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Chapter 3 Solutions - 3-1 In a closed end fund ...

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Unformatted text preview: 3-1 In a closed- end fund, investors liquidate their investments by selling their shares to other investors in the secondary market. The prices at which the shares trade in the secondary market are based on the percep>ons of the value of the fund's [email protected] companies. Because investors are concerned that they may be trading with others who are beBer informed, secondary market liquidity is limited and the manager is under pressure to provide a high level of informa>on to investors on a con>nuing basis. In a limited partnership, investors all invest at the same >me, or in a small number of closings. The investors liquidate their holdings of the fund through distribu>on of proceeds of harves>ng of the fund's investments. Thus, there is less need for the manager to provide frequent valua>on informa>on. This structure also subjects the manager to the market test. If the manager is not successful, the fund s>ll will be liquidated and the manager will have trouble raising a new fund. 3-2 In 1977, capital commitments to VC funds totaled $39 million; this number jumped to $600 million in 1978. Two factors were behind the significant increase. One was a reinterpreta>on of the "prudent investor" standard by the Department of Labor, which made it acceptable for pension fund and endowment managers to invest in alterna>ve asset classes like hedge funds and VC funds. The second factor was the Revenue Act of 1978, which reduced the capital gains tax rate and spurred increased entrepreneurial ac>vity. It also made inves>ng in in financial instruments which produced capital gains rather than dividends more aBrac>ve. 3-3 Fund managers with established reputa>ons can aBract entrepreneurs with good investment opportuni>es and investors who are pa>ent and trus>ng of the manager's decisions. Investors who are reputable can be relied on by the fund manager to honor their commitments when capital calls are made and not to seek early withdrawal of their capital. Entrepreneurs who are reputable can aBract the interest of good venture capitalists, can more easily nego>ate deals that provide the entrepreneur with flexibility, and can operate with less direct oversight and interven>on by the fund manager. Without reputa>on, VCs will have trouble aBrac>ng good deal flow and nego>a>ng flexible terms with entrepreneurs. The entrepreneur, for example, may not trust the VC to provide financing in subsequent rounds on reasonable terms. An entrepreneur without a track record will be kept on a short leash. Limited partners lacking reputa>ons may be asked to provide their en>re commitment up front rather than over the life of the fund via capital calls. 3-4 When the market was small, it is possible that there was a scarcity of venture capital, rela>ve to the needs of companies that were suitable for VC financing. In such an environment, fund managers could cover their opportunity cost by realizing the 20% carried interest on small investments in rela>vely early- stage ventures with very high poten>al. With an increasing supply of capital, compe>>on could force funds to look at a broader set of opportuni>es, including later- stage investments. To cover their opportunity costs, fund managers might find it necessary to make larger investments and to seek higher carried interest. Even though the carried interest is higher, the financial return to the general partner would be comparable to the earlier environment. Investors would accept this arrangement, if their 70% carried interest were sufficient to provide a fair return on their capital. Tes>ng this is difficult because of the high vola>lity of venture capital returns and the lack of reliable informa>on on returns to fund managers. However, in principle, evalua>on of the explana>on would be based on examina>on of the fund manager's returns rela>ve to opportunity cost, and on examina>on of whether a 70% carried interest to limited partners could s>ll aBract capital to the fund. 3-5 By raising capital only when necessary, the fund enables the limited partners to keep their funds invested in other assets un:l it is needed. Alterna:vely, the fund could invest the money for the limited parnters, but a contract that would permit this could be difficult to structure and could also create incen:ve problems. The ability to extend the fund's life increases the poten:al for the manager to con:nue to add value to ventures that may not b ready for harvest, to :me harves:ng with the ups and downs of the market, and to get porAolio companies to stages where more than one exit might be possible. These all enhance the manager's ability to provide higher returns to the fund's investors. VC investors must be those the manager can rely on to meet their capital calls, which implies they must have sufficient liquidity to be able to deliver substan:al amounts of capital on short no:ce. Also, because the :ming of harvests is highly uncertain, the investors must not be dependent on any specific distribu:on schedule. 3-6 a. The annual management fee will be 2% of $30 million, or $600,000. Split among three GPs means $200,000 per partner. b. As the [email protected] companies are harvested, the annual cash flow in years 5- 8 aIer the 2% management fee will be $19.1 million. AIer they return the LP's iniNal investment, the GPs will get 20% of the capital appreciaNon, or $2.3 million, as carried interest. This works out to $0.77 million per GP each year. c. For the LPs, aIer management fees, the return of their inNal investment plus their 80% carried interest provides a cash flow of $16.8 million in Years 5- 8. If they invest the full $30 million up- front, this produces a 16.1% IRR. d. If the LP's make equal $7.5 million investments in Years 1- 4, their IRR increases to 22.3%. Investment return = Management fee = Carried interest = Total Fund = c. d. Year Fund Cash Flows Capital calls (1-4) Management fee Year 1 investments Year 2 investments Year 3 investments Year 4 investments Cash Flow Before Carried Interest Return of Invested Capital Capital appreciation Carried interest: GPs Carried interest per GP LP Return ($) LP IRR = LP Return ($) LP IRR = 30% 2% 20% $30.0 million 1 2 3 4 $7.5 ($0.6) ($6.9) $7.5 ($0.6) $0.0 ($6.9) $7.5 ($0.6) $0.0 $0.0 ($6.9) $0.0 ($30.0) 16.1% ($7.5) 22.3% 5 6 7 8 ($0.6) ($0.6) ($0.6) $19.7 $0.0 $0.0 $19.1 $7.5 $11.6 $2.3 $0.77 $16.8 $19.7 $0.0 $19.1 $7.5 $11.6 $2.3 $0.77 $16.8 $19.7 $19.1 $7.5 $11.6 $2.3 $0.77 $16.8 $16.8 $16.8 $16.8 $0.0 $0.0 $7.5 ($0.6) $0.0 $0.0 $0.0 ($6.9) $0.0 $0.0 $0.0 $0.0 ($0.6) $19.7 $0.0 $0.0 $0.0 $19.1 $7.5 $11.6 $2.3 $0.77 $16.8 ($7.5) ($7.5) ($7.5) $16.8 3-7 Costs are reduced are proximate to their por1olio companies, their rivals, and other market par7cipants such as suppliers and specialized labor. Value is added through close working rela7onships between VCs and por1olio fi rms, which will be more efficient with proximity. When new venture ac7vity is concentrated, VC fi rms can more easily monitor industry trends. In addi7on, VC fi rms and por1olio companies have specifi c human capital requirements and tend to cluster around large and talented university popula7ons. 3-8 One way to address the adverse selec7on problem is to adopt contracts that limit investor reliance on ex ante due diligence and valua7on. This can be accomplished by staging the investment based on the venture's achievement of specific milestones. Adverse selc7on can also be mi7gated throught the use of certain financial contrac7ng structures. These include conver7ble preferred stock ,performance- based rights or a ratche provision. 3-9 a) Investors may object to the addi7on of new GPS to an exis7ng fund out of concern it could lead to shirking on the part of the original parnters. Investors also made their investment decision based on the managment team in place and may believe the new managers are less skilled. b) Fundraising for a new fund may dilute the GP's efforts on behalf of the current fund and adversely impact the returns to the LPs. c) The GPs already have a financial stake in the fund's por1olio companies via their carried interest. Any addi7onal investment in a por1olio company by a GP with personal funds would present a conflict of interest as the GP may then put more effort into crea7ng value at that company, poten7ally to the detriment of the other por1olio companies and the LPs. ...
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