PRIVATE EQUITY & VENTURE CAPITAL

LECTURE 1

Theodosios Dimopoulos
HEC Lausanne,
Swiss Finance Institute
 Today’s Topics

1. What is Private Equity?

2. Types of Private Equity Funds
3. Players
4. Private Equity across countries
5. Job Market
6. Limited Partnership

Readings: YM Ch. 1,2

What is Private Equity?

It is:
“Equity capital that is not quoted on a public exchange. Private equity
consists of investors and funds that make investments directly into
private companies or conduct buyouts of public companies that result in
a delisting of public equity” (Source: www.investopedia.com)
 Famous Cases: Google

• Example 1

• 1996: Larry Page and Sergey Brin, PhD students at Stanford work privately on a new search
engine
• 1998: Andy Bechtolsheim provides $100,000 financing
• 1999: Private equity firms, KPCB and Sequoia Capital participate a $25mil financing round
• 2004: Google’s Initial Public Offering (IPO) yields a $23 bil. market cap

• Today Google is part of Alphabet which trades at around $1,45 trillion market cap
 Famous Cases: Whatsapp

• Example 2

• 2009: Brian Acton and Jan Koum founded Whatsapp

• Employed at Yahoo! Until 2007, applied for jobs at Facebook in vain, stayed unemployed in
South Africa
• 2011: First round investment by Sequoia ($8M)
• 2013: Second round investment by Sequoia ($52M)
• 2014: Facebook acquires Whatsapp for $19 billion!
 Famous Cases: Groupon

• Example 3

• 2008: Andrew Mason, Eric Lefkofsky and Brad Keywell founded the company ($1M)
• Idea: Round up people to place group orders and obtain quantity discounts
• First round: New Enterprises Associates ($4.8M)
• Second round: New Enterprises Associates, Accel ($30M)
• Third round: Battery Ventures, Holtzbrinck Ventures, DST Global ($135M)
• 2011: Company launches IPO. Valued at $13billion
• Today, it is valued only at $366 million!
• https://www.businessinsider.com/five-key-problems-currently-facing-groupon-2011-2?r=US&IR=T
 Famous Cases: Snap
• Example 4
• 2011: Evan Spiegel and Bobby Murphy founded the company
• 2012: Seed financing by Lightspeed Venture Partners ($480K)
• 2012: Series A by Benchmark ($13.5M)
• 2013 (July): Series B by General Catalyst, SV Angel, Tencent Holdings, Institutional Venture
Partners, and SF Growth Fund ($60M)
• 2013 (Dec): Series C by Coatue Management ($50M)
• 2013: Company refuses takeover offers from Facebook, Google
• 2017: IPO with valuation at $25B
• 2021: Market value at $114B
• Today: $ 20.8B!
 Famous Cases: Twitter
• Example 5
• 2006: Jack Dorsey publishes first Twitter message
• Initially service used as internal tool for Odeo employees
• 2006: Biz Stone, Evan Williams and Dorsey form Obvious Corporation
• 2007: Twitter spun off into stand-alone entity
• 2007: Series A by Union Squares Ventures ($5M)
• Despite early explosive growth, failure to meet revenue targets discouraged many VCs later on
• Company turned down a $12M acquisition proposal by Yahoo!
• USV however, continued to believe in the company
• Later RV, Kleiner Perkins, Benchmark, Insight Venture Partners encouraged by the growth of the company
• 2013: Twitter IPO at a valuation of $14.2B
• Today Twitter is worth $32B
 Famous Cases: Facebook
• Example 6
• 2003: Mark Zuckerberg creates the Facemash website while at Harvard
• 2004: He creates a new website, the Facebook. Site quickly expands to Columbia, Yale,
Stanford, MIT and other universities
• June 2004: Angel investment by Peter Thiel, co-founder of Paypal.
• 2005: Series A by Accel ($12.7M)
• 2006: Series B by Founders Fund, Interpublic Group, Meritech Capital Partners, and Greylock
Partners ($27.5M)
• 2007: Microsoft acquires 1.6% of Facebook for $240M, implied total valuation of $15B
• 2012: IPO of company, at implied value $104B.
• 2015 onwards: Company accused as a vehicle of spreading fake news, fallacies and
conspiracy theories, ranging from health issues to political campaigns
• 2021-2022 Facebook (META) drops from $993 B to $ 454 B!
 An infamous case: Procket Networks

• Example 7:

• 1999: Dr. Sharad Mehrotra, Dr. Bill Lynch, and Dr. Tony Li work on network processors and
core routers
• 2002: The firm has accumulated private equity financing of $272 mil and its value is estimated
at $1.55 mil
• 2004: Following disappointing sales track, the firm is sold to Cisco Systems for $89 mil
Types of PE funds
Venture Capital

• A Venture Capital fund (VC) is a financial intermediary, i.e. they take the investors’ capital
and invest it directly in portfolio companies.

Entrepreneurs VC Investors
The VC flow of funds

VC Funds
Managed by
General Partners Portfolio
(“VCs” or “GPs”) Companies

Limited Partners
“Exits”:
(Investors or
Sale of Portfolio companies
“LPs”)
to public markets (IPOs) or
to other companies
 Venture Capital

• A VC will only invest in private companies. This means that once the investments are made,
the companies cannot be immediately traded on a public exchange.

• no simple mark to market

• no liquidity

• A VC takes an active role in monitoring and helping the companies in its portfolio.
The Goal of VC

Source: CB Insights 2022

A VC’s primary goal is to maximize his financial return by exiting investments

through a sale or an initial public offering (IPO-SPAC).
VC Investment Stages

Depending on expected time to exit, a VC investment is classified as

Early stage
Mid-stage
Late stage
VC investment by stage
VC investment by stage
Venture Capitalists

https://www.cbinsights.com/research/top-venture-capital-partners/
 Buyout Funds

• Buyout funds raise money from investors and acquire public (listed) companies, with the
purpose of making them private

• Often the deals are partially funded by debt, thus giving rise to Leveraged Buyouts

• Buyout funds are the largest category of private equity

 Buyout Transactions

• Example 1: the $25 bil. buyout of RJR Nabisco by Kohlberg Kravis and Roberts (KKR) in 1989

• Example 2: the $45 bil. buyout of TXU Corp. by KKR, Texas Group and Goldman Sachs

• Not always is debt financing involved (eg. smaller deals)

• Some funds pursue a buy-and-build strategy, by which they acquire and integrate businesses
in a fragmented sector
Buyout Funds

https://www.privateequityinternational.com/database/#/pei-300
 Other funds

• Mezzanine funds participate the financing of late stage VC investments or buyouts.

• Often the financing comes in the form of subordinated debt

• Distress funds are buyout funds that specialize in the buyout of firms that have trouble
meeting their debt obligations

• Most of our lectures will be devoted to VC and Buyout funds

Private Equity Financing

Source: Bain & Company, Global Private Equity Report 2022

 Players

• Most PE firms organize their activity by setting up PE funds, which assume the legal form of
limited partnerships. The same PE firm typically runs multiple PE funds at the same time

• In those partnerships, the PE firms are the “General Partners”, responsible for making and
managing the investments into private firms, which form the fund’s portfolio

• The PE funds are financed by investors, who are the “limited partners”, so called because their
liability is limited to the amount they invest
 Who are the LP’s

❑ We have already seen some of the best known PE firms, which form the GP in PE
partnerships

❑ Who are the LP’s?

❑ In other words, where does the money for PE investing come from?
 Who are the LP’s

• The LP’s are most often:

1. Angel Investors
2. Endowments
3. Pension Funds and FoFs
4. Corporations
5. Sovereign Wealth Funds
6. Intermediaries
Who are the LP’s in the European VC market

Source: Invest Europe 2022

Who are the LP’s in the European buyout market

Source: Invest Europe 2022

Most Active VC Markets
Investment as a % of GDP. Source: Invest Europe 2021
Most Active Buyout Markets
Investment as a % of GDP. Source: Invest Europe 2021
 PE financing in the World

❑ Most PE activity is located in the US

❑ Recently there is an upward trend in Europe

❑ The same pattern is met in emerging market countries

 Jobs in PE

COO
MP

CFO General Partners

(Partners, General Operating Partners
Legal Dept Partners etc.)
Special Advisors
Accounting Principals
Consultants
Vice Presidents, Jr Partners etc.
Investor Relations

Assistants Analysts and Associates

 PE Partnership structure

❑ When a fund is raised, the LP’s promise to provide a certain amounts of capital at given dates
or at the GP’s discretion
❑ These capital provisions are called capital calls, drawdowns or takedowns
❑ The total promised capital is called “committed capital”

❑ Once committed capital has been raised, we say that the fund has been closed
 PE Partnership structure

❑ The fund invests this capital into portfolio companies within the investment or commitment
period (e.g. 5 years since the first amount of capital was raised).

❑ The fund can then make only follow-on investments in the current portfolio companies

❑ Hopefully, some of these investments will prove fruitful, through an IPO or buyout exit
Key terms in LPA
LPA=Limited Partnership Agreement

1. Compensation structure
• Management fees
• Carried interest

2. Covenants
• Activities of the fund
• Activities of the individual General Partners
 Management Fees

• Annual management fees

• Level
• Basis: committed capital or net invested capital

• lifetime fees = The total amount of fees paid over the lifetime of a fund

• investment capital = committed capital - lifetime fees

• invested capital = cost basis (i.e amount) for the investment capital of the fund that has already
been deployed at a given point

• Net invested capital = invested capital - cost basis of all exited and written-off investments
 Fees example

ABC Ventures has raised their $100M fund, ABC Ventures I, with management fees computed based
on committed capital. These fees are 2 percent per year in the first five years of the fund, then fall by 25
basis points per year in each of the subsequent five years. The fees will be paid quarterly, with equal
installments within each year.

Problem
Given this description, what are the lifetime fees and investment capital for this fund?
 Carried Interest: definition

❑ Definition: % of the realized fund profit, defined as cumulative distributions in excess of carry basis, that
gets paid to GPs

❑ Terms that need to be specified:

• Level
• Basis: Committed capital or investment capital
• Timing
• Priority return
• Catch-up
• Claw back
 Example
• Sunny Bird Ventures is considering two alternative carry structures for its SBV II.
• 25% carry with a basis of all committed capital
• 20% carry with a basis of all investment capital

❑ Committed capital = $ 250 M

❑ Management fees = 2.0% of committed capital every year
❑ Fund duration = 10 years

Suppose total cumulative distributions for 10 years = $400 M.

1. How much carry would GP get under 1 and 2?
2. What is the breakeven amount of distributions that makes GP indifferent between structure (1)
and (2)?
 Carried Interest
• Contributed capital = invested capital + management fees that have been paid to date
❑ For a fully-invested and completed fund:
contributed capital = investment capital + lifetime fees = committed capital

• Carried interest timing

❑ Return all carry basis (committed or investment capital) first (25%)*
❑ Return all contributed (or invested) capital plus priority return first (45%)
❑ Return only part of contributed/invested capital
✓ Often distinguishes between realized and unrealized investments
✓ Fair value test (14%)
❑ Other (16%)
* Numbers in parenthesis indicate frequency of funds using each choice
 Carried Interest

❑ Priority return: For some funds, some minimum rate of return (called priority return or
hurdle rate) must be achieved by LPs before GPs receive carried interest
• 45% of VC funds have a priority return
• More common among late-stage funds than early-stage funds

❑ Catch-up: Once this threshold return is achieved, there is often a catch-up period during
which GPs receive disproportionately high ratio of profit until the aggregate profit is split
according to the carry rule (e.g., 20:80).
• Priority with catch-up affects timing of cash flows, but not the eventual aggregate profit
split if there are sufficient exits
• This is much more common
• Priority without the catch-up, on the other hand, permanently affects the eventual
aggregate profit split
 Detailed Example

Owl Ventures III is a VC fund with commited capital of $500M.

❑ Lifetime: 10 years
❑ Commitment period: 5 years
❑ Fees: Based on commited capital
❑ Carried interest: 25%
❑ Carry basis: Commited capital
❑ Timing: Contributed capital must first be returned to LPs
❑ Clawback: GPs need to return to LPs any excess distributions it has enjoyed before liquidation.
Assume that investment capital is spent evenly over the commitment period
 Detailed example: assumptions

Year 1 2 3 4 5 6 7 8 9 10
Est. Portfolio
83.3 333.3 124.9 139.4 146.0 43.8 13.1 3.9 1.2 0.4
Value
Exit
0.0 250 12.5 13.9 58.4 17.5 5.3 1.6 0.5 0.1
Distributions
Fee % 2.0 2.0 2.3 2.3 2.0 1.8 1.5 1.3 1.0 0.8

Q: What are the fees and distributions over the lifetime of the fund?

A: See spreadsheet
 Covenants on fund activities

• Investment focus: LPs want GPs to focus on their area of expertise

❑ Limits investment in asset class other than private portfolio companies (e.g., public
companies, other PE partnerships)
❑ Limits investment in sector / stage other than the fund’s defined specialization

• Investment size
❑ GPs have incentive to place big bets and increase variance in fund returns
❑ Solution: To limit size of a single investment (10-25% of fund size)
 Covenants on fund activities

• Co-investments across funds

❑ Later funds may be used to salvage investment gone awry in earlier funds
❑ GPs may especially want to do this when raising another fund!
❑ Solution: To require approval by LPs, co-investment by earlier fund, or by third-party

• Reinvestments of profit: Often permitted but restricted

❑ Until invested capital reaches 100-125% of committed capital
 Covenants on GP

• Co-investments by GPs themselves

❑ LPs don’t want GPs to spend all of their time on companies they’re personally invested
with
❑ Solution: To require LPs’ approval, restrict investment size, timing, and terms

• In general, LPs want GPs to be devoted to their fund

❑ Future fundraising activities: Not allowed till sufficient amount of investment is made for
the current fund
❑ Sale of GPs’ interests: Not easily allowed!
❑ Inclusion of new GPs: Restricted
Most contentious LPA terms

Source: Private Equity International, 2019