Private Equity Lecture 3: Selection & monitoring of investments

Transcription

1 MSc in Investment Management Private Equity Lecture 3: Selection & monitoring of investments Course leader: Prof. Robert Cressy 1 Learning objectives To become familiar with a significant real-world US venture capital company s stated characteristics, investment philosophy and criteria and the firm s application requirements To be able compare these with the statistics from the Venture Economics database To become familiar with the format required from VCs and with ways of avoiding early rejection of an application for funds 2 1

2 Structure of the lecture Investment selection in the course will be examined from two perspectives The practitioner perspective The research perspective Today s lecture: Practitioner: Case study of investment selection: Mobius Venture Capital Research: Theoretical and empirical research on investment criteria & monitoring 3 1/ Case study of VC investment selection: Mobius venture capital Mobius background Location California, USA Other offices Massachusetts Colorado Age About 6 years Founded 1996 Legal status Formerly subsidiary Now independent 4 2

3 Case cont d Fund type Size Private equity firm investing own capital Capital under management $2.8 billion Membership affiliation Member of the National Venture Capital Association (NVCA) (see Executives Backgrounds Ages Qualifications 5 Case cont d Track record (see Table 1) Total # companies invested in over the last 6 years 208 Total number of investments ditto 324 Investment outcomes(see Chart 1) Non-exited investments Privately held 68% Exits IPOs 10% Trade sales 14% Defunct 0.5% Bankrupt 0.5% 6 3

4 Chart 1 How good is your VC? Investment outcomes for Mobius Mobius venture capital investment outcomes, Percent of companies Bankrupt In registration Defunct Went public Acquired Privately held Outcome type 7 Note that the majority (68%) of investments are still privately held Only a minority (25%) have exited successfully A very tiny minority have failed completely One reason for the failure to cash in is timing the majority of investments were made in the last three years (see Chart 4) The IPO market dried up about 2 years ago This is the preferred exit route for US VCs 8 4

5 Chart 2: Explanation? Mobius vintage breakdown Chart 4: Mobius vintage breakdown Percentage of investments Noteworthy from Chart 2 is the fact that half of the current portfolio of investments Mobius made were done in one year, the fateful year millenium. Given the industry structure of their investments (see later) this makes them rather vulnerable in the face of the downturn 10 5

6 Investment philosophy Case cont d We strive to add experience and expertise to invention in order to bring brilliant ideas to the technology marketplace We continue to build companies of lasting value (from the Mobius website) 11 Current investment criteria Private companies only Stage of involvement Focus on Early stage Case cont d Later stage also considered Speed and degree of involvement 2/3 of investments Mobius claim to be the first venture money in the deal Generally the lead investor I.e. has the biggest stake Minimum equity stake: 20% Size of investment Early stage: Typically $2-5m Later stage: Typically $50-100m 12 6

7 Case cont d Industrial focus Communications Infrastructure Professional services Enterprise applications Emerging technologies Components Healthcare informatics Geographical focus California (65%) Ex-California US West of Colorado (20%) New York, Washington DC and Boston (15%) Other restrictions Must be US companies I.e. Head Office in the US Funding process (see website: 13 Chart 2: Mobius industry breakdown Chart 2: Industry breakdown of Mobius investments, Percent of companies Internet Specific Computer Software Communications and Media Financial Services Consumer Related Semiconductors/Other Elect. Computer Hardware Business Serv. Computer Other Other Transportation Biotechnology 14 7

8 The most obvious thing about this chart is the extreme dependence of Mobius portfolio on Internet investments (almost 2/3!) This has had major implications for its current performance 15 Chart 3: Mobius investment stage breakdown Chart 3: Mobius Stage breakdown Percentage of investments Expansion Early Stage Other/Unknown Later Stage Startup/Seed Buyout/Acquisition 16 8

9 Noteworthy in Chart 3 is the fact that the majority (half) of Mobius investments are in fact not in Early stage (seed and startup account for about 17%) but at the Expansion stage (47%) This seems at odds with their website statements! 17 Making the application Information required from applicants Executive summary (<2 pages) Business plan (<30 pages) Resumes of key personnel (1 page each) Financial projections (realistic + assumptions) 18 9

10 Case cont d Capitalisation table Current ownership Number of shares Percentages to various groups Tips for successful application Online application form Company information Name Address Contact details Business information Date founded Elevator pitch What does the company do? (max 500 words) 19 Case cont d Product or service Market overview Who does the company sell to? Through what channels? How big is the addressable market? Revenue model (<250 characters) How does it intend to make money? (Its profit formula ) Customer/Partner overview What key customer or partner relationships do you have? (<750 characters) Management Team and Board of Directors/Advisors Describe the positions, background and expertise of the key personnel. (For each person enter name, role, past companies, years in the industry (<1000 characters).) 20 10

11 Case cont d Industry/competition Describe the industry, your competitors and how your solutions differ from theirs (<1000 characters) Synergies with the portfolio Describe how you company might fit with existing Mobius portfolio companies (<500 characters) Product development Stage Industry Funding information $ seeking Total financing sought now $ Pre-Money valuation 21 Planned use of funding Case cont d How do you plan to use the funding for this round? How long will it last? Prior funding history Describe how much money the company has raised to date, when, and from whom 22 11

12 Avoiding early rejection Common reasons for rejection Conflict with existing portfolio Cannibalisation competing products/services Diversification imbalance towards a particular area Capacity restrictions Insufficient expertise: product/service lies outside current technology focus Current geographical focus Appropriate managing director is fully occupied with other deals at present 23 2/ Research on investment selection & monitoring Kaplan and Stromberg(2000) Nature of the study: Empirical analysis of VC partnership What investment criteria do VCs use? How do these investments perform? Sample Objects sampled VCs, investments and companies Country in which VCs and firms located: USA Period of study:

13 Criteria contd Data Investment memoranda from 10 American VC partnerships An investment memorandum is a document that a VC considering an investment will complete as a record of his/her decision These memoranda cover 58 investments in 42 portfolio companies Hence 1-2 investments per company Thus some are follow-on investments, I.e. additional funds provided by a VC to the same company They collect additional information on investee companies: Business plans of the founders Pre- and post-investment performance of the companies 25 Criteria contd Analysis The analysis encompasses venture capitalists Pre-investment behaviour Data collection What kind of information do they ask for? Selection procedure What criteria do they in fact use to select their investments? Post-investment behaviour Monitoring How, how often, in what detail? Control 26 13

14 2/ Descriptive statistics About equal proportions of investments were in companies that were Not yet operating i.e. pre- revenue Already operating i.e. post-revenue The median amount of VC funding was measured: Committed funding, i.e. funds agreed but subject to milestones Median amount: $7.9m per firm Funding disbursed i.e. funds paid out to date Median amount: $5m per firm 27 Descriptives contd Outcomes at mid-2000 for the investee companies: Still privately held (67%) Gone public (24%) Trade sale (7%) Liquidated (2%) Thus 31% had either been profitably sold off or gone public in 5 years or less 28 14

15 Note that: This is a higher percentage than the VC industry average Suggests that the VCs were of above average ability More established companies in the industry Not a random sample! The study was done in before the slump in the technology sector Hence the outcomes for this reason would be expected to be more favourable than for Mobius examined earlier However, the main difference from Mobius is that there is a higher percentage of 29 3/ Analyses performed by VCs Prior analyses by VCs on investments Five types of analyses were done in over 80% of the investments (see Chart 1) Why do the investment? Investment thesis or rationale How good is the management team of the company? The management How risky or uncertain is the project? Risk/uncertainty What is the quality of the market opportunity presented? The market How strong is the competition? The competition 30 15

16 Chart 1: VC investment analyses Chart 1: Types of investment analyses done by VCs % of companies analysed Investment thesis Management Risks/uncertainties Market Competition Analysis type Exit Customers/Adoption Financial projections Technology 31 Analyses contd Other very important analyses done in about 2/3 of cases answered the question Is there an exit route (way of cashing in) for the investor? Exit What is the likely rate of customer adoption of the firm s product or service? Adoption 32 16

17 Analyses cont d Only about half of investments were subjected to analysis of: Financial projections of the company Technology of the product In particular only 40% of firms financial projections were analysed This suggests limited reliance on such items Perhaps demand and cost projections are highly subjective But VCs were interested in the qualitative issue of whether there was a market for the product/service 33 Other confirmatory work This meshes well with the paper by Sahlman (1999) on Writing a great business plan He argues that less emphasis should be placed in writing a business plan on financial projections with more emphasis on the investment thesis management market etc

18 4/ Selection criteria Investment rationale There were a number of reasons why a particular investment prospect for the VC was judged attractive and/or subject to risk or concern 1. The opportunity Market size or growth potential Attractive: Large market/potential Risk/concern: The converse Business or strategy model of the entrepreneur Attractive: Good approach Risk/concern: Bad/can t be implemented The business competitive position Attractive: few competitors Risk/concern: entry etc. 35 Opportunity contd Likelihood of customer adoption Attractive: High likelihood Risk/concern: Low likelihood/rejection The product or technology Attractive: appealing product/technology Risk/concern: fails scientific tests e.g. clinical trials 36 18

19 Chart 2: Attractions of the opportunity Chart 2: The Opportunity % of respondents quoting reason Any of the following Large market size and growth Attractive business strategy/model Favourable competitive position High likelihood of customer adoption Attractive product and/or technology Explicit reason for choosing particular VC investment 37 Chart 3: Risk associated with opportunity Chart 3: Risks & uncertainties in VC investment - The opportunity % of respondents quoting particular risk factor Any of the following Risks in business/strategy model Risky compeititive position Uncertain market size and growth Uncertain product or technology Uncertain customer adoption Type of risk considered 38 19

20 Management team 2. The management team Quality of management Attractions: Strong management (2/3 cases) Risk/concern : weak/incomplete team Favourable performance to date Attractive: Had done well (1/4 cases) Risk/concern: Prospects less optimistic 39 Chart 4: Attractions of the management Chart 4: Management: Quality and previous experience % of respondents quoting reason Any of the following Quality of management Favourable performance to date Reason for choosing particular VC investment 40 20

21 Chart 5: Risk associated with management Chart 5: Risk and uncertainty in VC investment - Management % of respondents quoting type of risk Any of the following Quality of management Questionable performance to date Type of risk 41 Deal terms 3. The Deal terms Contractual structure limiting risk Attractive: limits risk Risk/concern: converse Fit with the VC s portfolio Attractive: good fit, e.g. requires similar skills Risk/concern: converse Price of the investment Attractive: bargain Risks/concern: overpriced Positive influence on other investors Attractive: Others might participate (more expertise available) Risk/concerns: they may not (less expertise available) 42 21

22 Chart 6: Attractions of the deal Chart 6: Deal terms % of respondents quoting reason Any of the following Contractual structure that limits risk Good fit in the VC investment portfolio Explicit reason for choosing particular VC investment Low valuation (I.e. a bargain) Positive influence of other investors 43 Chart 7: Risk associated with the deal Chart 7: Risks & uncertainties in VC investment - The deal terms % of respondents quoting type of risk Any of the following Costly to monitor investment High valuation (I.e. paying too much) Contractual structure and downside risk Negative influence of other investors Type of risk 44 22

23 5/ Sources of information Where do VCs get their information? VCs are required by Investors to carry out due diligence on investee companies This is a detailed investigation of the quality of the proposal The purpose of DD is to protect investors money Areas covered include: The market for the product or service Technology of the product Customer adoption rates Competitor analysis Financial projections 45 Diligence cont d Due diligence sources identified in the KS study include: Other VC portfolio companies Hired independent research/consulting firms Existing industry surveys Interviews with potential customers/industry participants Internal VC company estimates Experts on technology 46 23

24 Market analyses Market size (N=32) Median $6.5bn Min $0.06bn Max $151bn Degree of optimism Strong 64% Not strong 29% No analysis 7% 6/ Analyses 47 Technology analyses Analyses contd Degree of optimism concerning technology: Strong (no/low risk) 17% Not strong (med/high risk) 26% No analysis 57% Of which: Non-technological venture 53% Total 100% 48 24

25 Analyses contd Customer/adoption analyses Degree of adoption concern: Small 36% Strong/some 26% No analysis 38% Total 100% 49 Competitor analyses Analyses contd Degree of competitive concern Small 40% Strong/some 48% No analysis 12% Total 100% 50 25

26 Analyses contd Management team analyses Strong 41% Neutral 50% Weak 7% No analysis 2% Total 100% 51 Financial projections Financial projections were made for half (20) of the 42 companies 14 projections contain both sales and EBIT 4-year sales growth: median $0.2m to $63m 4-year EBIT growth: median -$0.2m to $6m Exit strategies Exit route IPO preferred (78% cases) Trade sale (22% cases) Expected time to exit: 3 years from date of investment 52 26

27 Analyses & contractual terms Regressions (OLS or Probit, dependent variable in italics) Pre-investment value of company Significant variables Competition weak (-) Comments: less competition the higher the company s monopoly power Hence it can charge the VC a higher price for equity Commitment to staged investment Significant variables Market size risk(+) Competition weak (+) 53 Analyses cont d Regressions cont d Contingent contracting Strong management(-) Management risk (+) VC cash flow rights (% in best case) Competition risk (-) Management risk (+) Change in entrepreneur s compensation % Market size risk (+) Competition risk (+) Management risk (+) 54 27

28 VC voting control Competition risk (+) VC board control Competition risk(-) Management risk(+) Analyses cont d 55 Analyses & performance Performance is measured by Probability of going public (doing an IPO) by a specific cutoff date Potential bias Not all firms outcomes will have been observed by the cutoff date Some investments will IPO but need longer time But these are coded as zeros (non-ipos) If all firms received their first investment at the same time the bias would be eliminated However, since they do not, a control for initial investment is required. Control used Dummy variable =1 when first investment before 1999 Better: include the time from the first investment to the cutoff 56 28

29 Bivariate results Performance contd Management & performance A firm with strong management assessment is three times more likely to go public than one with a weak assessment: Pr(IPO strong)=35% Pr(IPO weak)=13% Markets & performance There is no difference in the performance of firms with attractive rather than unattractive markets Conclusions People factors have better predictive power than market factors 57 Regression Probit regression: Performance contd Pr(IPO by 31/7/00 Analysis variables) Results Significant variables Strong management (+) High risk strategy (-) Weak competition (-) Comment Both strong management and high risk strategy are meaningful Weak competition is counterintuitive 58 29

30 Relationship of criteria to performance VCs play a role in shaping/recruiting the management team Before the investment VC involved in 14% of cases After the investment VC involved in 50% of cases VC role in team-building influences The form of the financial contract The subsequent performance of the firm 59 30