Monday, October 26, 2015

Uncertain Health in an Insecure World – 62

“Saving Private Equity”

In Steven Spielberg’s Saving Private Ryan, Tom Hanks leads a band of eight G.I. (government issue) soldiers into post D-Day France in search of the surviving 25% of Mrs. Ryan’s sons. The movie was based on the true WWII story of the Niland brothers. As the embattled G.I.’s search for Private Ryan, they frequently utter the term "FUBAR", reflecting frustration with the absurdity of the personal risk they bear for returning one mother’s last son.

Indeed, "F***ed Up Beyond All Recognition" describes many government issues.

For example, money from the very banks rescued by the U.S. government in 2008 (see post #61) now heavily impacts the private equity venture capital (VC) marketplace. Bank-backed VC's financial return point-of-view now counterbalances the more strategic approach of non-banking corporate VC’s. At a recent University of California Berkeley meeting, one corporate VC director from General Electric called his firm “a bank”. The irony of public sector reversal of private sector misfortune was not lost on those in the room.

In the private equity sector, fund illiquidity is the most common investment outcome.

In the Wall Street Journal (Sept. 20, 2012), Deborah Gage reported on the big secret of VC – 3 out of 4 start-ups fail. The U.S. National Venture Capital Association confirms that 95% of private equity funded start-ups return no cash to investors, or miss important business hurdles. Such outcomes are even harder on the entrepreneurs who have maxed out credit cards and borrowed from friends & family to get a VC deal rolling.

In the Harvard Business Review (August 5, 2014), Diane Mulcahy cynically (?) posited that VC general partners (GP’s) get very well paid to lose limited partners’ (LP’s) money. VC investors take on the very real risk of losing big as a way to outperform public equity markets, which is rarely accomplished by the majority of private equity funds.

Mulcahy concluded that most VC’s can serially underperform and not only survive, but thrive!

Remember, a typical 20% carry to the GP’s on a $1 billion VC fund is $20 million annually. Given that, one wonders, “What’s the hurry for these big funds?” Is an early exit financially better for GP’s than running the course? Of course not! And the market standard deal is for GP’s to personally invest only 1% of the fund size while LP’s contribute the remaining 99%.

Talk about playing with house money!

Global stock markets tank when economists discover that The Fundamentals are off. But VC has been resilient, surviving the 2008 depression, and weathering the 2015 China market meltdown. However, annual industry performance data shows that VC’s routinely underperform the S&P, NASDAQ and other public equity market indices. Riding this wave of VC underperformance in a $1 billion fund is still profitable to the GP’s, while more typical $100 million funds cannot coast on such choppy surf.

Investors seeking returns on capital freely pivot to the best opportunities. If the VC sector does not reward risk by outperforming the public markets by 300-500 basis points, the VC industry sector contracts. But serious investors require investment vehicles – viable choices – including both the public equity markets and private equity funds.

Only the bigger better VC funds that consistent generate venture level returns survive to fight another day.

With the current average time from start-up to Newco launch of 11-14 years exceeding the desired VC fund 10-year liquidity goal, time is clearly money for all involved. The 460 highest performing VC start-up companies (the “0.3% Club”) grow the fastest, leaving more money in private equity partnerships for the founding managers and investors on exit.

For example, LinkedIn founder Reid Hoffman (above) retained 20% of the company’s original start-up funding, as compared to the typical 3% figure in most new tech evolutions. Fifty percent of the 0.3% Club’s exiting tech companies (the ‘Alpha’) is found in California, and 50% of that Alpha is located in the Silicon Valley.

Top Newcos outstrip their start-up contemporaries by growing faster and using cash more efficiently.

While the big banks that were bailed out by the U.S. government in 2008 are now major corporate VC investors, that same government is not a player in the high risk early round private equity market. The Fed will never directly bail out failing big VC firms or save this important financial sector. It is just not in the public interest to rescue underperforming high-risk private equity.

There’s no bailout mission coming for private equity!

Given this reality, is a fundamental restructuring of the classic VC fund fee & carry deal and the typical entrepreneur investment model needed?

Does the pro-entrepreneur VC sector need to innovate itself?

AngelList is an emerging group of investment syndicates that forgo VC management fees in favor of carry, such that the GP’s and LP’s share in the investment upside and downside. This absence of fees puts VC’s and angels on similar financial footing.

And as always, China is paying close attention.

On October 12, 2015, AngelList CEO Naval Ravikant (above, right) announced that his 30 person syndicate will be getting US$400M from a Chinese VC fund, CSC Upshot. As late stage investing in startups lags in the wake of the recent market correction, he says “You don’t want to be a company that is burning tens of millions of dollars a year and hoping you are about to raise another $200 million around the corner.

Smart investors and wise objects in these syndicates (above) learn from their mistakes.
And sometimes you have to make big mistakes… FUBAR’s…. to make a real and necessary change.

Perhaps, these new age investors, in the words of Captain Miller, are “the angels on our shoulders…”

We in the Square understand the risks and rewards. But Miller's rules of war are that combatants should not freely sacrifice the innocents.

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