Venture Capital and Private Equity Session 2

1. Venture Capital and Private Equity Session 2 Professor Sandeep Dahiya Georgetown University

2. This Course • No easy answers – Boot Camp (Up to 100+pages of reading before class!!) • Main Perspective • Key aspects and practices of industry • How these key features are a response to the difficult environment • Constant comparison of the US and European experience

3. Investing Capital Exit and returning capital Fund raising We will follow the “Venture Capital Cycle”

4. Course Road Map • What is Venture Capital - Introduction • VC Cycle • Fund raising • Investing • Exiting • Time permitting – Corporate Venture Capital (CVC)

5. Some Important Terms VC firm general partner (GP) VC fund limited partner (LP) committed capital early-stage, mid-stage, late-stage fund, multi-stage fund raised, closed vintage year capital call = drawdown = takedown

6. Quick Overview of Venture Capital Institutional Investors (Pension Funds/ Endowments etc) Fund of Funds (FOF) Individual Investors Family Offices Limited Partners (LP) € € € VC FUND (Partnership Agreement) Advice VC Fund Management Company Portfolio Company 1 General Partner (GP) € Portfolio Company 2 + Advice Portfolio Company 3 …

7. Concerns for LPs Institutional Investors (Pension Funds/ Endowments etc) Fund of Funds (FOF) Individual Investors Family Offices Limited Partners (LP) € € € • Hand over money for 10 years – No control once committed!!! • Hard to get out mid-way VC FUND (Partnership Agreement) • 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!

8. Compensation of VCs Management Fee (2% of Committed Capital) • How do GPs get compensated? • Carried Interest (20% of Profits) • Reputation • Signal VC FUND (Partnership Agreement) Advice VC Fund Management Company General Partner (GP)

9. Exit and Distribution Institutional Investors (Pension Funds/ Endowments etc) Fund of Funds (FOF) Individual Investors Family Offices Limited Partners (LP) € € € VC FUND (Partnership Agreement) € Advice VC Fund Management Company Portfolio Company 1 General Partner (GP) € Portfolio Company 2 + € Advice Portfolio Company 3 …

10. Who are the LPs? Historically, just under half of all committed capital comes from pension funds. The next two largest groups are financial institutions and endowments/foundations, each with about 1/6 of the total. Individuals/families and corporations make up the remainder, and are more fickle than the other types.

11. Fund Raising Process Private Placement Memorandum 1. Executive summary 2. Firm and Fund investment philosophy 3. Investment Professionals and Advisory Committee 4. Summary of GP/LP terms and agreements 5. Investment track record and prior fund performance 6. Legal and tax matters 7. Inherent related investment risks 8. Accounting and reporting standards

12. Time Line For Fund Raising FUND VINTAGE YEAR 2000 1997 Announcement – Plans to raise a $100 Million Fund 1998 Commitments of $25 Million 1999 Commitments of $75 Million 2000 First Investment of $15 Million Fund CLOSING YEAR

13. Time Line Investment and Distribution Final Year 2009 2000 Total investment $15 Million PLUS 2 Million for Management fees 2001 Investment of of $65 Million PLUS 2 Million for Management fees 2008 Distribution of $120 Million Still $ 2 Million for Management fees 2009 Distribution of $160 Million Still $ 2 Million for Management fees Capital Call/ Draw Down Of $17 Million

14. The key terms in VC partnership agreement Compensation structure Management fees Carried interest Covenants Activities of the fund Activities of the individual General Partners

15. Fees: definitions Annual management Fees Level: Basis: committed capital or net invested capital lifetime fees = The total amount of fees paid over the lifetime of a fund investment capital = committed capital - lifetime fees invested capital = cost basis for the investment capital of the fund that has already been deployed at a given point Net invested capital = invested capital - cost basis of all exited and written-off investments

16. Example ABC Ventures has raised their $100M fund, ABC Ventures I, with management fees computed based on committed capital. These fees are 2 percent per year in the first five years of the fund, then fall by 25 basis points per year in each of the subsequent five years. The fees will be paid quarterly, with equal installments within each year. Problem Given this description, what are the lifetime fees and investment capital for this fund?

17. ABC Ventures

18. Carried Interest: definition Definition: % of the realized fund profit, defined as cumulative distributions in excess of carry basis, that gets paid to GPs Level Basis: committed capital or investment capital Timing Priority return Catch-up Claw back

19. Carried interest Contributed capital = invested capital + management fees that have been paid to date For a fully-invested and completed fund, contributed capital = investment capital + lifetime fees = committed capital Carried interest timing Return all call carry basis (committed or investment capital) first (25%) Return all contributed (or invested) capital plus priority return first (45%) Return only part of contributed/invested capital Often distinguishes between realized and unrealized investments Fair value test (14%) Other (16% of sample)

20. ONSET Ventures PAGE 20-21 Fund NameVintage YearCommittedIRR CapitalFundLP ONSET 1984 $5M ONSET I 1989 $30M 26.30% 21.72% ONSET II 1994 $67M 15.49% 11.69% ONSET III 1997 $100M

21. Return Definitions (1) Internal rate of return (IRR) = a rate of return that implies an NPV of 0 for a given cash flow stream Value multiple (TVPI)*= Total Value Paid In= investment multiple = multiple of money = Value multiple = Realized Value multiple = Unrealized value multiple = (IKV)

22. 5 steps to calculating value multiples There are 3 components that contribute to value multiples: Total (cumulative) distributions to LPs, value of unrealized investments, and contributed capital. • Calculate distributions to LPs each year. • Distributions to LPs = total distributions - carry • Sum them to date to get total distributions to LPs • Get value of unrealized investments (after exits) = portfolio value (before exits) - total exits in year t. This is an estimate value of illiquid investments and not a market/transaction value. • Calculate contributed capital = invested capital + fees to date. • Calculate

23. 5 steps to calculating IRRs for LPs As LPs, there are 3 components that contribute to your net cash flows: fees, new investments, and distributions. • Calculate fees • Calculate distributions to LPs • Distributions to LPs = total distributions - carry • Calculate net cash flows = Distributions to LPs - new investments - fees • For the IRR of a fund that is T years into its life and is still alive, the value of unrealized (i.e., remaining) investments at the end of year T is counted as if it is a positive cash flow. This is an estimate value of illiquid investments and not a market/transaction value. • Cash flow if final year of IRR calculations = Distributions to LPs - new investments - fees + portfolio value of remaining unrealized investments • IRR(year 1,…, year X) = IRR(CF1, …, CFT)

24. The IRR is not perfect • Cannot be compared to time-weighted returns • Compounding of periodic returns • Realized vs. unrealized investments • Difficult to make risk adjustments

25. Management Fee Management Fee 2 2 2 2 2 2 88 Investments Investments 20 20 20 20 20 20 Carrying Value Plus some distributions (some possible at this stage) Carrying Value And/or distributions ( very rare at this stage) 40 176 Cash Flows to LPs Cash Flows to LPs -22 -22 18 -22 -22 154 Committed Capital 100 Management Fee 2% Year 1 2 3 4 5 6 7 8 9 10 Management Fee 2 2 2 2 2 2 2 2 2 2 Investments 20 20 20 20 Remaining Value plus distributions 40 40 40 40 40 200 Cash Flows to LPs -22 -22 -22 -22 38 38 38 38 38 198 Performance Committed Capital 100 Management Fee 2% Year 1 2 3 4 5 6 7 8 9 10 Notice it was not paid out IRR -18.2% Multiple 0.90 x (40/44) Committed Capital 100 Management Fee 2% Year 1 2 3 4 5 6 7 8 9 10 IRR 49% Multiple 2.0 x IRR 30% Multiple 4.0 x

26. Example of a J-curve

27. 0 1 2 3 4 5 6 7 8 9 10 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 -50 100 80 IRR=7.87% Multiple 1.8x What if 100 was distributed at the end of Year 5 instead of Year 7? • What is distribution? • What is the IRR when the Fund was 4 years old? • How does the VC get paid?

28. CalPERS – Performance Review of Private Equity Investments

29. VC Industry Historical Performance

30. 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

31. Basics of Fund Performance • Simple calculations have ignored fees/expenses to be paid • We shall see a more realistic example in Key Ventures

32. 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 – Carry is 20%

33. Key Ventures Year 9 296.1-250=46.1 20% of 46.1=9.2 64.9-9.2=55.7 50.00 0.0 0.0 0.0 0.0 288.3 405.4 456.1 513.1 577.2 50+112.5*(1.25) 50+50*(1.25) 0.0 0.0 0.0 0.0 40.5 45.6 51.3 57.7 0.0 0.0 0.0 0.0 76.6 122.2 173.5 231.2 0 1 2 3 4 5 6 7 8 9 10 Year 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 5 5 5 5 5 5 5 5 5 5 0 Management Fee 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 50.00 50.00 50.00 0.0 0.0 0.0 Investment 0.0 0.0 0.0 0.0 40.5 45.6 51.3 57.7 50.0 112.5 190.6 360.4 649.4 730.5 Estimated Portfolio Value 0.0 0.0 0.0 0.0 76.6 122.2 173.5 231.2 36.0 64.9 730.5 Distributions 112.5 190.6 288.3 364.9 410.5 461.8 519.5 36.0 296.1 1026.7 Cumulative Distributions 110.0 165.0 220.0 230.0 235.0 240.0 245.0 250.0 0.0 9.2 146.1 Distribution to Key Ventures 100.0 150.0 200.0 200.0 200.0 200.0 200.0 200.0 0.0 9.2 155.3 Cumulative Distributions to Key Ventures 5.0 5.0 5.0 5.0 5.0 14.2 36.0 55.7 584.4 Distribution to LPs 36.0 286.9 871.3 Cumulative Distributions to LPs -55.00 35.54 40.61 46.31 52.72 50.71 50.0 324.3 584.4 0.0 Portfolio value after capital returned 55.0 225.0 250.0 Contributed Capital 50.0 200.0 200.0 Invested Capital 5.0 5.0 5.0 5.0 146.1 Cash Flow to Key Ventures 82 NPV for Key Ventures -55.00 -55.00 -55.00 31.04 584.43 Cash Flow to LPs 20.14% IRR for LPs

34. HOME WORK 1 • Accel VII – ANSWER ALL STUDY QUESTIONS

35. Yale University Investments Office August 2006

36. 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.

37. An Unconventional Mix

38. Picking the Pickers… Source: Yale Endowment Report 2010

39. Strong Track Record • 1980-2010 year return of 14.6%: • 4.1% above S&P 500 • 4.7% above all universities Can PE returns be compared to other asset classes?

40. 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. How easy it is to invest in top PE funds?

41. 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.”

42. Implications of fund Influx • Alteration in incentives. • Relaxation of covenants. • Concerns about within-fund compensation. • Quality of deals.

43. 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.

44. 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?

45. Yale Investment Office 2008 • Domestic Equity 10%, Bonds 4%!!! • Private Equity 20% • Real Assets 29% • Beat S&P 500 in every year since 2002 by Wide margins!! Endowment size $22.8 billion But what about 2009!

46. Future of Swensen Model • On December 16, President Levin delivered a message to Yale’s faculty and stated that : “Our best estimate of the Endowment’s value today is $17 billion, a decline of 25 percent since June 30, 2008.” President Levin’s estimate incorporated returns on marketable securities through October 31 and projections of write downs on illiquid assets. Based on marketable security returns through December 31 and illiquid asset projections, the estimated investment decline remains at 25 percent • Salary and hiring freeze instituted (Endowment had provided 37% of Yale’s operating budget in 2008!) • Context –Domestic Equity fell 30%, Foreign Equity fell 47% 2010 Yale Endowment had 8.9% return Endowment assets went up from 16.3 Billion to 16.6 Billion