Monday, August 12, 2013

What To Do With My Unfunded LP Commitment Before Capital Calls?

I got an interesting question the other day from a client about what to do with the unfunded portion of his LP commitment.  It was the first time I got the question from an LP but have actually been thinking about it myself quite a bit.  Of the LP capital commitments I have to date, the unfunded portion is sitting all in cash. Over the past several quarters I've realized, that the time value of money on that cash just sitting with my bank is really unexciting given how well the public markets are performing of late.  So I asked myself the same question the LP did of me, what should I do with the unfunded cash I have set aside?  Being a naturally conservative person, I've always thought I should hold everything in cash so that I never have capital call timing issues.  That may be the conservative reformed lawyer in me or the worry wart, but I think a lot of people simply keep their unfunded commitments in cash.  With a fund-of-funds structure, its capital calls are much more predictable and easier to manage on an individual LP looking to commit roughly 15-20% a year of the LP's capital commitment during the first 3-4 years with it tapering in later years.  

But, do I need 100% of the unfunded commitment amount in cash?  I probably don't and probably shouldn't because a 0.01% interest rate from J.P. Morgan isn't beating any PME (including inflation)!  As such, I've made a tactical decision to reserve one year's forecasted capital call needs in a money market fund and then have the rest of the unfunded/unreserved capital commitment be invested in mutual funds without early redemption penalties, just to be extra safe.  

No one talks about the real return on your money in private equity if you commit $100,000 in Year 1 and then only have $50,000 drawn by the end of Year 3 and $50,000 continues to sit in cash.  A good portfolio manager should be thinking about what to do with your entire capital commitment, both unfunded and funded.  Obviously, an adviser should be helping you pick good funds (the funded piece) and then be helping you maximize your all-in net return by eking out a few hundred basis points of alpha by actively (or passively using mutual fund indexes) managing your unfunded commitment.  The goal in private equity should be to outperform the public markets by 300-500 basis points, and the all-in net performance of the unfunded commitment should be part of this calculation as well.  Obviously, it will vary from LP to LP with no two LPs having the same asset allocation of their unfunded commitment, but I don't think it's a topic that is often discussed and I'm glad I woke up and made a change which should hopefully allow me to eek out a few extra basis points of alpha with the clarity of mind that I'll always have cash to meet capital calls. 

Curious what others think though and welcome feedback/advice!

Wednesday, August 7, 2013

What Is Growth Equity?

Today, Cambridge Associates came out with benchmarks for U.S. growth equity funds, which they acknowledge has a murky definition somewhere between venture and buyout.  So what is growth equity then?  Everyone seems to love it because it's like venture in that you should be able to get a venture-like 3-5x return multiple but also like buyout in that growth equity managers are investing in more mature companies that have meaningful revenue (maybe profitable) and were most likely bootstrapped by their founders prior to raising institutional capital.

Summit Partners calls their growth equity strategy: "Financing that helps exceptional companies accelerate their growth.  By providing capital, strategic guidance at the board level, and operational support, growth equity investors can help companies realize their full revenue, profit and market-value potential.  Many growth equity investors will make minority investments and prefer that current managers continue running their businesses."  That sounds exactly like venture capital, right?  Invest money, add value, make money...

In having met with managers across the entire spectrum of self-proclaimed "growth equity" managers, there is a noticeable delineation between managers that blur the lines with late stage venture and managers that blur the lines with buyout.  With notable exceptions, I think growth equity managers are minority investors and are investing in growth companies with meaningful traction and little debt coverage.  

In theory, growth equity should be the dream date for private equity LPs.  If you can take the value-added board leadership and entrepreneurial operational experience of venture capitalists and combine it with the investment banking financial modeling, low loss rates and shorter duration to liquidity of the buyout space, what more can you ask for.  If you can do a 3.0x net TVPI over an 8-year investment period consistently, wouldn't you invest in that fund all day, every day?  

As late stage venture capital has become overheated and the irrational exuberance of piling into the latest and greatest tech company in the Valley subsides, we're seeing more VC firms who do later stage investing become "growth equity firms".  Moreover, we're seeing more buyout firms seeking proprietary dealflow and alpha by chasing high growth venture-backed companies.  I don't see any difference between a buyout fund doing a minority investment and calling it growth equity, or a venture fund doing a later stage deal with no previous venture money in the company, and calling it growth equity.  

What really defines growth equity is the sourcing.  If there is no proprietary deal any more in the venture ecosystem, there certainly are proprietary deals in the growth equity space.  That's why there isn't a huge ecosystem of managers and it's hard to say who does growth equity and who doesn't.  Direct outbound calling programs are the biggest differentiators for growth equity managers are the reason why firms like Summit, TA and Insight are among the very best.  

Therefore, I don't think there is such a think as a growth equity manager, but only a growth equity deal. Growth equity may be the last bastion of proprietary deals.  

Tuesday, August 6, 2013

You Are Your Fund Size

I've been spending a lot of time meeting with new boutique VC funds raising capital right now. I think there has been a fairly quick shakeout between the haves and the have-nots in the seed stage space as the early entrants have 100+ deal track records, exits (yes exits) and good performance to show LPs.  As a result, they've been able to raise the same amount of capital as their first fund(s) or raise slightly more.  

Every seed fund raising more capital for Fund II than Fund I says they are doing it because they "could have put so much more to work in their previous winners".  You don't say...! This is really the only real explanation for increasing fund size.  It's relatively unheard of for a seed fund to increase its fund size because it is adding a partner.  

If you are a seed fund and are raising $20M, you are going to have a much different strategy and portfolio construction than a $50M or $100M fund.  Moreover, if you have a $100M fund, I would find it hard to call yourself a seed fund.  More likely, you're an early stage firm that puts down call options at the seed stage and buys its ownership at the Series A.  Otherwise, how can you possibly put $100M to work over a 3-4 year investment period if you're writing $500-750k checks?  

When you put out a pitch deck, declaring your intentions to raise a $50M seed fund, make sure you understand how you're going to be able to put that amount of money to work and make sure that you're honest with yourself and your prospective investors about your ability to write larger checks.  It's easy to be a nice guy and be invited into party rounds, it's not so easy to lead/co-lead the majority of your deals and politely yet sharply build ownership and selectively squeeze out the lemmings.  

Either the collapse or evolution of seed funds today is going to come as they increase fund sizes and react to the reality of the day that party rounds are popular and you have to be a nice guy to keep getting invited to the party, but you are your fund size and can't write $250k checks out of a $65M fund. Those funds that over time will evolve to larger lifecycle venture capital funds, will likely do so by being great sourcers at the seed stage and are able to lead/co-lead A rounds and retain board seats. If you know you're not a lead investor yet and are just getting your feet wet after having left an exited startup, be honest about this and raise a small fund, so that if you get lucky or are a quick learner, those 1-2 companies will be able to return the fund off your $100-250k check. Smart small, learn quickly and grow as your experience does. Those seed funds that are intellectually honest with themselves about what they need to be and how they need to do it, based on their fund size, will evolve and are more likely to excel as the haves in the seed stage market, and potentially emerge as the next go-to Series A funds given their networks as seed investors. In ten years when these fund are close to winding down, hopefully we'll all be able to say "they are who we thought they were".