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", "GP Capital Commitment" or "GP Commit."  ​

To read more, please click "Read More" to the lower right.

This article comes on the heels of some other public comments made by others in the industry and outside the industry which have re-kindled a long-standing debate about the merits of the private equity industry.

I have previously posted about this topic, and I think the prior posts help to frame this article.

Prior posts:
http://www.allenlatta.com/allens-blog/mike-moritz-on-private-equity-aka-leveraged-buyouts
​http://www.allenlatta.com/allens-blog/a-response-to-mike-moritzs-article-on-stephen-scharzman

Link to Reuters article:
http://www.reuters.com/article/us-milken-conference-privateequity-idUSKBN17Y2MT

I read an interesting article today titled "Nasdaq 6000: What It Reveals About Tech Stocks And Venture Capital."  The article discusses whether there is a tech bubble in the public markets (no) and whether there's a venture capital bubble (possibly).  It's worth a read.  Link:
http://www.nasdaq.com/article/nasdaq-6000-what-it-reveals-about-tech-stocks-and-venture-capital-cm779469

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.  ​

Stephen Davidoff Solomon's opinion piece "A Venture Capitalists's Misguided Critique of a Trump Adviser" rebuts Mr Moritz's article in a number of ways.  Whether you agree or disagree with the opinions of Mr. Solomon and Mr. Moritz, this very public debate is pretty fascinating.  

​Link to prior post:
http://www.allenlatta.com/allens-blog/mike-moritz-on-private-equity-aka-leveraged-buyouts 

Link to Mr. Solomon's article:
https://www.nytimes.com/2017/02/14/business/dealbook/a-venture-capitalists-misguided-critique-of-a-trump-adviser.html
​
Link to Mr. Moritz's article:
https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html 

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.  

Link:  https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html?_r=0

The bottom line is that too much money is going into venture funds and companies, and too little is being returned to investors.  In my view, this will lead to overall lower returns for the venture capital industry and will highlight the need to be very selective when investing in venture capital funds in order to select only the best managers who can deliver exceptional returns.

Link:
https://www.bloomberg.com/gadfly/articles/2017-01-11/silicon-valley-startup-pipeline-needs-shot-of-drano

Now Fortune has published an article "The Ugly Unethical Side of Silicon Valley" which discusses scandals at portfolio companies.  I found this to be an interesting article.  My opinion is that scandal is likely more probable at startup companies than venture capital funds for a few reasons:

• Opportunity.  There's likely more opportunity for a startup executive to commit fraud, as accounting, sales and operating systems are typically not in place or if in place, not robust enough at startups to prevent fraud.  Venture Capital funds have fewer opportunities for fraud, as there are fewer moving pieces.  A VC fund pays the GP management fee and carry, pays for certain fund and transaction expenses (legal, accounting and insurance are typically the largest fees), makes capital calls and distributions, and makes investments - and that's pretty much it .  A startup has many more moving pieces.
• Culture.  Startups in many instances are like the Wild West - immense opportunity, gun-slinging attitude, and young entrepreneurs who typically don't have a lot of management experience.  Compare this to a venture capital fund, which typically has an in-house CFO and back-office team that is experienced and establishes a more structured, professional culture than many startups
• .Accountability.  Most startups fail.  If a startup executive realizes that the company isn't going to make it, there may be a temptation to maximize personal gain over doing the right thing (shutting the company and returning money to investors).  If a company fails, the winding-up process is typically very quiet and private (known as an assignment of the benefit of creditors).

"Fraud by Venture Capital Fund Managers" can be found at:
http://www.allenlatta.com/allens-blog/fraud-by-venture-capital-fund-managers

The Fortune article "The Ugly Unethical Side of Silicon Valley" can be found at (copy and paste in browser):
​http://fortune.com/silicon-valley-startups-fraud-venture-capital/ 

The BloombergBusinessweek article "The Tech Bubble Didn't Burst This Year. Just Wait" examines the current state of the venture capital industry.  The article provides various data points, and quotes Benchmark's general partner Bill Gurley as saying that the venture capital industry is "in a slow correction."  I agree with Mr. Gurley's assessment.  While venture capital funds are raising money at an incredible rate, it seems that VCs are being more selective and valuations are slowly rationalizing.  

Link:  http://www.bloomberg.com/news/articles/2016-10-20/the-tech-bubble-didn-t-burst-this-year-just-wait

Reasons for the reduced outlook for private equity returns include an "unprecedented" $1.47 trillion in capital overhang in the private equity market - known as dry powder - which PE firms will use to invest in companies.  As PE firms are expected to invest the capital they raise, this could present a problem as PE firms compete for deals, increasing entry prices.

Another interesting point in the article is that Calpers has had negative cash flow for the five of the past seven years, which is leading to a shortfall forecast at $9.2 billion by fiscal 2032.  What's troubling is that this forecast is based on a 7.5% annualized return from Calpers' investments, when a prominent consultant has projected a more conservative 6.0% annual return rate.  If the 6% annual return rate is accurate, the shortfall could be much higher.

Link:
http://www.bloomberg.com/news/articles/2016-10-07/calpers-sees-next-headache-in-slowing-private-equity-cash-gusher

The Harvard Crimson has an article "A Tale of Two Endowments" comparing the endowment performance between Harvard and Yale.  David Swensen, Yale's Chief Investment Officer, has posted some impressive returns over the past decade.  

Link: http://www.thecrimson.com/article/2016/9/29/a-tale-of-two-endowments/
​

Professor Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University, is a leading expert in the fields of corporate finance and equity valuation.  Yesterday, Prof. Damodaran posted a very interesting article on his Musings on Markets blog called "The Ride Sharing Business: Is a Bar Mitzvah Moment Approaching?"  ​

In this article, Prof. Damodaran examines the ride sharing market, the business model, and an analysis of a ride-sharing company's transition from surface measures of growth to more substantive measures of monetization.  He then updates his valuation of Uber, which he valued at $23.4 billion in September 2015, to $28 billion, which is significantly lower than the reported pricing of Uber's recent financing rounds.

It's a fascinating article and well worth a read.  He also has a downloadable spreadsheet which contains his valuation model.  Finally, he has added a video explaining his valuation methodology.

Disclosure: Prof. Damodaran was a teaching assistant for an economics course I took while I was an undergraduate at UCLA.

Links:
Damodaran's NYU page: http://pages.stern.nyu.edu/~adamodar/
Damodaran's blog: http://aswathdamodaran.blogspot.com/
Damodaran's blog post on Uber: http://aswathdamodaran.blogspot.com/2016/08/the-ride-sharing-business-is-bar.html

Link to a prior blog post on this topic:
http://www.allenlatta.com/allens-blog/gurley-v-damodaran-on-ubers-valuation
​

I knew the market for initial public offerings was bad, but wow.  Here's a link to the Fortune article "IPO Market Is Worst Since the Financial Crisis."

Link:
http://fortune.com/2016/08/01/ipo-drought-sorry-private-equity/

While the numbers are impressive, I believe there may be cause for some concern.  These totals don't include monies allocated to venture capital by corporate venture capital arms, mutual funds and hedge funds.  These totals don't take into account angel investors.  The bottom line is there is a ton of money in the venture capital ecosystem.  This money will finance hundreds of venture capital companies over the next several years.  The problem is that the exit market isn't keeping pace with this explosion of capital into the venture world.  The amount of capital raised by funds but not invested is known as dry powder.  There seems to be lot of dry powder in the industry right now.

In the first half of 2016, there were 155 total M&A deals, with disclosed value of $14.1 billion and 18 initial public offerings raising $1.5 billion, again according to Thomson Reuters and the NVCA.  This means a total of 173 liquidity events.  However, there were 1,061 deals in the first quarter of 2016 according to PricewaterhouseCoopers LLP and the NVCA, suggesting around 2,000 deals in the first half of 2016.  Now the number of deals is different than the number of companies, but one gets a sense of the number of companies that have received venture capital funding is very large compared to the number of liquidity events.  If companies don't or aren't able to achieve a liquidity event, the rates of return for venture capital will ultimately suffer.

Venture capital is a cyclical industry, and the amount of dry powder may be cause for concern.

Links:
http://nvca.org/pressreleases/venture-investors-raise-8-8-billion-second-quarter-invest-innovative-startups/

http://nvca.org/pressreleases/venture-backed-biotechnology-companies-continue-lead-charge-public-markets-tech-companies-remain-sidelines/

​http://nvca.org/pressreleases/12-1-billion-venture-capital-deployed-startup-ecosystem-first-quarter-according-moneytree-report-3/


​

Kellog Company has announced the formation of a corporate venture capital fund, called eighteen94 capital to "make minority investments minority investments in companies pursuing next-generation innovation, bolstering access to cutting-edge ideas and trends."  The focus will be on "start-up businesses pioneering new ingredients, foods, packaging, and enabling technology."  The fund intends to invest about $100 million.  Kellog joins General Mills and Campbell Soup which have established venture capital efforts.

Here's a link to the Kellog press release:
http://newsroom.kelloggcompany.com/2016-06-20-Kellogg-Company-Establishes-Venture-Capital-Fund-To-Support-Growth

Here'a a link to a Fortune article on the topic:
http://fortune.com/2016/06/20/kellogg-launches-vc-fund/

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.

Links:
http://www.wsj.com/articles/startup-employees-invoke-obscure-law-to-open-up-books-1464082202

http://www.wsj.com/articles/own-startup-shares-know-your-rights-to-company-financials-1464082203

I enjoy watching the Sunday morning political news shows, and I often watch Fareed Zakaria's show GPS (Global Public Square) on CNN.  This week he had an interesting segment on the decline of the US startup, and he has an accompanying op-ed piece in The Washington Post.  Here's a link to the story:

https://www.washingtonpost.com/opinions/why-is-the-number-of-us-start-ups-falling/2016/05/19/53fe8e04-1ded-11e6-9c81-4be1c14fb8c8_story.html

The piece has some very interesting observations, including that the decline in start-ups may be generational.  Baby boomers were great entrepreneurs, the article observes, but succeeding generations have been less likely to start their own companies.

​I think it's an interesting piece and worth a read.