Venture Capital and Private Equity: Module I

Introduction

The first module of "Venture Capital and Private Equity" examines how private equity funds are raised and structured. These funds often have complex features, and the legal issues involved are frequently arcane. But the structure of private equity funds has a profound effect on the behavior of venture and buyout investors. Consequently, it is important to understand these issues, whether one intends to work for, receive money from, or invest in or alongside private equity funds.

The module will seek not only to understand the features of private equity funds and the actors in the fundraising process, but also to analyze them. We will map out which institutions serve primarily to increase the profits from private equity investments as a whole, and which seem designed mostly to shift profits between the parties. We will seek to understand the functions of and reasons for each aspect of private equity fundraising.

Why This Module?

The structuring of venture and buyout funds may initially appear to be a complex and technical topic, one better left to legal specialists than general managers. Private equity partnership agreements are complex documents, often extending for hundreds of pages. Practitioner discussions of the structure of these firms are rife with obscure terms such as "reverse claw-backs."

But the subject is an important one. For the features of private equity funds—whether management fees, profit sharing rules, or contractual terms—have a profound effect on the behavior of these investors. It is clearly important to understand these influences if one is seeking to work for a private equity fund. But an understanding of these dynamics will also be valuable for the entrepreneur financing his company through these investors, the investment banker underwriting a firm backed by private equity funds, the corporate development officer investing alongside venture capitalists in a young company, and the pension fund manager placing her institution’s capital into a fund.

An example may help to illustrate this point. Almost all venture and buyout funds are designed to be "self-liquidating": i.e., to dissolve after ten or twelve years. The need to terminate each fund imposes a healthy discipline, forcing private equity investors to take the necessary-but-painful step of terminating underperforming firms in their portfolios. (These firms are sometimes referred to as the "living dead" or "zombies.") But the pressure to raise an additional fund can sometimes have less pleasant consequences. Young private equity organizations frequently rush young firms to the public marketplace in order to demonstrate a successful track record, even if the companies are not ready to go public. This behavior, known as "grandstanding," can have a harmful effect on the long-run prospects of the firms dragged prematurely into the public markets.

A second rationale for an examination of the concerns and perspectives of institutional investors and intermediaries is that they provide an often-neglected avenue into the private equity industry. Many students diligently pursue positions at the traditional private equity organizations, but neglect other routes to careers as private equity investors. A position evaluating private equity funds and putting capital to work in these organizations is likely to lead to a network of relationships with private equity investors that may eventually pay handsome dividends.

The Framework

There are a wide array of actors in the private equity fundraising drama. Investors—whether pension funds, individuals, or endowments—each have their own motivations and concerns. These investors frequently hire intermediaries. Sometimes these "gatekeepers" play a consultative role, recommending attractive funds to their clients. In other cases, they organize "funds-of-funds" of their own. Specialized intermediaries concentrate on particular niches of the private equity industry, such as buying and selling interests in limited partnerships from institutional investors. In addition, venture and buyout organizations are increasingly hiring placement agents who facilitate the fundraising process.

This module will examine each of these players. Rather than just describing their roles, however, we will highlight the rationales for and impacts of their behavior. Some institutions and features have evolved to improve the efficiency of the private equity investment process, while others appear to be designed primarily to shift more of the economic benefits to particular parties.

Investing in a private equity fund is in some respects a "leap of faith" for institutional investors. Most pension funds and endowments typically have very small staffs. At the largest organizations, a dozen professionals may be responsible for investing several billion dollars each year. Meanwhile, private equity funds undertake investments that are either in risky new firms pursuing complex new technologies or in troubled mature companies with numerous organizational pathologies and potential legal liabilities.

Many of the features of private equity funds can be understood as responses to this uncertain environment, rife with many information gaps. For instance, the "carried interest"—the substantial share of profits that are allocated to the private equity investors—helps address these information asymmetries by insuring that all parties gain if the investment does well. Similarly, pension funds hire "gatekeepers" to ensure that only sophisticated private equity funds with well-defined objectives get funded with their capital.

At the same time, other features of private equity funds can be seen as attempts to transfer wealth between parties, rather than efforts to increase the size of the overall amount of profits generated by private equity investments. An example was the drive by many venture capital funds in the mid-1980s—a period when the demand for their services was very strong—to change the timing of their compensation. Prior to this point, venture capital funds had typically disbursed all the proceeds from their first few successful investments to their investors, until the investors had received their original invested capital back. The venture capitalists would then begin receiving a share of the subsequent investments that they exited. Consider a fund that had raised capital of $50 million, whose first three successful investments yielded $25 million each. Under the traditional arrangement, the proceeds from the first two offerings would have gone entirely to the institutional investors in their fund. The venture capitalists would have only begun receiving a share of the proceeds at the time that they exited the third investment.

In the mid-1980s, venture capitalists began demanding—and receiving—the right to start sharing in even the first successfully exited investments. The primary effect of this change was that the venture capitalists began receiving more compensation early in their funds’ lives. Put another way, the net present value of their compensation package increased considerably. It is not surprising, then, that as the inflow into venture capital weakened in the late 1980s, institutional investors began demanding that venture capitalists return to the previous approach of deferring compensation.

This twin tension—between behavior that increases the size of the "pie" and actions that simply change the relative sizes of the slices—runs through this module. We will attempt to both understand the workings of and the reasons for the key features of these funds using this framework.

The Structure of the Module

The first half of the module introduces the key elements of the private equity fundraising process. Among the actors whose structure and concerns we will examine are institutions, private equity investors, "funds-of-funds," and "gatekeepers." We will put particular emphasis on the agreements that bring these parties together into limited partnerships. Because they play such an important role in shaping behavior, compensation terms will be an especial focus.

The second half of the module looks at the raising of three funds by private equity organizations. We look at private equity organizations of very different maturities and with varied investment targets: two men seeking to raise a first fund to pursue opportunistic late-stage investments, a venture organization trying to raise its second seed capital fund, and a established British private equity organization considering a new template for a fund to undertake buyouts across Europe. The funds that emerged from these circumstances reflected not only the differences between the investments that each fund promised to make, but also each group’s ability to persuade—or demand—a better deal from its investors.

Venture Capital and Private Equity: Module I

Introduction

Why This Module?

The Framework

The Structure of the Module

Further Reading on Private Equity Fundraising and Partnerships