Thursday, February 25, 2010

Where are the Venture Capitalist's Yachts?

Yes the real title refers to customer's yachts, I know.  Tom Perkins owns the coolest sailing yacht in the world.  You can see it here.  You don't buy a Perini Navi unless you have serious bucks.  I've had the pleasure of sailing on this one with my kids.  As it was their first time on a sailboat, I said, "No, this isn't normal.  This is bigger than the Mayflower."

So, Tom Perkins writes in today's WSJ about why venture capitalists are not the pigs investment bankers are.  He says VCs work much harder for their money.  Bankers make big, quick hits because they "do deals".

We're going to talk about how VCs make their money.  Only one part of it.  VC fund investors commit capital to investments for a very long time, say seven years, and they agree to pay 2% annual management fees, and 20% performance fees to the manager. This is going to get a little hold on...

 In my parlance, investors hand the manager 2% annual annuities, (management fees), a call on the investors' balance sheets, (remember, the money isn't invested immediately, but the investors must be prepared on a moment's notice to fund deals,) and a 20% at the money call on the ending assets, (that's the performance fee the manager charges.  The manager has the right to own, for nothing, 20% of the portfolio if it's value is above the starting point.)

How do the VCs invest the money?  Incredibly risky, high growth companies.  Why does that matter?  Because the VC owns a 20% at the money call on the investments, and the VC controls how risky the portfolio will be.  On an expected value basis, this is stealing money!  Why?  I'll show you, with some examples of option pricing.

Here's a useful link to an option pricing calculator.  Assume a stock price of 100 to keep things simple, (this is arbitrary.)  An at-the-money call means the strike is 100 also.  Volatility?  Well, a well established enough to be public small cap growth company can have a vol well over 50%.  Even a diversified index like the Russell 2000 right now has a vol in the mid 20s.  VC portfolios also aren't particularly diversified.  Let's use 50%.  Don't forget to set the days to expiration at 2555, that's seven years.  Hit calculate.  You now see the call the manager has is worth about 60...that means the manager has an option worth 60 cents of every dollar the investor has put up.

But wait, there's more.  First, that doesn't include the management fees.  Keep it simple, and say the management fees are worth another 10-12 cents (2 cents on the dollar each year, for seven years, discounted back...I really can't do fancy math, and that's close enough.) So, $1 committed to a VC fund is now worth, ex ante, 70-72 cents to the management company.

But wait, there's more! That interest rate cell in the calculator?  We can use this cell to approximate what happens as a result of the manager expecting that he is making investments that have positive returns.  In other words, the companies in which he'll invest are risky, but they're expected to go up in value.  How much?  Well, what did he tell you before you invested? 20% maybe? Use 20%.  Re-calculate.  What did you get?  79.6.

With not unreasonable assumptions, we've just learned that by raising $100 million VC fund, the management company has just extracted $90 million (or more) in expected value for itself.  All they've done is fund raising to accomplish this!

[There's another step too, but it gets complicated.  The VC also holds the option on when to actually call the capital.  Arguably, they will only call the capital when the expected return materially exceeds their target expected return, but this also reduces the time to expiration.  The first option is conditional on the second.  This under virtually all conditions, adds more value to the manager.]

So, with all due respect to Tom Perkins who has been far more successful in his investing career than I can ever imagine, I don't think he should be crying overworked and underpaid relative to his investment banking brethren.

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