DR.CHENJIAZI ZHONG

The Yale Endowment’s investment success has been largely driven by the categories that are designed for sophisticated investors, such as PE. Ten years ending June 30, 2013, the endowment fund’s U.S. equities returned 10.8%, while PE portfolio returned 14.4% per annum. Yale’s PE investments include venture capital (VC) and leveraged buyouts (LBOs)

Venture Capital

After World War II, PE investments began to emerge, by the founding of the first two VC firms in 1946: American research and Development Corporation (ARDC) and J.H. Whitney & Company. Former employees of ARDC established several prominent VC firms including Greylock Partners and Morgan, Holland Ventures, the predecessor of Flagship Ventures. During mid-1980s and late 1990s, numerous VC groups have grown dramatically.

VC relates to the equity co-invested with entrepreneurs to fund their young but potentially fast-growing businesses. It is a very important source of funding for startups or new companies with short operating history due to their limited access to capital markets. VC is often active in technology-related sectors, such as telecommunications, life sciences, biotechnology, IT, software, and clean technology.

Thomson Reuters and the National Venture Capital Association (NVCA) released a global VC market summary on October 7^th 2013 that VC funds raised $4.1 billion from 56 funds during the third quarter of 2013, an increase of 28.0 percent compared to the level of dollar commitments raised during the previous quarter, and a 14.0 percent increase by number of funds.

VC has two subcategories, based on which stage of development the funded company is at:

• The financing provided at the early stage is used to fund research to assess an initial concept and to develop a new product. A core skill within VC is the ability to identify novel technologies that have the potential to generate high commercial returns at an early stage.
• The financing provided at expansion stage, also called development capital stage, is used to allow more rapid growth by increasing production capacity, developing markets, or providing additional working capital. Typically the amounts that VC firms usually invest at this stage range from $500,000 to $5 million.

U.S. Venture Capital Index and Selected Benchmarks Statistics

In the report “Peer Review: Exploring Some of the SaaS Metrics that Matter Most at the Expansion Stage” by OpenView Venture Partners, the VC manager provided an overview of the operating and financial metrics that firms at expansion-stage need to build in order to minimize costs and maximize profits. These metrics include annual revenue growth rate, average revenue per employee, annual customer growth rate, and percentage revenue loss. The report furthered that companies would achieve the greatest workforce efficiency once they could earn between $3.5 million and $5.0 million in monthly recurring revenue.

Investing in VC businesses requires a unique set of skills. Unlike other investment styles, in the VC investments, although performance is important, aspiring VC managers should also possess leadership and relationship-management savvy, as well as a flair for process to round out their management skills:

• VC managers need to have the right disposition to work with LPs to figure out the best way to market the firm, given a specific budget.
• VC managers need to be expert at the very type of VC business, not only the deal stuff, but  also the other pieces of it, e.g., the dynamics of working with entrepreneurs, the terms, and how to project the portfolio.
• VC managers should be good process people and they should know how to keep a team motivated.
• VC managers must have the knowledge of “intuition-building.” What entrepreneurs or young professionals need to see is not the good companies; rather, they need to see more troubled ones, and hence to better discern between them.
• VC managers must have superior communication skills to be able to establish trust and develop positive relations with LPs. Industry wise, many VC managers focus on quarterly portfolio reviews with all of their LPs or an advisory committee meeting or via a conference call to achieve this goal.

There are tons of cases where the LPs invested too much capital in underperforming VC funds due to the frequently misaligned terms and some managers’ flawed “logo-chasing” investment model. Therefore, long-term institutional investors have to be more selective and disciplined in VC investing. The best investors are those who know how to negotiate better alignment, transparency, governance, and terms that take into account the skewed distribution of VC returns.

An Oct 2013 newspaper disclosed the fact that several VC firms in the U.S. have recently reduced the size of their investing teams, and changed the focus of their investing or shrunk the size of their funds. Earlier-stages investing is becoming tougher for VC firms with big funds. Besides, VC firms are under closer scrutiny by their LPs. In the PE space, recent dramatic growth in the industry is more driven by buyouts.

Buyout

Buyout is a generic term that comprises a change of ownership with the support of LPs. It relates to capital provided as a mix of debt and equity to acquire an established business, business unit, or company that is privately held or a spin-off from current shareholders. A company in buyout stage has advanced operations and is prepared to acquire another competing company as a subsidiary, or expand into new markets and products with the purchase of an existing company. Monies for this type of capital can range between $3 and $20 million. Since buyout is normally beyond the cash-burning stage, it allows the use of debt to finance part of the transaction, and in these cases, buyouts are referred to leveraged buyouts (LBOs). LBOs are a very common occurrence in today’s M&A market. They can have different forms such as management buyout (MBO) and management buy-in (MBI).

VC funds are high-risk, high-return investments in small growth companies. VC managers on the entrepreneur’s business model are often involved in the firm’s board of directors and strategic planning process. Historically, good opportunities exist when investments are made in funds raised at the bottom of the cycle. In contrary to VC, buyout funds are lower-return, lower-risk investments focusing on more mature companies. VC and buyout investments differ in several aspects, notably in the business model, deal structuring, the role of the PE manager, and valuation risk.

• Business Model – VC investment opportunities can be very difficult to assess and they are usually highly concentrated in advanced technology sectors, which often result in a number of small investments. In buyouts, however, the large capital requirements as well as lower level of risk have led most buyout managers to make a relatively small number of investments. Since buyout managers need to give extensive strategic business planning advice, they tend to focus on consistent rather than outsized returns. Not surprisingly, buyout firms experience fewer failures but they have limited upside potential.
• Deal Structuring – VC transactions do not typically involve debt, and venture capitalists gain control of a company over time through a series of equity investments. Buyout managers, on the other hand, use a mix of equity and debt financing to acquire companies; assets are used as collateral for the debt, and the cash flow of the company is used to pay off the debt.
• Role of PE manager – VC managers look to launch new or emerging companies, whereas buyout managers focus on leveraging an established company’s assets; VC managers back entrepreneurs, whereas buyout managers deal with experienced managers.
• Valuation Risk – valuation in VC investments is complicated due to a short operating history and the lack of appropriate comparison, so the valuation can pose significant problems. Beyond that, there are no consensus on how to value a VC. This explains why VC managers carry out more extensive sector and product due diligence than buyout managers. Valuation risk in buyout investments is much lower.

In addition to the lower capital requirement, one positive aspect of LBOs is that poorly-managed firms prior to their acquisition can undergo valuable corporate reformation when they become private. By changing their corporate structure, replacing executive and management staff, modifying unnecessary company divisions, and improving excessive expenditures, a company can revitalize itself and earn substantial returns.

References:

1. Press Release by Thomson Reuters and the National Venture Capital Association, Oct 7^th, 2013
2. “Peer Review: Exploring Some of the SaaS Metrics that Matter Most at the Expansion Stage” by OpenView, October 2013