Venture Capital and Private Equity

Session 2Professor Sandeep Dahiya

Georgetown University

Course Road Map

• What is Venture Capital - Introduction• VC Cycle

– Fund raising– Investing– Exiting

• Time permitting – Corporate Venture Capital (CVC)

ONSET What Happened

• Raised 100 million for ONSET III• Has raised 7 funds to date inclusing a

$200 million fund in 2004!• Now has over $1 billion in assets

under management (Seed Stage???)• We will return to TallyUp later in the

course

Quick Overview of Venture Capital

Institutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement) Portfolio Company 1

Portfolio Company 2

Portfolio Company 3

…

€ € €

Advice

€+

Advice

Concerns for LPsInstitutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

VC FUND(Partnership Agreement)

€ € €

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

•Restrictions on size of fund, size and type of investment, and use of debt•Restrictions on co-investments with earlier funds•Pre Agreed “Take Down” Schedule – will give money when “Capital Calls” are made•Fund Life restricted to 10 years (may be extended by additional 2 years)•Compensation Structure of GP!

•Restrictions on size of fund, size and type of investment, and use of debt•Restrictions on co-investments with earlier funds•Pre Agreed “Take Down” Schedule – will give money when “Capital Calls” are made•Fund Life restricted to 10 years (may be extended by additional 2 years)•Compensation Structure of GP!

Compensation of VCs

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement)

Advice

•How do GPs get compensated?

VC Fund Management Company

Carried Interest (20% of Profits)•Reputation•Signal

Management Fee (2% of Committed Capital)

Exit and DistributionInstitutional Investors (Pension Funds/ Endowments etc)

Fund of Funds (FOF)

Individual Investors Family Offices

Limited Partner

s(LP)

Limited Partner

s(LP)

General Partner

(GP)

General Partner

(GP)

VC Fund Management Company

VC FUND(Partnership Agreement) Portfolio Company 1

Portfolio Company 2

Portfolio Company 3

…

€ € €

Advice

€+

Advice

€

€

ONSET Ventures

Fund Name Vintage Year Committed IRR Capital Fund LP

ONSET 1984 $5M

ONSET I1989 $30M 26.30% 21.72%

ONSET II 1994 $67M 15.49% 11.69%

ONSET III 1997 $100M

Review of Important Terms

• VC firm• General partner (GP)• VC fund• Limited partner (LP) • Capital call = drawdown = takedown• Committed capital• Early-stage fund, late-stage fund, multi-stage

fund• Vintage year• Management Fees• Carried interest

Some Basics

• How is return of a fund measured?• Consider a fund that raised 100 million – Drew down 50

million at start of year 1 and Year 2. Distributed 100 million at the end of year 7 and 80 million at the end of year 10.

-50

0 1 2 3 4 5 6 7 8 9 10

-50 100 80

IRR=7.87%

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

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

Basics of Fund Performance

• Simple calculations have ignored fees/expenses to be paid

• We shall see a more realistic example in Key Ventures

Key Ventures• Size is $250 million, life 10 years• Management Fee 2% collected at start of

each year. (2%x250 = 5 million each year)• Lifetime fees = 10x5=50 million• Investment Capital = 250-10x5= 200 • Assume 4 equal take downs (200/4=50)• Assume gross return is 25%• 10% of portfolio value is distributed every

year starting in Year 4 (end of year).• No carry till the entire 250 million is returned

to investors

Year 0 1 2 3 4 5Management Fee 5 5 5 5 5 5Investment 50.00 50.00 50.00 50.00 0.0Estimated Portfolio Value 50.0 112.5 190.6 288.3

0.0360.4 405.4

Distributions 0.0 0.0 0.0 0.0 36.0 40.5Cumulative Distributions 76.6Distribution to Key

Cumulative Distributions to Key

36.00.00.0

0.00.0

Distribution to LPs 40.5Cumulative Distributions to LPs

0.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.0

36.036.0 76.6

Portfolio value after capital returned 50.0 112.5 190.6 324.3 364.9Contributed Capital 55.0 110.0 165.0

288.3220.0 225.0 230.0

Invested Capital 50.0 100.0 150.0 200.0 200.0 200.0Cash Flow to Key Ventures

NPV for Key Ventures 82Cash Flow to LPs

5.0 5.0 5.0 5.0 5.0

-55.00 -55.00 -55.00 -55.00

5.0

31.04 35.54

100

95

0.0649.464.9

296.19.29.2

55.7286.9584.4250.0200.0

14.2

50.71

0.0730.5730.5

1026.7146.1155.3584.4871.3

0.0250.0200.0

146.1

584.43

65

0.0456.1

45.6122.2

0.00.0

45.6122.2410.5235.0200.0

5.0

40.61

What effect would having a 25% carry but management fee only for the first 4 years have?

Key Ventures

A Clear Philosophy

• Focus on Equities--public or private.• Avoiding market timing.• Focus on inefficient markets.• Pick investment managers rather

than investments.• Focus on incentives.

An Unconventional Mix

Yale Peers All UniversitiesBonds 4% 16% 22%Public equities: Domestic 12% 25% 46% Foreign 15% 17% 13%Private equity 16% 9% 2%Real estate 28% 11% 4%"Absolute return" 23% 20% 9%

Strong Track Record

• 15 year return of 14.2%:– 2.7% above S&P 500– 4.3% above all universities.

Private Equity is an Important Element

• Investor since 1973.• Repeated investments in

partnerships formed by a select group of organizations.

• Emphasis on value-added strategies.• Focus on incentives.

Spectacular Success in Private Equity

• 31% over 29 years--well above benchmarks.

• Success in venture capital, buyouts, and oil & gas.

• Prestige investor.

But Worries About Future

• Recent fund influx:– Private pension funds in 1980s.– Public pension funds in 1990s.– Private equity pool--from $4B in 1980 to

~$300B in 2004.– “Virtual overhang.”

Private Equity Fundraising

0

25

50

75

100

125

150

OtherBuyoutVenture

Billions of 2002 $s Source: Venture Economics and Asset Alternatives.

Private Equity Returns

-25%

0%

25%

50%

75%

100%

125%

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Source: Venture Economics

Venture Capital

Buyouts

Mixture of Funding Sources

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Others

Individuals/families

Endowments/foundations

Banking/insurance

Pension funds

Implications of Fund Influx

• Alteration in incentives.• Relaxation of covenants.• Concerns about within-fund

compensation.• Quality of deals.

But ...

• Good returns during last fund influx.• Inter-quartile spreads:

– 3% in public equities.– 12% in private equity.

• Private equity small relative to potential: $1:$30.

But…. (2)

• Ways to manage risks:– Top down: Optimizer.

• Drove decision to undertake major hedging effort in 1999.

– Bottom up: What—in Swensen’s team’s judgment—are the interesting areas going forward?

• Swensen: Must use both approaches!– Need for communication and trust with

Investment Committee.

Challenge of Internationalization

• 10% of Yale’s private equity, mostly Europe.

• Poorer returns.• Organizational worries and

difficulties of assessment.• Who to back?

Swensen’s Dilemma

• Is private equity still viable for Yale?– If so, where?– If not, what other asset classes should

they pursue?

• How far can it go in pursuit of returns?

• How dangerous is it to be different?

Yale Investment Office 2006

• Domestic Equity 12%, Bonds 4%!!!• Private Equity 17%• Real Assets 27%• Beat S&P500 in every year since

2002 by Wide mragins!! Endowment size $18 billion