Venture Capital Flashcards
Explain the Venture Capital Model and its actors.
VC in a financial intermediary between the LPs and the Entrepreneurs.
LP - limited partners
GP - general partners
Entrepreneurial company
- Investment phase: Capital contributions, GP contribution, Management fee, Equity investment.
- Return phase: Exit proceeds, Carried interest, Fund distribution.
Who are limited partners?
institutional investors whom commit money directly (Endowments, Family offices, corporates) or also themselves are on behalf of others (Pension funds, insurance companies, sovereign wealth funds (state-owned)).
They face two choices:
- Asset allocation choices.
- Choice of VC portfolio.
Which types of asset classes exist and what asset class is VC?
Asset Classes:
- Stocks
- Bonds
- Commodities
- Alternative Assets (VC, real estate, hedge funds, woodlands, Buyouts)
a. Allocation of LP into VC is typically <5% of their total assets.
b. Key characteristics: illiquid and specialized.
i. Illiquid = they don’t have a deep and thick market (like bonds and stocks). It’s difficult to sell them once you buy them.
ii. Specialized = they invest in specific risk-return configurations. This is why LPs need GPs, as intermediaries, who understand well what to invest in.
How do LPs choose their VC portfolio?
Criteria for choosing VC:
- Stability of team at Partner level
- Proposed Investment strategy
- The GPs Internal Rate of Return (IRR) on previous funds
- GP reputation
VC markets are illiquid and fragmented: periodic ‘callouts’ for funding.
Established GPs run out quickly.
Funds of funds, grants access to successful VCs but has double level of intermediation.
What are LPAs an why are they useful?
LPA – contracts that legislate the interaction between LPs and GPs.
On LPs side: Needed because LPs often can’t understand the technical work of GPs.
On GPs side: Preserve limited liability. To not be sued. LPs refrain to intervene in the fund’s management.
What is the key structure of an LPA?
Fund Structure: size, horizon, periodic “capital calls”.
Fund Rules: Investment restrictions (narrow investment strategy, no drifting), Management rules (capital distribution back to LPs: Cash or Stock. Limits to ‘recycling’ fund profits), Partner activities restrictions (cherry picking, Key Man Rule).
Compensation: 2/20 rule (2% management fee, 20% carried interest).
Timing of compensation:
o Management fee: quarterly
o Carry: at fund liquidation (‘European Waterfall’)
at each exit event (‘American Waterfall’) more common
How is the management fee taken ?
2% management fee – based on the committed capital or Invested capital. Cover operational cost.
If on investment capital, incentive to rush investing.
Common compensation agreement: 2% on committed capital in investment period, 1% on invested capital in harvest period.
Management fees also creates an incentive to raise larger funds.
How is the carried interest taken?
- Carried interest (Carry), goes back to GP: used to align interests of LPs and GPs.
Standard: 20% of profits from investment. GPs leave this amount as it is and increase the size of the pie.
Profits = exit proceeds – contributed capital – management fee
Hurdle rate (minimum acceptable rate of return) = 8% return on committed target. If they don’t achieve it, they don’t get any Carry.
How are VC firms structured ?
VC firms are professional partnerships, where profit are share by a number of senior people. Partners/principals. Often entrepreneurs themselves, participate in firms for a limited period of times.
Majority of VC use unanimity of consensus model for investment decisions.
One partner that chose the company becomes responsible for the company and is on the board of the company.
What are alternative partnership models?
Alternative partnership models:
- Evergreen funds, profits don’t go back to LP, always re-invest - rare
- Listed VC firms, difficult to value – rare
- Captive funds, owned by parent organization (bank, corporation, gov): LP owns the GP, there is no ‘going back to the market’
What are the main characteristics of VC firms strategy?
Strategy is defined at the FUND LEVEL.
Three main dimensions to the strategy:
- Specialist vs Generalist. Industry, fertile soil to new entries and disruption (technology, deregulation…)
Specialist vs Generalist - Local vs Global
Interaction with entrepreneurs
Knowledge of business environment - Early vs Late stage investing.
Different risk profiles
Early, less money, more time and mentoring
Late, more money, less time
Additional elements: deal sources (proprietary deal flow or syndication), relationship with entrepreneur
What are the main investment strategies?
- Portfolio size and structure (balanced strategy vs spray-and-pray vs highly focused)
- Timing of portfolio investments
- Risk management
On what levels can returns be computed?
- Company level returns.
Failure is endemic in the industry, left skewed.
Unrealised exits?
Challenges:
data availability, disclosure is voluntary, still opaque industry
data quality: selection biases – only good returns are reported
- VC fund level. better data.
Cash-on-cash (Ch. 4).
Annual net returns.
Public Market Equivalent (PME, was investing in VC better than indexed stock?) - LP level, after of fees, net returns to the LP.
What is the difference between gross returns and net returns when looking at fund returns?
Gross returns - from perspective of the GP fund (outflows = investment into the company, inflows = exit proceeds go back into the fund)
Net returns - from perspective of LP (outflows = capital contributions, inflows = distributions back to the LPs)
