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Lecture 2: Venture Capital and Private Equity

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Investments in private and public companies consisting of equity that is not ... Limits to adding less experienced new GPs. Forfeit of share of profits when GP leaves. ... – PowerPoint PPT presentation

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Title: Lecture 2: Venture Capital and Private Equity


1
Lecture 2 Venture Capital and Private Equity
2
Structure of Lecture
  • Defining PE.
  • Why PE investing?
  • PE and VC Funds
  • Types.
  • Operations.
  • Alignment of interests.
  • The VC cycle and process.

3
Turning
into
4
Defining P/E and V/C
  • Private Equity
  • Investments in private and public companies
    consisting of equity that is not quoted on any
    public / official stock exchange.
  • Venture Capital
  • Investments that are made to finance new
    businesses, early developments or expansion.

5
PE in the Investment Hierarchy
Alternative Investments
Traditional Investments
Cash
Bonds
Listed equities
6
PE vs. Public Equity Investments
Private Public
Liquidity Low High
Investment horizons Long Short to medium
Active involvement Often Rarely
Market efficiency Low High
Results published No Yes
Regulatory oversight Low High
7
Size of investment universe.
of Unlisted Companies
of Listed Companies
  • Companies listed on JSE 500.
  • SA Businesses of all sizes many 10,000s?
  • By , not of economy.

8
Drivers of Investment in PE
  • PE ? higher risk, higher return.
  • Portfolio investing ? risk reduction per
    individual investment.
  • Reduces required rate of return for investing in
    risky assets.
  • Flow of funds to private equity ? growth of
    international and small cap PE markets (US and
    Europe).

9
Getting in at the bottom
  • Companies with greatest growth potential often
    not listed (not corporates).

Track Record
Profits
IPO / listing
Time
S-Curve
10
SA Private Equity in Context
USA
SA
UK
Source 2004 KPMG / SAVCA PE Survey (2002 data)
11
Reasons for Investing in PE
  • Diversification.
  • Higher returns possible.
  • Active investment - unlocking of value.
  • Inefficient market and undervaluation.
  • Other
  • Economic growth, empowerment etc.

12
Investing in a PE Fund
  • Long time horizons.
  • Risk-return profile and risk tolerance.
  • Correlations between funds and listed equities.
  • Intra-Fund correlations.
  • Choosing high quality funds (with good underlying
    investments, monitoring systems and structures).
  • Track records.
  • Diversification across funds.

13
US Venture Capital Partnership Returns Versus
Public Market Returns Funds Formed 1969-2001
(quarterly returns)
Database Source VentureXpert database from
Thomson Venture Economics Investment Data Source
The MoneyTree Survey by PricewaterhouseCoopers/Tho
mson Venture Economics/NVCA Overall Source
Thomson Venture Economics
14
Correlations PE Fund Sectors
15
Constraints to Institutional Investment in
Private Equity
  • Regulatory restrictions.
  • Low liquidity.
  • Lack of regulation of unlisted entities.
  • Lack of historical data.
  • Risk / return trade-off.
  • Valuation difficulties.

16
Types of PE Financing
  1. Seed Financing
  2. Startup Financing
  3. First Stage Financing.
  4. Second Stage Financing.
  5. Mezzanine Financing.
  6. Buyout Financing

V/C
Develop-ment
17
Private Equity Funds
  • Types
  • Role Players
  • Fees and Split of Returns.
  • Duration.

18
Types of Private Equity Funds
  • Independent Funds.
  • Listed, e.g., Brait, , Venfin, Cycad.
  • Unlisted e.g., Ethos (RMB), HBD.
  • Captive Funds.
  • E.g., Investec, Nedbank Corp. PE.
  • Government Captive Funds
  • E.g., Khula, IDC, Umsombomvu etc.

19
Makalani
20
SA Venture Capital Industry
21
General Partners
  • The fund managers investment decisions and
    active involvement.
  • Marketing to both entrepreneurs / business owners
    and potential investors (limited partners).
  • Objective
  • Increase personal wealth by managing other
    peoples money in active direct investments.

22
Limited Partners
  • The passive investors.
  • In US mostly pension funds and some HNWI, in SA
    mostly corporate (captives).
  • Objectives
  • Exposure to alternative asset class.
  • Maximise returns.
  • Minimise risk.

23
Entrepreneur or Inventor
  • Owner/s or shareholders of the unlisted business,
    or generator of the business idea.
  • Objectives
  • Obtain financing for business / idea.
  • Minimise finance cost (equity sacrifice).

24
Risk Reward Structure
25
Investments, Returns and Rewards
Time 0
General Partners
Limited Partners
4
Cumulative Limited Partners Investment
2
Initial Commitment
Realisation
3
1
Time
1
2
Investment
3
4
Drawdown
26
The VC J-Curve
Returns (IRR)
Time
  • Reasons
  • Fees (2.5) regardless of performance.
  • Good managers terminate bad investments early.
  • Dogs die before winners run.

27
Fund Duration
  • Typically around 10 years.
  • Investors capital in theory locked up for that
    period.
  • Can have an extended contingency cash-out
    period.

Fund Ends
Public Equity Market
Fund starts
Contingency Extension
10 Year Fund Life
28
A typical P/E investor?
29
Conflicts of Interest
Management vs. Investment Partners.
General Partners vs. Limited Partners.
30
Owners/Managers vs. Investors
  • Information Asymmetry owners / managers
    oversell positives and downplays negatives.
  • Build this into valuation process.
  • Incentive issues once investment made,
    management make selfish operating decisions (risk
    for possible short-term gain).

31
Solutions Performance Incentives
  • Management Stock Ownership required (tie-in).
  • Equity type PE investor holds preferred stock
    and management ordinary stock (higher ranking).
  • Employment contract penalties for poor
    performance.

32
Solutions Direct Control Mechanisms
  • Board membership general partners.
  • Controlling or largest outside shareholding.
  • Contingent financing (depending on performance).
  • Other mechanisms on-going supervision,
    inspection and approval.

33
Positive Covenants
  • Contractual agreement - things the company must
    do, such as
  • Maintain insurance.
  • Audited financial statements.
  • Maintain certain ratios (working capital).

34
Negative Covenants
  • Contractual agreement - things the company may
    not do, such as
  • Limitation on dividends.
  • Not pledge assets to other lenders.
  • Cannot be acquired.
  • Cannot dispose of significant assets without
    prior approval.
  • Cannot issue additional debt or senior debt.

35
GP vs LP Overall Fund Management
  • Limit to size of investment in specific firm.
  • Why?
  • GPs may attempt to salvage poorly performing
    investment with more resources or take risky big
    bets.
  • Disproportionate gain from increasing risk at
    expense of diversification.

36
GP vs LP Overall Fund Management
  • Limits to use of debt.
  • Why?
  • GPs may attempt to increase variance of
    portfolio returns through debt (excessive
    gearing).
  • Also limits to guarantee of debt of investment
    companies (indirect borrowing).
  • Restrictions to term of debt (short-term only).

37
GP vs LP Overall Fund Management
  • Co-investments with other / earlier PE funds.
  • GPs may try to salvage investments in earlier
    funds using current fund.
  • Profit Reinvestments.
  • Fees may be based on assets under management
    incentive for GPs not to pay out.
  • But further reinvestment may benefit both
    parties approval needed.

38
GP vs LP Activities of Investors
  • Limit to GPs personal investments per portfolio
    firm.
  • GPs may devote excessive effort to their
    investments.
  • Limits to sale of partnership interests by GPs in
    specific firms.
  • Reverse of above reduces GP incentive to
    montiro and manage specific investment.

39
GP vs LP Activities of Investors
  • Restrictions to future fund raising.
  • Increases fees to GPs, but neglecting LPs
    investments.
  • Often certain of current funds invested
    before new capital may be raised.
  • Minimum time spent on investments.
  • Limits to adding less experienced new GPs.
  • Forfeit of share of profits when GP leaves.
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