Yale University Investments Office Professor Sandeep Dahiya Georgetown University

Road Map Last Class –VC Fund structure introduction (Fixed Life, GP, LP, compensation etc.) –What do VCs do –VC Cycle Today’s Class –View of a prominent LP –Role of VC investments in Broader portfolio management of LPs –Trends in Private Equity Tomorrow’s Class –ACCEL VII CASE HOME WORK –Start on VC method of Valuation

ONSET Ventures What Happened?

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? How does the VC get paid? What about funds that are only a few years old? Multiple 1.8x What if 100 was distributed at the end of Year 5 instead of Year 7?

Yale Investment Office Some Background Facts –How and why is the endowment important for Yale? –How has the Investment Office done under Swensen?

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.

Asset Allocation at Yale YALEPEERSALLYALEPEERSALL Domestic Equity Foreign Equity Bonds Cash Real Assets Private Equity Absolute Return

Asset Allocation at Yale YALEPEERSALLYALEPEERSALL Domestic Equity Foreign Equity Bonds Cash Real Assets Private Equity Absolute Return

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

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 margins!! Endowment size $18 billion

How Are VCs Compensated? Management Fee – (Little risk) –Like Salary –What are the incentives' for GP? –Why 2% (Usually) of “Committed Capital” Carried Interest – (Performance Based) –Like bonus –How to measure performance? –Can this cause problems? Let us look at an example

Key Ventures Size is $250 million, life 10 years Management Fee 2% collected at start of each year. (2%x250 = 5 million each year) 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 Key Ventures What effect would having a 25% carry but management fee only for the first 4 years have? Year 8 Cum Distribution = Year 9 first 18.8 ( ) go to LPs Rest 46.1 ( ) shared 80/20

Key Ventures – Full Analysis