Venture Capital and Private Equity Session 2 Professor 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 Partners (LP) Limited Partners (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 € +

Concerns for LPs Institutional Investors (Pension Funds/ Endowments etc) Fund of Funds (FOF) Individual Investors Family Offices Limited Partners (LP) Limited Partners (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 Distribution Institutional Investors (Pension Funds/ Endowments etc) Fund of Funds (FOF) Individual Investors Family Offices Limited Partners (LP) Limited Partners (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 € + € €

ONSET Ventures Fund Name Vintage Year Committed IRR Capital Fund LP ONSET1984 $5M ONSET I1989 $30M 26.30% 21.72% ONSET II1994 $67M 15.49% 11.69% ONSET III1997 $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 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 = x5= 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 Management Fee Investment Estimated Portfolio Value Distributions Cumulative Distributions 76.6 Distribution to Key Cumulative Distributions to Key Distribution to LPs 40.5 Cumulative Distributions to LPs Portfolio value after capital returned Contributed Capital Invested Capital Cash Flow to Key Ventures NPV for Key Ventures 82 Cash Flow to LPs What effect would having a 25% carry but management fee only for the first 4 years have? Key Ventures

Yale $18 billion endowment Pressures to spend money: – Declining Federal dollars. – Infrastructure. – Faculty salaries. – New Haven investment. Two bad historical bets: – Bonds in late 1930s. – Small-cap stocks in late 1960s.

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

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 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 – “Virtual overhang.”

Private Equity Fundraising

Private Equity Returns

Mixture of Funding Sources

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 – 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?

Private Equity Fundraising Outside U.S.

Alternative Strategies Real estate: – Aggressive market timing. – Willingness to back new partnerships. Oil-and-gas: – Increasing reliance on public companies because too many conflicts in partnerships.

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