Ahmed-JCurveExposure15-19

Ahmed-JCurveExposure15-19 - _/ :ntive is supposed the fund....

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Unformatted text preview: _/ :ntive is supposed the fund. Usually nce investors have a. They also often themselves at risk reir success. These JG that the potential :d partners. e investments or to ids typically do not ital calls when they if the drawdowns is 1nd, funds may even is are received, they :lf—liquidating’ as the :ally have no right to tly in the second half ‘in kind’ as securities publicly tradable. ip shares are illiquid, :re is a private equity D return to the capital artner depends on the management fees will ually full liquidation - n the old funds under rivate equity funds as .lows them to withdraw y expertise has become 10 do not need to value k record and reputation ate equity firm can act ally, limited partnership be same manager before ally more than 70%) of ,egal framework and its 1 gains or losses among general partner, possible nent company enters into Lerner of Harvard Business School: Institutional Investing in Private Equity 15 The establishment of the first VC limited partnerships in the USA dates back to the late 19505 and 1960s. This model for VC investments is arguably the most successful worldwide and is followed in many international markets. The limited partnership is a result of the extreme information asymmetries and incentive problems that arise in the private equity market. rship proved to be a much more hing that had been tried before. Snow (2006) Beyond such eye-popping returns, the limited partne flexible and useful vehicle for venture capital than anyt Although the partnership structure is often seen as an innovation for VC investing, its origins date back to ancient times. For example, partnerships were already referenced in the Mesopotamian Code of Hammurabi, the first written code of laws in human history dating back from the early 2nd millennium BC. Indeed, for unusually large or especially risky enterprises it seems natural to pool resources to better exploit investment opportunities. Any form of equity financing involves a sharing of potential losses as well as of potential gains. Medieval merchants had been combining their capital with other merchants in one way or another, but they also financed their ventures and shared the risk in an asymmetric manner by accepting funds from small investors. Private partnerships carrying limited liability were unknown in classical Rome, but such contracts could be of either Byzantine or Arabic origin. The profit-and—loss-sharing part- nership is embodied in the concept of Islamic finance, where one party provides 100% of the capital and the other, i.e. the ‘mudarib’, manages the venture using his or her skills. Such ‘asymmetric’ partnerships were based on a statute in the Code of Justinian and on the Rhodian Sea Law, a 7th century body of regulations governing commercial trade and navigation in the Byzantine Empire. This ‘Lex Rhodia’ focused on the liability for lost or damaged cargo and divided the cost of the losses among the ship’s owner, the owners of the cargo and the passengers, thus serving as a form of insurance against storms and piracy. It was effective until the 12th century and greatly influenced the maritime law of the Italian cities from the 11th century onwards. Partnerships were introduced into Europe as Italian merchants increasingly traded in the Eastern Mediterranean, thus becoming familiar with business practices in this region and adopting the ‘commenda’. The commenda contract had a sedentary investor, known as the ‘commendator’, who advanced capital to a traveling associate, known as a ‘tractator’. The commenda combined financing with insurance, as the recipient of the financing was freed from any obligation to the provider of the financing if ship or cargo was lost. The contract ended when profits were distributed after the merchant returned. The comrnendators, in turn, diversified their risks by entering into commenda contracts with many different merchants. The cornmenda not only was a good too allowed reducing capital risk.2 It flourished acres but from the mid-13th century onwards it was big was a convenient way of combining capital with merchant entrepreneurship. The seafaring ‘ merchants brought their trade network, nautical experience and considerable leadership for managing their crew into the venture, and for these rare skills they rightfully expected to l to circumvent restrictive usury laws but also 5 Europe after its introduction into Italy, hly successful in the maritime trade, as it 2 See Kohn (2003). Hickson and Turner (2005) or Snow (2006). 16 J Curve Exposure take a good share of the profits. For example, in a so-called ‘unilateral commenda’ the ase the commendator received merchant added only his own skill and knowledge. In this 0 re efficient bilateral commenda three—quarters of any profit and the tractator the rest. In the me the merchant also advanced some capital and in turn could take a higher share of the profits .3 Box 2.2: (Pre—)Islamic finance and venture capital4 ‘Wer sich selbst and andre kennt, Wird auch hier erkennen, Orient and 0kzident, Sind nicht mehr zu trennen’.5 Johann Wolfgang von Goethe (West—Osflicher Divan) The concept of risk-sharing us excess liquidity springing from the recent oil-boom, Largely driven by the enormo s in the field of Islamic finance have equally boomed financial concepts and product in recent years. The market for Islamic bonds (sukitk) alone is estimated at $40-50 billion worldwide.6 No longer a peripheral phenomenon limited to certain countries or groups of people, financial products deemed in compliance with the religious precepts of Islamic finance are also being offered by several Western banks or their regional subsidiaries, such as UBS, Citigroup or HSBC. One conceptual underpinning of Islamic finance is commonly perceived to be the prohibition of interest-taking (riba). While at times in the past this has been interpreted as the prohibition of usury-type interest only, it is now largely accepted to include interest payments that are part of standard Western fixed—income instruments. Durrani and Boocock (2006) point to the fact that also other belief systems, like Christianity or Hinduism, at some point in their history have disallowed the charging of interest. In Islamic finance one common perception is that interest in a standard loan is quasi—risk- free, because the lender is guaranteed a return, independent of whether the underlying In general, in Islamic finance there is a need business transaction is successful or not. for a more direct relationship of risk-sharing between the provider of capital and its tresses the need to share rather user. Durrani and Boocock (2006) argue that ‘Islam 5 there appears to be a priori a than transfer [. . . ] risk’. In this wider context then, high degree of compatibility between the notion of risk—taking in venture capital and Islamic finance. In the wake of the current boom, is increasing. For example, in 2004 th principles of Islamic law, the Sharia, the variety of Islamic finance products offered e first fund-of—hedge-funds compliant with the has been introduced in the USA. Similarly, / 3 See Hickson and Turner (2005). 4 We thank Ulrich H. Brunnhuber, 5 ‘He who knows himself and others, I will also recognize here: / Orie 5 See Bokhaii (2007). CFA who researched and authored this box. nt and Occident, / can no longer be separated’. ’__,_’— 1menda’ the nor received 11 commenda E the profits.3 :her Divan) t oil-boom, 11y boomed 1 at $40—50 countries or )us precepts lClI‘ regional ed to be the n interpreted d to include ants. Durrani Christianity 3f interest. In is quasi—risk- ie underlying rere is a need apital and its ' share rather be a priori a re capital and )ducts offered )liant with the 3A. Similarly, Institutional Investing in Private Equity 17 the Islamic Development Bank (IDB) in Jeddah had earlier launched a VC fund that targets high-tech firms in Muslim countries. Finally, it appears that historically Arabian (pre-)Islamic contract law has provided at least one of the bases for the partnership structures widely used in vcnture capital today, in the form of the mudt‘zraba contract.7 Mudaraba and musharaka In light of the above, it is no wonder that Islamic contract law has had a long tradition of defining and sharing investment risks among the relevant parties to a business venture. In fact, according to Choudhury (2001) some of these concepts date back to pre-Islamic days. A mudaraba is a form of commercial contract whereby an investor8 - or a group of investors — entrust capital to an agent (mudarib), who trades in it and then returns the principal along with a predetermined share of the profits to the investors. The investors generally are not liable for any transactions the agent enters into with third parties, beyond the sum of money they provided. The agent, on the other hand, also shares in the success of the business venture based upon a previously agreed share of the profits. However, any losses incurred in the venture are the sole responsibility of the investors, with the agent losing his time and effort, and any anticipated gains she or he would have made had the venture been successful. Furthermore, the agent is also entitled to deduct legitimate business-related expenses from the capital sum provided. The mudaraba form of financing a venture has developed in the context of the pre-Islamic Arabian caravan trade. As such, it appears that its roots are indigenous to the Arabian Peninsula and that it played a critical part in the long-distance caravan trade for the Hejaz region. Numerous prophetic traditions and the extensive treatment of the mudaraba structure among Islamic jurists point to an established commercial institution with long experience on the Arabian Peninsula.9 More importantly, with the Arab conquest, the mudaraba spread to Northern Africa and the Near East, and ultimately to Southern Europe. With its introduction as the commenda in the Italian seaports, it laid the foundation for the expansion of European trade in the Middle Ages. In fact, Udovitch has demonstrated a very strong correlation between the structures of the commenda and the Arabian mudaraba.10 In Udovitch (1962) he concludes that it ‘is the earliest example of a commercial arrangement identical with the later commenda, and containing all its essential features’. Al-Sarakhsi, a jurist who lived in the 11th century, devoted an entire chapter (kitab) in his legal commentary (mabsflt) to treating the mudc‘zmba structure of commercial activity. After citing a number of prophetic traditions as a basis, he further argues for the use of this type of commercial contract: ‘Becausc people have a need for this contract. For the owner of capital may not find his way to profitable trading activity, and the person who can find his way to such activity may not have the capital. And ; See Udovitch (1962) and Durrani and Hancock (2006). 9 Rabb al-mal or owner of the capital. See Udovitch (1986) and Wakin (1993). mated, 1 Depending on the school of thought, mudaraba contracts are also referred to as kirad or mukarada. These terms can largely be re sep » used interchangeably. 10 Box 2.2: (Continued) profit cannot be attained except by means of both of these, that is, capital and trading activity. By permitting this contract, the goal of both parties is attained.’11 The separation between capital and labor for a mudaraba contract is a critical element in most schools of thought,12 which is one of the reasons why, for purposes of modern venture capital, the mudaraba is combined with another commercial contract, called musharaka, which allows for both parties to provide capital — in modern terms, it would allow the general partner as agent to invest ‘hurt money’ into the partnership structure as well. A mushdraka — often translated as ‘participation financing’13 # is a contractual part- nership with joint participation and exploitation of the capital, and joint participation of the profits and losses. Thus, a musharaka is the classical form of partnership where all parties contribute towards the financing of the business venture. The partners’ share of profits are based on a pre—agreed ratio; losses are shared according to each party’s investment. The management of the underlying venture can, however, be carried out by just one partner, some or all. Durrani and Boocock (2006) and Choudhury (2001) have pointed to some short— comings of both the mudaraba and the musharaka structure based on some of the underlying principal/agent issues. With some further finetuning they proffer hybrid structures that correct for these problems. Still, mudaraba and mushdraka (m&m) provide the main legal - and historical - basis for VC activity within the precepts of Islamic finance. Investment restrictions While the agents in the structures outlined above have considerable freedom in con- ducting their business, investors can impose certain restrictions. Based on the Islamic belief system, certain industry sectors and/or activities are considered not permissible. They are deemed to be generating profits in a religiously unacceptable manner. Typi- cally, these include some or all of the following: tobacco, alcohol, gambling or gaming activities, pornography, weapons and armament, pork products and conventional finan- cial services. Thus, negative screens are applied much like in the Western tradition. In fact, when comparing the potential investment restrictions found in Western venture capital, the significant overlap of what would typically fall under an exclusion criterion in the Western tradition versus the Islamic finance concept is quite striking. Some public and private players in the Western venture capital arena also want to be perceived as ‘socially responsible investors’ and their negative screening lists may, with of course the exception of the prohibition of pork products and conventional financial services, include all of the above. In a venture capital context these exclusion criteria would be placed alongside other aspects in the investment guidelines of the partnership agreement. And in fact, there appears to be a growing number of conventional private u Al-Sarakhsf (Sarakhsf, Mabstzt, xxii, 19) as cited/translated in Udovitch (1986). '2 With the exception of the Hanbali school. 13 More literally ‘sharing’, ‘participation’. 'ading ritical DSCS of ntract, terms, tership 31 part- ipation » where 9’ share party’s ried out e short- : of the r hybrid (m&m) :cepts of a in con- e Islamic .missible. rer. Typi— )I‘ gaming «nal finan- adition. In 11 venture n criterion want to be :may, with 11 financial ion criteria partnership )nal private Institutional Investing in Private Equity 19 equity and venture capital funds that have passed compliance tests from an Islamic finance point of View, with only minor adjustments. In assessing the permissibility of a proposed investment in terms of investment restrictions, Islamic scholars sometimes apply what amounts to a materiality test in the Western accounting tradition. A business activity is considered a core source of revenue or income when it constitutes more than 5% of a company’s total revenue or gross income. On the other hand, if an entity’s income is derived less than 5% from incidental impermissible activities, such as gambling, alcohol or the production of defense products, then it might be considered acceptable from an Islamic finance point of view. However, that portion of the underlying business activity’s income needs to be purified by donating it to specified charities. In the absence of uniform standards, the interpretation and application of these investment restrictions can vary between countries and schools of thought. In the early 20th century increasingly limited partnerships were used in the USA to raise capital for prospecting new oil fields. Finally, in 1959 Draper, Gaither and Anderson adopted this structure and set up what, in all likelihood, was the first limited partnership in the VC industry.14 The long—term success of this firm, later renamed Draper Fisher Jurvetson, contrasts with the demise of the original non-family venture capital firm American Research and Development (ARD). General George Doriot, the pre—WWII Harvard Business School professor, organized ARD as a publicly traded, closed-end investment company subject to the Investment Company Act of 1940. This closed—end structure was, according to Hsu and Kenney (2004), plagued by three main problems: (1) Its structure as an investment fund pressured ARD’s management to generate a steady stream of cash. (2) It also inhibited the provision of competitive compensation for ARD’s investment pro— fessionals. This reduced their incentives and eventually led to their resignation. (3) Closed-end investment funds often trade at a discount to their value in terms of cash and marketable securities, thus making them targets for corporate raiders. ARD was a pioneering organization whose business model ultimately failed while the limited partnership had a better fit with the business environment. Indeed, many see the limited partnership as an ideal vehicle for private equity investing. Snow (2006) even mused whether the ‘recent surge in public-to—private transactions has led some to wonder whether private limited partnerships are even beginning to challenge the public corporation as a form of corporate governance’. In essence, terms and conditions aim to align the interests between fund managers and their investors and to discourage ‘cheating’ (moral hazard), ‘lying’ (adverse selection) or ‘oppor- tunism’ (hold-up problem) in whatever form. The limited partnership agreement addresses questions of corporate governance and investor downside protection. For example, the ‘key- man’ provision caters for investors’ concerns that particular people should remain as fund managers. It usually provides that, on a material change in the fund management team, the “ See Snow (2006). m ...
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This note was uploaded on 01/12/2012 for the course LAW 621 taught by Professor Arshada.ahmed during the Fall '11 term at UC Hastings.

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Ahmed-JCurveExposure15-19 - _/ :ntive is supposed the fund....

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