003d Venture Capital and Private Equity
Chapter 3d of 'There are no grown ups'
What is it?
A venture capital / private equity fund typically pools the cash of investors and uses it to invest in early stage companies. The fund structure can be
a) Listed; in the UK this may be as a Venture Capital Trust (which has tax benefits)
b) An unlisted private fund making investments that, in the UK, typically attract Enterprise Investment Scheme tax relief.
c) An venture investment specialist putting investors into individual positions that are held directly by the investor, though with the investor typically represented by the venture capital specialists
Leverage (gearing)
As these are usually deemed to be high risk investments against which banks will not lend, the fund/investments tend not to be leveraged, albeit that the companies getting venture capital equity may be taking in debt as well as equity, in which case there is de-facto gearing (though no more than when an un-leveraged unit trust buys shares in a company like CocaCola or BP, which issues corporate bonds as well as equity
How do you buy / sell the investment
For a listed venture capital trust, you deal through the exchange (eg via online broker).
For an unlisted pooled investment you either approach the fund directly (if HNWI / sophisticated investor) or you may be referred by an IFA (more usual for a ‘retail investor’). At least that is how you buy. Selling is not so easy. These investments are typically illiquid, with most investors making tax-favoured investments on which the tax relief would be lost in the event of early withdrawal, and for which there is hardly any market (those interested are keen to get then tax relief by investing directly rather than buying off the initial investor)
What happens to the investment vehicle when you buy or sell
The investment vehicle is typically open ended. On buying, it gets cash, which it then uses to invest in newly issued shares.
Restrictions on selling
Being ‘locked in’ for 5+ (often 10-14) years is usual. It may be that you can only get out (other than at a fire sale price) when the underlying investor company is sold or listed.
Who gains / loses when you buy it?
If you were referred by a financial advisor, they will get a commission. The fund management company will extract a fee when the cash goes into its fund and/or when the fund uses the cash to buy shares in an investee company. The investee company probably also gains when your cash filters into its account and can be used as working capital to fund growth. Those people gaining employment in the investee company probably gain, as do those in the supply chain serving that company. If the investee company goes on to disrupt a costly market, the entrenched providers (and their staff / supply chains) may loose out.
Who gains / loses when you sell it?
If you need to sell ‘early’ or quickly, you are likely to loose, and any gain would go to a (probably vulture) buyer.!!
Who makes the investment management decisions?
The investment management company
How can the investment management company be fired if they are doing a bad job?
Typically they can not
How does the investment manager make more money for themselves out of the trust?
More size, longer holding, successful exit fees
Also, after perhaps 3yrs of active investing, the investment manager can sit on their hands doing very little for 7-10 years, until exit. During this time they still collect the hefty 2%pa fees (plus charging investee companies for director services of their nominees)
Typical cost of buying
The cost is opaque as, as well as any entrance fees charged by the investment manager to the investor, the manager is probably charging a fundraising / marketing fee to the investee company. You may ask ‘if the investment manager is retained by the investee company & paid a fee to raise capital (at a price the company finds acceptable), and is also employed by the investor and paid a fee to deploy the capital into good companies at the best possible price for the investor, is there not a conflict of interest? Is the manager working for the company (which wants to give away as little equity as possible for the cash it needs) or for the investor (who wants to get as much equity as possible for their cash)? The answer is: neither. The investment manager is working for the investment manager.
Typical annual management costs
The investor will usually pay c2% of ‘assets under management’, as the assets are usually illiquid their value is difficult to determine: try to sell quickly and you will find that you get out rather less than you put in. As you may have guessed, the deemed value, on which the investment manager charges their fee, is often assessed ‘generously’: unless an investment is made into a company that actually goes bankrupt, expect the ‘value’ to be deemed to be at least the purchase price, unless and until something gives the investment manager an excuse to put a higher price into their model. If a company has raised £100m at £1 per share, the investment manager will be taking £2m pa (2% of £100m) in fees. If a year later the company raises another £5m at £2 per share, you can expect the original investors deemed ‘assets under management’ to have risen to £200m, so the annual management fee on that rises to £4m pa. Within 30 months, the £5m of new investment revived by the investee company will have been matched by an extra £5m of fees charged to investors by the investment manager. As well as charging fees to the investors, the investment manager is likely to be charging fees to the investee company for ‘directors services’ of one of their favoured people to sit on the investee company board and ‘represent the investors’ (ie represent the investment manager).
Typical ‘Total Expense Ratio’ (not including crossing the spread)
The total expenses tend to add up to an impressive amount of any investment, not least as ‘success fees’ may be charged on a deal by deal basis, so an investment manager that makes 5 loosing investments & has a big winner yielding a 500% return (ie, on balance only just achieves breakeven) can end up taking a big slice of the 500% as its ‘success fee’. As you might have guessed from the investment manager’s initial ‘riding both horses’ approach to fundraising, in which the manager can be paid by both the investor and the investee company, when there is a successful exit, the investment manager likes to get two bites of the cherry. The investor is expected to pay perhaps 20% of the profit (this is often called the manager’s ‘carried interest’), while the investee company, grateful for the fundraising, has given the investment manager warrants (call options) to buy stock at a big discount to the price expected for a successful exit. Lets look at a 10 year holding period ending with a successful exit (perhaps the fate of 1 in 6 or 1 in 7 investments)
Fees on the way in 10%
Annual fees 10 x 2% pa = 20%
(possibly more if subsequent funding rounds validate a higher value on which to charge annual fees).
Exit success fee (carried interest) 20%
Exit warrants 10-20%.
On this basis you may as well say to the investment manager ‘suggest an investee company to me, and I will buy two shares, one for me and one for you’. Don’t make the mistake of thinking that the investor does not pay for the warrants: if the investee company was not giving warrants to the investment manager, the company would have been prepared to give more equity to the investor for their money.
I make 2 observations here
A) Venture capital is often given tax advantages (in the UK, the Enterprise Investment Scheme, & Seed Enterprise Investment Scheme, deliver tax relief on the way in and exemption from capital gains tax on the way out), but almost the entire tax benefit, and possibly a bit more, is captured by the investment manager & the salesperson/advisor.
(B) One reads about the success that US university endowments have had with VC and PE investments. These investments were not necessarily via funds or paying the same level of fees suffered by private investors. In at least some cases (and I don’t know the proportion) they are likely to have been given an opportunity to co-invest without paying fees eg if a Harvard man was making an investment (personally or on behalf of a fund they were managing) they may have called the investment committee at Harvard and offered them the chance to come along for the ride without paying fees
Typical cost of selling:
Within a fund, or for a privately held share that achieves an exit, there will be significant fees to lawyers, etc to effect the sale transaction. On sliver sling Is that formal dealing fees / exit charges are not usual.
Other
When dealing with venture capital or private equity businesses, manager alignment is particularly important. Be extra careful if there is a bank or conglomerate as a ‘parent company’ to the VC fund. From time to time the fund may back an amazing winner, one that can return not just 10 tines the investment, but 100 times. You can bet that, when that happens, if there is a big parent enterprise, and the fund is looking at the investment which has grown 10 times already and has the potential to grow much much more, there will be a vast temptation for the VC to push for the investee company to be acquired by the VCs parent. The investors are told ‘look at how well we have done for you, enjoy spending your profits’ while the parent company scoops the really big win. I have seen Asia Healthcare Trust (parent conglomerate: Dahbur ) try to pull this stunt with a very successful chain of opticians: imagine their disappointment when German Esslar also bid for the company
The article https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ is instructive, and highlights the fact that ‘Most funds, while only actively investing 3-5 years, are bound to 10 years. Many newer studies are showing that 12-14 year funds are more accurate for today’. So, having spent 3-5 years investing, the fund then waits c5-11 years to sell its holdings. During those 5-11 years, it does very little, other than collect a cumullative 10-22% of the funds’ value in annual management fees.