A simplified hypothetical representation is of the J-Curve is below:
First time investors in private equity funds are sometimes alarmed / confused / surprised to learn that their fund investment has a negative return in the early years of the fund’s life. Then, to their relief, as the fund ages, the fund’s return increases. This is known as the ”J-Curve” and it is a common phenomenon in private equity, particularly early-stage venture capital.
A simplified hypothetical representation is of the J-Curve is below:
For investors that are new to investing in private equity funds (venture capital funds, growth equity funds and buyout funds), one area of confusion is often around how the fund cash flows work from the investor perspective. This blog post attempts to explain this.
As an initial matter, it is important to understand that private equity funds are very different from mutual funds. When an investor invests in a mutual fund, the investor will write a check on day 1 and at some point later in time will withdraw money from the fund. Private equity funds operate on a very different basis - known as a "called capital" basis. Let me explain.
Investing in private equity funds is a long-term process. Private equity funds have finite lives, unlike mutual funds. Most private equity funds come to market with a 10 year term with up to two one-year extensions at the discretion of the manager. This suggests a fund term of 10-12 years. However, most funds exist for much longer than 12 years from the initial call of capital to final liquidation.
I view the life of a private equity fund as having four phases:
The four phases of a fund’s life can be viewed graphically:
The private equity world has a lot of terminology. In a prior post, I discussed the structure of a private equity fund, and introduced the terms "limited partners" (or "LPs"), the "general partner" ( or "GP") and the "management company." In this post, we'll explore fund "sizes" and a little bit of how investments in private equity funds work.
The "size" of a private equity fund is based on the total amount of money all investors commit to invest in the fund - known as "committed capital." Because a private equity fund invests capital over time, the fund does not need all of the investors' money at the inception of the fund, and so the fund "calls" capital over time. Private equity funds typically have initial terms of 10 years, but most of the new investing occurs during the first several years (usually 3-5 years) of the fund, known as the "investment period." As a result, the fund calls the bulk of capital from the investors during this investment period.
Let's use an example.
For investors new to investing in private equity funds, the mechanics of how funds work can be a bit confusing. This post introduces the typical private equity fund structure that's used in the United States - the limited partnership.
Basic Limited Partnership Structure
In a basic limited partnership, there are several passive investors (known as "Limited Partners" or "LPs") and the manager of the fund, (known as the "General Partner" or "GP"). The diagram below illustrates this basic structure.
Private equity funds (buyout, venture capital and growth equity funds) are typically structured as limited partnerships, which have two types of partners: limited partners, or LPs, which are passive investors in the fund; and a general partner, or GP, which is the manager of the fund. As I evaluate funds, one of the fund terms that receives special attention is the amount of money the GP will commit to the fund - which is called "GP Commitment" or "GP Commit."
Private Equity is a term that has two common meanings: (1) as an asset class, which covers strategies such as venture capital, growth equity, buyouts, mezzanine financings and distressed debt; and (2) as a transaction type, where it really means buyouts.
There is often some confusion between venture capital, growth equity and buyouts, and this post explores the similarities and differences between venture capital and emerging equity. More specifically, this post will explore the difference between early stage venture capital and growth equity. Venture capital itself has a number of stages, from seed, to early-stage, to late-stage financings. By comparing early-stage venture capital to growth equity, the differences are more clear and understandable.
The Fortune article "Snapchat Actually Isn't the Hottest IPO This Year" argues that MuleSoft is actually a hotter initial public offering than Snap. This argument is based on post-IPO trading metrics, such as first day "pop" (first day closing trade price vs IPO price) and price-to sales metrics. It's an interesting article. Link: http://fortune.com/2017/03/30/snapchat-ipo-snap-stock-mulesoft/
In a prior post "Mike Moritz on Private Equity (aka Leveraged Buyouts)" an opinion piece penned by the famed venture capital investor was discussed. Now there's a rebuttal to Mr. Moritz's article.
Mike Moritz, the famed venture capital investor at Sequoia Capital, has published an opinion piece on the New York Times called "Stephen Scharzman's Bad Business Advice." In this opinion piece, he takes a swipe at the leveraged buyout business, which is now known as private equity. He focuses on the amount of debt used in these transactions and the attendant cost-cutting that often includes layoffs. I have met Mike Moritz on a couple of occasions, and found him to be a very smart and opinionated person. His piece is worth a read, even if you don't agree with his positions.
There's a recent Bloomberg Gadfly article by Shira Ovide called "Silicon Valley Needs Startup Drano" that explores the imbalance in venture capital between funds flowing into venture capital funds and companies and the money being returned from these companies and funds. I enjoyed this article, both for its Drano metaphor as well as for its content. I have been very concerned about this imbalance for some time now, and this article explains it well.
My blog post "Fraud by Venture Capital Fund Managers" was originally posted in June 2014. My introduction to the post was that instances of fraud by venture capital fund managers were very rare. The post then highlighted a few cases of alleged fraud by venture capital fund managers
I recently gave a talk about Venture Capital at UC Hastings College of Law (where I went to law school), and during the talk we went over the basics of venture capital. It seemed to me that it would be a good exercise to write out the definition of venture capital as I see it. So here goes…
The Wall Street Journal has two articles today that are of interest to shareholders of startup companies, primarily former employees who hold shares of these startups. The articles "Startup Employees Invoke Obscure Law to Open Up Books" and "Own Startup Shares? Know Your Rights to Company Financials" discuss laws that may require some startup companies to deliver certain financial data to shareholders which may help these shareholders value their stock.
Specifically, the articles reference Section 220 of the Delaware General Corporations Law, Section 1501 of the California Corporations Code and Rule 701 of the Federal Securities Act of 1933. These provisions may provide certain shareholders of some private companies the ability to obtain selected financial statements.
Business Insider had an article this week called "The steroid era of startups is over -- here's what 8 top VCs think will happen next" that made a number of good observations. In this article, eight venture capitalists discussed how the environment has been changing, and the article identifies a number of ways the changing environment will impact startups. The main categories are:
Bill Gurley, General Partner at Benchmark Capital and a leading venture capitalist, has posted a sobering, but excellent article about the state of the venture capital industry. I generally concur with his viewpoint. While a long read, it's definitely worth the investment of your time.
Here's the link
There were no initial public offerings (IPOs) of tech companies in the first quarter of 2016, according to the National Venture Capital Association (NVCA). This is the first time since the depths of the Great Recession that no tech companies have gone public in a quarter. Six life science companies did hold IPOs, but the total of six venture-backed IPOs in the first quarter of 2016 is the lowest tally since the third quarter of 2011, when there were five IPOs. To add to the misery, there were 79 reported mergers and acquisitions of venture-backed companies, down from 105 in the fourth quarter of 2015 and down from 97 in the first quarter of 2015.
As liquidity events are crucial to the venture capital lifecycle, this is troubling news.
According to the Business Insider article "'The Great Reset': Venture Capitalists and Startups Have Shifted from Greed to Fear," the technology startups and venture capitalists have begun to temper valuation expectations. This is driven by a number of factors, including (1) the slowdown in the tech IPO market, (2) public tech company valuations have declined, some significantly, making many private tech companies looking overvalued, and (3) some tech companies are now laying off people.
The article indicates that the conversation is changing between venture capitalists and startups, with VCs asking tougher questions, and now looking for "cockroaches" - companies that can survive in any market.
It's an interesting article and worth a read.
There's an insightful article on TechCrunch "Will the Bubble Burst? Ask Your Cabbie" that I found interesting. The author recounts the first Internet bubble and then the credit/real estate bubble and how he realized that the markets were overvalued at these times and how he avoided the market downturns. From that experience, he then looks at the current environment. It's a good article and worth a read.
Investment in US venture-backed companies reached $15.7 billion in the first quarter of 2015, according to data provided by Dow Jones VentureSource and quoted in today's WSJ.com article "Startup Funding Hits 15-Year High While Valuations Set Record." A few highlights from the article:
Link to article:
San Francisco's South Park neighborhood is centered by a beautiful park surrounded by Victorian homes. Over the past several years, there has been an influx of venture capital firms to the neighborhood. The Re/Code article "Has South Park Finally Become the New Sand Hill Road?" takes a look at this phenomenon. But it's not just South Park - venture capital firms are either headquartered or opening offices all over San Francisco. San Francisco is also home to many venture-backed companies, including Twitter, Uber, and more. San Francisco has become the new epicenter of technology venture.
Scott Kupor, Managing Partner of venture capital firm Andreessen Horowitz, has an interesting blog post "What's Holding Tech M&A Back?" that's worth a read. In the post, Kupor asserts that only 10% of tech mergers & acquisitions have been "growth" transactions - deals "involving rapidly expanding, venture-financed private companies or modern software-as-a-service providers." Worse, 40% of this deal volume has been by five acquirers - Facebook, Google, Microsoft, Oracle and SAP.
This paucity of growth transactions is due to two main factors: (1) venture-backed companies are staying private longer due to the significant availability of private capital available to these companies; and (2) public companies are hamstrung due to activist investors, which are demanding actions like stock buybacks, dividend distributions and breakups - short-term actions to books stock price - at the expense of actions that enhance long term shareholder value such as investing in R&D or growth-oriented acquisitions.
It's a thought-provoking piece that's worth a read.
Link to blog post: http://a16z.com/2015/04/10/whats-holding-tech-ma-back/
Mike Moritz, the Chairman of famed venture firm Sequoia Capital, has cautioned that valuations are very high and that a number of "unicorns" - startups that are valued at over $1 billion - will become extinct. Both Business Insider and Fortune have good analyses of Moritz's warnings (the remarks were made originally in an interview with The Times of London, but the article is only available to subscribers).
Moritz joins other notable venture capitalists, such as Bill Gurley of Benchmark, in warning of valuation concerns in Silicon Valley.
While Moritz does believe that valuations are "very sporty" and that some unicorns will fail, he also adds that "a good number" of unicorns that will succeed.
Moritz also feels that while there will be a setback in Silicon Valley tech, he does not believe it will be as bad as the tech bubble bursting in 2000 because companies today are more sustainable.
Business Insider article:
Bill Gurley warned of there being "no fear in Silicon Valley right now" at South by Southwest, according to this article by Fortune. While he said that we may not be in a tech bubble, we are in a risk bubble. He added that he thinks there will be some "dead unicorns" this year, a unicorn being a startup with a valuation in excess of $1 billion. Gurley also warned that if the free flowing capital dries up, it could have a ripple effect that will affect more than money-losing startups. It could affect San Francisco real estate prices as well as companies that rely on spending by these startups.
It's a good article and worth a read.
Link to Fortune article about Bill Gurley:
Link to Fortune article "The Age of Unicorns":
Link to Fortune's "The Unicorn List":
Mark Cuban has published a post on his Blog Maverick site called "Why This Tech Bubble is Worse Than the Tech Bubble of 2000", which is an interesting read, but one with which I generally have a different perspective.
The distinction Mr. Cuban makes is that in the Tech Bubble of 1999-2000 the tech companies were publicly traded, while today the tech companies (apps and small tech companies) are not. Mr. Cuban contends that investors in public companies during the Tech Bubble had liquidity - the ability to sell their stocks on the public market. Today, investors in these private companies have no liquidity, and so can't sell their stock if things turn south.
A second point he makes is that there are significant numbers of "Angel" investors investing in these companies and he first states that he thinks most of the investments made by these angels are under water because of the lack of liquidity. He then takes a jab at equity crowdfunding, the rules for which have not yet been finalized by the SEC, because he believes "there is no reason to believe that the SEC will be smart enough to create some form of liquidity for all those widows and orphans who will put their $5k into the dream only to realize they can't get any cash back when they need money to fix their car.
I respectfully disagree with much of Mr. Cuban's post. First, he assumes that we are in a bubble today, while I think there is lots of disagreement on this point. Please see my prior blog posts on this for more on whether we are in a bubble. Second, as the law stands today, it is mainly accredited investors who invest in these private companies. An accredited investor in the US is one who has net worth of $1 million (not including the value of their primary residence) or who has income of at least $200,000 each year for the last two years (or $300,000 together with their spouse if married). This seems to contradict Mr. Cuban's comment about these Angel investors not knowing what they have gotten into. Third, the Jumpstart Our Business Startups (JOBS) Act does provide for annual limits on investing through equity crowdfunding platforms. The Act provides that people earning under $100,000 the investing limit is the greater of $2,000 or 5% of their income. These limits suggest to me that the maximum losses incurred by "widows and orphans" should not be devastating.
I do agree that the lack of liquidity in private company securities means that it is harder to exit the investment, but my view is that sophisticated investors understand this already, and for unsophisticated investors there are protections in place already (and probably more to be included in the SEC rules) that will prevent them from betting the farm on a poor, illiquid investment.
Link to Mark Cuban's post:
Links to prior posts on whether we are in a tech bubble:
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