Archive pour juin 2009
Comments on « The geography of successful and unsuccessful venture capital expansion»
Posté par Cyril Demaria dans Uncategorized le 24 juin 2009
As this is a working paper, and obviously open for discussion, it will probably evolve, but:
1. The paper does not analyze the pre-money valuations of companies in CSAs vs rest of the country. This could explain why investments are more profitable out of these CSAs for VCs venturing out.
The reasons of higher pre-money valuations in the CSAs are:
i) a higher level of costs locally (that would need to be sustained with national statistics on office space prices and salaries as well).
The volatility of costs in CSAs and the rest of the nation could also be analyzed to see if this explains why investing in a downturn (when resource prices are depressed) is more profitable, even in CSAs.
ii) a higher level of competition as for VCs willing to invest in a company based in a given CSA (number of term sheets issued and eventually declined could be a useful indication).
In that respect, the statement (page 24) « While branch office investments and outside investments are more likely to IPO, exit multiples are similar across main office investments, branch office investments and outside investments» . How is this substantiated that? I may have missed the data. I thought that IPO exits presented almost systematically an upside in terms of multiple of investments compared to trade sales. Otherwise, it would make no sense to go through the costly and painful process of an IPO.
2. Assuming that companies have a higher pre-money valuation in CSAs than in the rest of the country (this can be checked with the Dow Jones VentureSource database), we would then need to see what is their exit price in CSAs vs the rest of the country.
My guess is that if valuations for VC rounds can significantly change according to local conditions (i.e., belonging to a CSA or not), exit prices are valid nation-wide. Said differently, a company bought out or going public will not be priced differently if it is based in Milwaukee or San Francisco. This creates however a significant difference for the investors, as they earn the difference, of course.
3. The reputation effect of VCs, which enables them to negotiate discounts if they are highly regarded in a region versus other term sheets, is another factor which could explain the discrepancies between the VCs in a given CSA (otherwise, the effect should be homogeneous). See HSU D., What Do Entrepreneurs Pay for Venture Capital Affiliation?, 2004.
4. Another reason of the subsequent performance (which could be measured by the mortality rate of companies in a given VC portfolio located in a CSA or not), is that the screening is probably tougher for distant deal flow. Bengtsson and Ravid (2009) are rightfully quoted as for the contractual clauses which are tougher as the investor is more distant. The introduction should be more qualified, notably because the reputation effect is lower (unless the VC fund manager is known nationwide) and it is more difficult to attract co-investors in a distant investment.
5. Given the level of management fees charged (2 to 2.5% p.a.), and the costs supported by the firm, costs of visiting are not a determining factor. If you think so, maybe you could provide some hard data on this ground, because my experience is that this does not play any major role in investments decisions. Due diligences are made on-site, that’s true, but phone is the major contact medium post-investment (actually, going from San Francisco to San Jose can take as much time with the traffic than going by plane to Seattle). Onsite presence once the investment made is not so frequent – at least not enough to weight in the choice of a VC fund manager to invest or not.
If you look at the amounts of money spent in traveling for fund raising purpose (which means that there is no guarantee whatsoever of success for a given travel), that should put some perspective on traveling to monitor and investment. As for due diligence travelling, this is usually pooled with other purposes such as monitoring, networking, etc.
I hope that these comments will be useful.
What is the next venture capital frontier?
Posté par Cyril Demaria dans Uncategorized le 24 juin 2009
Reports about decreasing venture capital investments are frequent, notably in the US, but also in Europe. Even the new VC darling, clean technologies, is affected . This triggers some comments (laments?) about the situation of the economy, the backlash against private equity affecting venture capital fund managers and the lack of initial public offerings windows.
What if the problem lies elsewhere? VC investors are all chasing the same target: the Google-like homerun. The question is: will there be another? What if this was an exception?
This would suddenly open a few questions:
1. The inflation of costs in start-ups.
It’s always a surprise to see entrepreneurs coming with cash needs of 1.5 to 2 million euro for a first round of financing. Even though this could be justified on the long term, there is the option to phase an investment and only go for a first tranche. Feeling ‘rich’ liberates the entrepreneur from the restraint of saving and managing wisely. Having a cash constraint forces optimization and spending for the best of the company only. Of course, this is not very compatible with generous plans on marketing ‘investments’ and operational expenses.
However, history shows that starting and developing regularly can be beneficiary – notably because the company can learn from its mistakes. « First mover advantage» is basically a myth in that respect.
Then, most of emerging companies can fund themselves through a consulting activity, or sometimes by having employees making an income on the side. Venture capital, in that respect, is providing money to finance heavy investments in machines, labs, prototypes (capex) and should only marginally finance operational expenses (opex).
2. With strong cash needs come big valuations
This infernal circle that needs to be stopped for the sake of the venture capital industry itself. There will be a time when venture capital investors will have to understand that they cannot hold a given company in their portfolio from scratch to the final liquidity event. There will be secondary sales to the next investor, each one being specialized in a specific task. To do that, the industry needs to apply a real discipline in valuations.
3. History rarely repeats itself…:
Some investors made a substantial amount of money with early Internet start-ups. The Web 2.0 was not a revolutionary technology which necessarily required VC investments. Even if it’s useful in many respects, entrepreneurs could finance it (assuming managing costs wisely and generating side income through consulting for example) without VCs – if it was viable and money making, of course. The fact that a lot of Web 2.0 investments do not generate any significant income is, of course, a concern – and even more if they don’t have a business model.
4. … but can echoe itself:
Interestingly, the first environmental bubble went on in the 1970s. It seems that the lack of history (and philosophy) at high school in the US does not help VCs (at least the ones which did not experience the environmental boom of the 70s) to learn from the past.
Clean technologies are extremely difficult to invest in. Intricate regulations, business economics, market dynamics and a lot of technological challenges take years to be understood. Converting an IT investor in an environmental technologies investor in a few months sounds at least presomptuous. A certain lack of humility will probably show that ethanol messiahs were just preaching in a (hopefully metaphysical, and not worldwide) desert.
5. Guess number 1: the next technological revolution will come from the empowerment of individuals. This is probably why Microsoft has faced such disappointments with its Windows and Office recent versions: it goes against this trend. Vista has suddenly cut the user from the real management of the operating system, which is quite frustrating. Office is still short in helping the user to write macros without going for a full cycle of Visual Basic classes. I don’t even mention doing graphs under Excel which are not in the predefined list…
Now that the crowd has an access to basic tools, it is time to offer the possibility to gain in skills and offer the tools for that. Instead of dumbing down, it is necessary to provide tools with a real depth of functionalities which can be really adapted to each user. There is a gap between beginners tools and expert tools which has to be addressed.
6. Guess number 2: with this empowerment will come the transition from virtuality to reality
3D printers are at the moment mostly unknown from the public, just like home (biotech) labs. My guess is that sooner or later, end users will be fed up of dealing with imposed functionalities in the products they buy. They will ask for designs that they can tweak themselves and produce at home (or outsource it for complex objects). This will create a real challenge to companies, as suddenly the production part will be separated from the design and intellectual property down to the end user, which means that there will be piracy and – hopefully – open source designs.
The two guesses may be connected in many respects, as they place the individual at the center of a web of dedicated software tools connected to home production units for hardware/bioappliances. The center of this web may be a repository of semantic concepts describing the preferences and the structure of the personality of the individual.
This sounds more of a technolgical revolution than an app for an iPhone – hence an investment field for venture capitalists.
Untested and stress-free regulation for LBO managers
Posté par Cyril Demaria dans Leveraged buy-out, funds of funds, general partners, limited partners, performance le 21 juin 2009
This week was released the Obama cabinet’s plan to overhaul the American the financial regulation system. Unfortunately, private equity is not explicitly mentioned and is wraped with hedge funds for the paragraphs dealing with alternative investments. Even if hedge funds managers are protesting, some private equity players have heavily sigh and almost celebrated these measures.
Of course, it is large/mega buy-out fund managers which are the happiest. Not only there is no governmental finger pointed at them, but they just have to register as financial advisers with the SEC. If there is a wonder why, we have to remember that the Geithner’s plan involves a « public-private partnership» where TARP assets were supposed to be acquired by (hint, hint) private equity funds. Those who can buy such things are the mega and large BO fund managers who raised distressed debt funds (the same who lighted the LBO debt craze).
Unfortunately, this could have been an occasion to really set some more than needed measures. One of them is the obligation to use the services of a fund administrator. This did not prevent to have scandals, but at least, a third party is certifying that cash flows are correctly reported.
The second would be to impose a minimum of corporate governance to private equity funds and funds of funds. Among these measures, the obligation to give the names and contact details of the representants of each LP to all limited partners, so that they can directly address some concerns without the imprimatur of the general partners.
That would be a start.
The next step would be to ask the managing directors of general partners to disclose their personal wealth (including direct relatives) before each fund raising. The idea is that to align interests, general partners have to put their own money at stake. Most of them limit their commitment to 1% of the fund, but their personal wealth can make this commitment ridiculously low.
Another step would be a gradual vesting of the carried interest, with no carried for a profit below 6% and 1.2x (net) for example. Then the proportion of carried interest would grow with the marginal increase of profits. In that respect, we have to go beyond the IRR to include investment multiples in every performance evaluation.
On the long term, it is necessary to force general partners to disclose the net performance of each fund that they have managed. That does not harm their business and would put some pressure on the management fees and carried interest level. An additional element would be to require that their due diligence material is audited just like any financial statement.
« Listed private equity» only benefits its promoters
Posté par Cyril Demaria dans listed private equity le 14 juin 2009
In a study released in January 2009, four authors from the University of Basel (Switzerland) and the company LPX discuss the pertinence and aim of listed private equity (which has its own association now).
Even if published as a scientific paper on the NBER website, the paper is strongly biased in favour of listed private equity. LPX competes with S&P as regard to imposing its index on this « sector» . The underlying purpose is of course to set an index supposedly representative of private equity as an asset class and give an exposure to investors supposedly economically and effectively. As a matter of fact, Société Générale created an ETF on one of LPX’s index.
Writing a white paper is not criticizable, as it serves a double aim: explaining and selling. It’s the corporate equivalent of « advertorials» , combining advertisement and editorial. What is unfair is to publish a white paper under a « scientific umbrella» – here the University of Basel.
What is raising these concerns?
1. the authors regroup very different vehicles under « private equity company» : evergreen funds, management companies (general partners), holdings (i.e., funds + management company in one structure), funds of funds… Do they integrate SPACs (Special Purpose Acquisition Companies) in their analysis? Because that’s listed PE. They do not provide any information on that. That leads to a scientific bias from the start, as these structures are different in their purpose and financial behaviour (income streams, etc.). Even worse, the figures exclude « non surviving» companies (figure 2), meaning that the base never shrinks.
2. the authors do not address the reasons why the original owners listed their structures, which could explain why there were « waves» of listings. That could hint of the validity of investing in such structures.
3. there is a confusion about who are the potential investors in these listed structures. Are they retail investors (which are sometimes mentioned) or institutions (as it seems that the paper is trying to target)? If it is both, then the paper needs to differentiate them as they have different investment target and behaviors.
More into details:
1. Quote: ‘The typical private equity features such as investment styles, financing styles and other important characteristics are shared between the unlisted and listed private equity universe.’
That does not mean that one is worth the other:
> In the unlisted world, limited partners can negotiate the terms of their investments in funds for example, which a retail investor in a listed structure cannot.
> In the unlisted world, limited partners have a rather clear idea of what will be the fees charged by general partners/fund managers, which are rather difficult to see in a holding structure. Moreover, once set in the limited partnership agreement, they cannot be exceeded. There is no such limit for a listed holding for example.
> In the unlisted world, transparency is comparatively higher than with public structures. Limited partnerships, we have quarterly updates, with details about portfolio companies evolution, wrap up about every company in the portfolio. We also have an annual meeting and a direct access to the fund managers. Listed funds or holdings do not provide this level of details, notably for non listed companies in their portfolio, hence the discount at which they are traded (black box effect).
2. Supposedly, listed private equity offers a ‘flexible investment horizon‘ (p. 2) and ‘ highly liquidity‘ (p. 4)
This is rather untrue for the second, as the liquidity is relative to the daily exchanges, which may be rather low (notably if the floating part is small and the investor has a substantial block of shares). As for the first, we will discuss it later in this post as this is rather unclear if it is for the investor or for the listed structure.
3. Is the discount negotiated on private placement secondaries is higher than the permanent discount to net asset value to listed private equity structures? That would have been a rather good question to look at before calling listed private equity a good substitute to private structures. Indeed, some private secondaries are negotiated at a premium, and the price varies greatly depending on the maturity of the portfolio.
4. Contrary to what is stated in the paper (p. 3-4), cash management is sub-optimal in listed structures compared to private structures. As a matter of fact, limited partners/investors commit to pay over the course of five years as opportunities appear through capital calls. They can use the cash meanwhile as they wish, and get the dividends of this cash management. The distributions (long term profits, low or no taxes) are made as soon as the cash is available.
An investor in a listed structure has no choice but pay upfront for what he gets. However, there is no other distribution than annual dividends (which are heavily taxed) and the cash can sit idle in the balance sheet of the structure while waiting for another investment opportunity.
5. The tax issue is rather crucial indeed, and not addressed at all. The net return of an investor in listed structures after taxes should be rather different than the one in an unlisted structure. This is unfortunately not addressed.
6. Groundless statement (1): ‘A pioneer is identifying and researching the global listed private equity universe is Swiss-based LPX. Their listed private equity index family [... is] accepted as a reliable tool for valuation and representative benchmarks for private equity in both the academic and industry experts‘ (p. 5).
Normally here, you would expect heavy references such as (name, date) – at least, this is what they usually do in the « academic world» . But there’s none.
Now let’s stake the highlighted words:
> « reliable tool» : Really? Given the correlation of LPX indexes with the stock market indexes, I would not call that « reliable» . Unlisted private equity is partly decorrelated in terms of cycle of investments and also in terms of valuations and volatility. If the index does not reflect that, why is it reliable?
> « valuation» : Of what exactly? Underlying porftolio companies? I wonder how. A fund? The net asset value of a fund is the sum of its portfolio companies as assessed by the general partner/fund manager.
> « representative benchmark» : now, raise your hands people who have heard of LPX out of Switzerland. The real « benchmark» if there would be one, is Thomson Venturexpert categories. And they are far from being perfect: incomplete (partial vintage, no fund of funds index…), rough (LBO and… non-LBO worlds) and mainly tracking only a portion of the universe. An alternative would be State Street for the overall sector. A few other providers such as Cambridge Associates are also on the track. But LPX? Not sure about that.
7. Groundless statement (2): ‘For an investor it is the same to participate in a buyout deal financed with equity or mezzanine capital via an unlisted or a listed private equity company‘.
I would like to meet this ‘investor’ and have a chat with him. I am not sure that he exists, and if he does, he may have missed the difference between equity and quasi-equity (that is to say convertible debt). He also may want to have a perspective on the returns of both instruments, their default rate and how their potential bias. I don’t see mezzanine in small buy out, for instance. That’s quite important. And there even was competition from second lien (ie, mezzanine rank as for debt repayment, not convertible in equity) at a certain stage. I am not sure that mezzanine investors are that busy at the moment. Maybe sponsorless mezzanine deals? Small and mid market LBO investors seem to continue to work, according to industry statistics (EVCA or national associations).
8. The paper does not differentiate the investment styles
Are we talking about lead investors or co-investors? Are we talking about syndication prone investors or sole investors? That makes a difference in evaluating the structures and hence the index validity.
9. The paper does not address the corporate governance issue
One of the reasons investors invest in private equity is not only returns and possible diversification, but also co-investment opportunities, access to knowledge and expertise, and the ability to exercise a corporate governance which is quite well defined. In particular, a fund manager cannot invest with one of the subsequent funds that he manages in the deals that would have been made with a previous fund – and this to avoid conflicts of interests.
Actually, one of the main concerns of listed private equity is that it is not reducing the principal-agent problem, but increasing it. Alignments of interests are reduced, as the managers do not face the regular sanction of a fund raising. They have a structure providing fees that they are mainly defining alone, and they have a pool of capital they can tap in without the same effort than with their private vehicles.
That is probably why KKR, Blackstone and the likes are salivating as regard to a listing: no annoying LPs doing their job and trying to reduce the fees you charge and asking difficult questions about the dogs in your portfolio.
10. Critics against unlisted private equity
There are mainly three, which can be discarded:
> Difficult access to fund managers and high minimum investment > can be solved with the help of a consultant, which can tailor a program or set a feeder fund for high net worth individuals. However, segregated accounts are better than pooled money, as they avoid the consequences of defaulting LPs and it is possible to negotiate a precise investment strategy.
> Illiquidity and fixed time horizon > history have proved that illiquidity can be a barrier against stupidity. By preventing massive retraction of the portfolio, it is possible to preserve a certain stability necessary to invest in the mid to long term. The partial sales of 3i and LGT’s Castle portfolio shows that listed structure are not immune from that – unlisted private equity is, at least if limited partners do not default. In that event, secondaries are still a possible way out.
Does this apply to the retail investor? No. The fact is that either retail investors should shoot for tax-efficient vehicles (such as FIP and FCPI in France) and get their immediate tax rebate by investing in a closed-end fund, or avoid private equity if they cannot afford to leave their money for a certain time at work.
Conclusion
So is there an interest in listed private equity? I would say no, unless you can « short» the structures. This is not addressed, but could make sense. It is not possible to do that in the private world. Actually, to balance a portfolio, and manage the overlap between public and private equity investments, it would be good to use the public part to actually capitalize on the trends downwards, notably when the cycle is turning to a recession. However, I am not sure that the listed structures would really like this idea.
No because:
> investing in an evergreen fund is not satisfying as there is no way to improve the corporate governance, act on the fees which are charged and negotiate the rules of investments. Cash management is poor, there is a permanent discount on NAV of the portfolio, the liquidity is fluctuating and the choice of managers is low.
> investing in a fund management company is a ripe, mainly because basically the managers control the expenses which are their salaries and bonuses. They can increase them as they wish, and the income streams are either management fees or carried interest. Basically, you get the crumbles as an investor.
> investing in a holding combining fund and management company is even worse as there is a pool between the money used for expenses and the money used for investments.
Maybe the real reason of the existence of listed private equity comes from the fact that until some recent evolution in pension investment rules, unlisted private equity was out of reach. To give them some sort of taste of what it would be, fund managers set up structures which were listed. However, as they were uneffective, listed private equity stagnated until it was ignited again by the succession issues in fund management companies and the BO bonanza. It will probably go back to its desert soon.
Private equity capital overhang is a myth
Posté par Cyril Demaria dans capital overhang, limited partners le 14 juin 2009
Pitchbook has published a report (Q2/2009) which raises the concern of a so-called « capital overhang» in private equity in the US. Unfortunately, it fails to convince just like the previous reports had (Preqin among others).
As usual, the authors of the report have made the title of the news but do not mention that the funds raised in 2007 and 2008 are commitments. This means that actually, limited partners have not paid in the total mentioned. And that’s the worrying part: why would there be an overhang if the general partners did not actually call the capital? They can still downscale their funds later on at no cost for the limited partners (except maybe for solvency and prudential reasons). The reverse is not true: fund raising has costs and implies strong delays.
Additionally, the usual investment period is of 5 years (and usually can be extended by one year). This means that the GPs can wait for a recovery on the credit side to deploy their capital – which is the reason why they did not so far.
So, a rather misleading picture, as we actually need to wait 3 to 5 years to see if there is a real overhang. Given the development of secondary BO, I would not be surprised that GPs find a way to deploy this capital regardless the situation on the stock exchange or on the trade sales side.
One of the worrying points, though, is the lack of secondary VC. Unless the stock exchange or trade sales pick up, the start-up pile up will prevent more capital deployment.
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