Venture Capital and Private

Equity Investors
Daniel Egger
 Venture capital and private equity funds differ from mutual funds
and hedge funds in a number of important ways. For one thing,
the fund managers do not collect all their cash from investors up
front. Instead, investors make commitments to provide a certain
amount of cash over the five to seven year life of a typical fund.

Fund Managers With trenches of that cash being available on what's called a call
basis, typically within 30 days of being called. So, a large
institutional investor might make a $20 million commitment to a
venture capital fund. And expect eight calls of $2.5 million each
spread out over four to five years. The reason for this structure is
that venture capital and private equity investments take a long
time to source, develop, and structure.

Do not collect cash upfront And, often multiple investments will be made in the same
company over a period of multiple years, up to five years. Prior
to the money actually being needed by the investors,

the outside sources of capital don’t want the money sitting

Investors commit $$ over around idle. They’d rather invest it elsewhere. In liquid
investments that can be cashed out quickly.

Because investors are providing cash to the fund in various

the “life” of fund amounts over a period of several years, the best metric for
evaluating performance of these types of funds is the internal
rate of return. The discrete, compounded rate of return on just
the money actually drawn by the funds.

$20 million commitment =

8 “calls” of 2.5 million
Spread out over 4-5 years
Time to source,
develop, and structure

Multiple investments,
same company

Investors don’t want

cash sitting idle
 Hedge funds have far fewer restrictions on what types of investments they can make than
mutual funds for instance. Hedge funds are permitted to short, which means structuring a
deal so that they can make money when a stock price goes down. And to invest in many
different types of assets, including options and derivatives. Hedge funds are not tied to a
single sector universe. So it would not make sense to use a sector benchmark to evaluate

Hedge Funds them. In fact, to achieve maximum diversification, investors in hedge funds typically want
hedge fund performance to have a low correlation to all the major equity markets. A great
hedge fund will be up in a bull market and up just as much in a bear market for equities.

Of course the track record, a strong annual rate return over multiple years is a key metric. So
is the sharp ratio.

Fewer restrictions And because the holdings and working of hedge funds are less transparent than mutual
funds, hedge fund investors are very wary of big draw downs. Therefore, another key metric
for hedge funds is the maximum drawdown from high water mark.

Permitted to “short”

Invest in different
asset classes

Not tied to single

sector “universe”
 Up in
Up in bear
bull markets
markets
Great
hedge
fund
Though it may look impressive, if from 2005 to 2015, a hedge fund has an annualized rate of return of 15% per year. But if there was a 30% draw-down, say during the big bare market in
2007, 2009, investors will think, I could have been the unlucky one who invested first right there. And so then I would have lost -30% of my money. Okay?

So the reality with hedge funds is if they start to show losses in the 20, 25, and certainly 30% range, people start redeeming their money immediately. And the hedgefund will generally
collapse. >> Metric related to maximum draw down from high water mark is years to break even. And the way to think about this is to identify the worst high to low loss over some time
interval.
And what we're looking at here is the SNP 500 index

from August 10, 2007 to May 20, 2015. And our worst loss would be from October 9, 2007 to March 9th, 2009.

Then the market was down 57%. Needless to say, no hedge fund would survive that kind of loss.

And then we calculate the annualized return from the beginning to the ends. So we're looking at the slope of this line, and this return would be 5%. And then we take the
absolute value of the maximum draw-down, divided by the annualized return. And that gives us a number, referred to as years to break even,

which is the number of years at the average return that an investor would recover from the worst lost. This of course, would assume that they entered the fund at the worst
possible moment. But somebody will right, and you don't want it to be you. It's interesting to see that for the SMP 500, the years to break even is over 11. Hedge funds need
to have the years to break even in the two to three year range maximally, in order to continue to attract new investment. >> Finally, to minimize correlation with equity
markets, investors like to see a strong linear trend in the log value of wealth in a fund. If a fund is generating a steady, continually compounded return every day, its volatility
of return would be zero. And its internal linear correlation of time and log wealth would be one.