adjustments Fixing the CAPM (1) Style Adjustments (2) Liquidity Risk (3) Stale Values Style Adjustments: The Fama-French Model (FFM) R it -R ft = α + β * (R mt R ft ) + β size * SIZE t + β value * VALUE t + e it where α, β, R mt, R ft, e it are defined as in the CAPM, SIZE t and VALUE t are the returns to portfolios of stocks designed to be highly correlated with their respective investing styles, and β size and β value are the regression coefficients on these returns. These portfolios are called factors, so that the FFM is a three-factor model: a market factor, a size factor, and a value factor, and the betas are known as factor loadings

30 Liquidity Adjustments: The Pastor-Stambaugh Model (PSM) R it -R ft = α + β * (R mt R ft ) + β size * SIZE t + β value * VALUE t + β liq * LIQ t + e it where LIQ is the new liquidity factor, β liq is its factor loading, and all other variables are defined as in the previous slide.. Stale-Value Adjustments R R *( R R ) * SIZE size vc, t ft m, t s f, t s s t s and 23 s 0 s s 0 s liq * VALUE * LIQ value s t s s t s s 0 s 0 s PASTOR-STAMBAUGH MODEL ESTIMATION FOR VC INDICES ***, **, and * Indicates statistical significance at the 1, 5, and 10% level, respectively. Market beta is now close to 2. Alpha is no longer significantly different from 0. Using both sets of estimates and taking the mid-point, r VC = 15% 0.04 (r f ) * 0.07 (Market) * (size) 0.68 * (value) * 0.05 (liquidity) = 14.1% (SHE estimates) 0.04 (r f ) * 0.07 (Market) +1.04* (size) 1.46 * (value) * 0.05 (liquidity) = 16.6% (CA estimates) We use 15% as the cost of capital for VC in the course Cost-of-Capital Estimation SHE index r i = 0.04 (risk-free rate) * 0.07 (market) 0.09 * (size) 0.68 * (value) * 0.05 (liquidity) = 14.1% CA index => 16.6% 4-12

31 Discussion True, False, or Uncertain: Early stage venture capital should earn a higher expected return than later-stage venture capital, because early stage ventures have a higher failure rate than later-stage ventures. Failure rates have nothing to do with the cost-of-capital. The cost of capital applies to expected values, and expected values already take into account the probability of failure. (NPV: DCF = expected CF/cost of capital). As an illustration, remember the Boxco and Drugco example from the chapter. Drugco has a high failure rate but also has a zero beta, so its cost of capital is equal to the riskfree rate. 4-13

32 Boom and Bust Ch 5 THE NATURE OF INDUSTRY CYCLES Cycles and Fund-Raising Cycles and Investment Levels Cycles and Investment Performance The Best VCs

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35 KPCB Returns Fund # Vintage Year Committed Net IRR Value Multiple Capital ($Millions) II III IV V VI VII VIII IX X Only $170M of Fund VII was ever drawn Demand (LP) and Supply (GP) of Investment 5-15 LPs react to strong fund performance by increasing their demand for the firm s next fund. VC firms may address the excess demand by increasing price (fees and carry) or quantity (size of the fund). Will GPs raise carry to the highest level as demand increases? a firm s (GPs) decision to limit fund size: Good investment ideas are finite. A VC s time is finite. Adding high quality professionals is difficult. will pyramid structure work? GPs share carry in the majority of carried interest from all deals 5-16

36 The Best VCs: A Subjective List top-tier firms Star funds have at least $50 million in committed capital and value multiples of five or greater superstar funds have at least $50 million in committed capital and value multiples of ten or greater. Selection criteria for the top-15 list included carry level, famous investments/exits, innovative strategy, intergenerational stability, and a subjective assessment of their reputation in the industry The Best VCs Location of top 15 - local network effects Does it matter? Yes. Hsu (2004) studies a sample of companies that receive multiple VC offers, and finds that highreputation VCs are more likely to have their offers accepted, and pay between 10 and 14 percent lower for shares than do low-reputation VCs. Group A carried interest to 30 percent superstar fund of at least $100 million in size plus another star (or better) fund. Accel Partners - Facebook Benchmark Capital Charles River Ventures (CRV) Kleiner, Perkins, Caufield & Byers (KP or KPCB) Asia and green technology Matrix Partners - China and India fund Sequoia Capital

37 Group B VC activities: VC Value-Added Alta Partners Apax Partners Austin Ventures Battery Ventures Draper, Fischer, Jurvetson New Enterprise Associates (NEA) Sevin Rosen Summit Partners Technology Crossover Ventures Investing Monitoring Exiting Monitoring: VC Value-Added Board Representation Yermack (1996): board size, Fich and Shivdasani (2006): busy boards Corporate Governance Hochberg (2005): IPO of VC-baked firms Human Resources Hellmann and Puri (2002): reputation Matchmaking Lindsay (2002): among portfolio firms Strategy: focus on industry, stage, etc

38 Chapter 6 VC Around the World Level of Investment 40% of $84B US and UK at the top, lag in continental Europe and Asia. why? Why? Reason #1 Exits Reason #2 The Entrepreneurial Ecosystem Reason #3 Law and Corporate Governance Reason #4 Country Risk Reason #5 Cultural Differences

39 Ratio of IPOs ($thousands) to GDP ($millions) Time to start a business, in days United Kingdom Hong Kong Greece Australia Canada Australia United States United Kingdom Sw eden Canada Hong Kong Sw eden Singapore Italy Singapore United States Korea Germany Japan South Africa Korea Chile Israel Greece Spain Germany Japan Argentina France Egypt Indonesia Venezuela South Africa Egypt France Russia Poland Italy Brazil India Mexico Argentina India Chile Israel Mexico Brazil Spain Bolivia China Venezuela Indonesia Index of protections against self-dealing (tunneling, investor expropriation) Singapore Hong Kong United Kingdom France South Africa Australia China Israel Indonesia United States Canada Chile India Egypt Japan Russia Korea Argentina Poland Italy Spain Sw eden Brazil Germany Greece Mexico Venezuela Bolivia Sovereign spread of dollar-denominated bonds 6% 5% 4% 3% 2% 1% 0% Russia South Africa Mexico Turkey Ukraine Brazil Venezuela Colombia Philippines Peru Argentina Ecuador 6-8

40 Entrepreneurial self-confidence (do you have the knowledge, skill, and experience to start a new business?) New Zealand Hungary United States Argentina Canada India Singapore Poland Germany Portugal Denmark Italy Finland Russia Israel Korea Sweden Japan AVERAGE 0% 10% 20% 30% 40% 50% 60% 70% 6-9 Discussion True, False, or Uncertain: Countries with common-law based legal system have relatively weak protections against investor protection (than civil-law based system)

41 LLH 8: The Globalization of Venture Capital and Private Equity THE EUROPEAN PRIVATE EQUITY CYCLE Fund-Raising Investing Exiting PRIVATE EQUITY IN THE DEVELOPED MARKETS Historical Experience The Industry Since 2000 Germany Why These Differences?

42 LLH 8: The Globalization of Venture Capital and Private Equity OTHER DEVELOPED PRIVATE EQUITY MARKETS Canadian Private Equity Israel: The Silicon Wadi Private Equity Down Under Japan LLH 8: The Globalization of Venture Capital and Private Equity PRIVATE EQUITY IN EMERGING MARKETS Emerging Market Private Equity in the Past Emerging Markets: Private Equity Since 2000 Private Equity Markets in Other Countries China India Africa Middle East and North Africa (MENA) Central and Eastern Europe (CEE) Argentina: Cry for Private Equity Brazil Russia

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44 LLH 8: The Globalization of Venture Capital and Private Equity THE EMERGING MARKET PRIVATE EQUITY CYCLE Investments Deal Identification and Due Diligence Deal Structuring Pricing Exits 6-27