Yale University Investments Office

Professor Sandeep Dahiya

Georgetown University

Road Map• Last Class

– VC Fund structure introduction (Fixed Life, GP, LP, compensation etc.)

– What do VCs do– VC Cycle

• Today’s Class– View of a prominent LP– Role of VC investments in Broader portfolio management of LPs– Trends in Private Equity

• Tomorrow’s Class– ACCEL VII CASE HOME WORK– Start on VC method of Valuation

ONSET Ventures

• What Happened?

Some Basics

• How is return of a fund measured?• Consider a fund that raised 100 million – Drew down 50 million at

start of year 1 and Year 2. Distributed 100 million at the end of year 7 and 80 million at the end of year 10.

-50

0 1 2 3 4 5 6 7 8 9 10

-50 100 80

IRR=7.87%

• What is distribution?• How does the VC get paid?• What about funds that are only a few years old?

Multiple 1.8x What if 100 was distributed at the end of Year 5 instead of Year 7?

Yale Investment Office

• Some Background Facts– How and why is the endowment important for

Yale?– How has the Investment Office done under

Swensen?

A Clear Philosophy

• Focus on Equities--public or private.

• Avoiding market timing.

• Focus on inefficient markets.

• Pick investment managers rather than investments.

• Focus on incentives.

Asset Allocation at Yale1985 2006

YALE PEERS ALL YALE PEERS ALL

Domestic Equity

61.6 51.5 46.1 11.6 24.5 45.8

Foreign Equity

6.3 2.0 0.8 14.6 17.4 12.7

Bonds 10.3 26.4 30.6 3.8 16.2 21.5

Cash 10.1 10.8 14.5 2.5 1.1 3.5

Real Assets

8.5 4.8 4.2 27.8 10.7 3.9

Private Equity

3.2 2.7 0.7 16.4 9.3 2.4

Absolute Return

0.0 1.8 3.1 23.3 20.7 8.7

Asset Allocation at Yale1985 2006

YALE PEERS ALL YALE PEERS ALL

Domestic Equity

61.6 51.5 46.1 11.6 24.5 45.8

Foreign Equity

6.3 2.0 0.8 14.6 17.4 12.7

Bonds 10.3 26.4 30.6 3.8 16.2 21.5

Cash 10.1 10.8 14.5 2.5 1.1 3.5

Real Assets

8.5 4.8 4.2 27.8 10.7 3.9

Private Equity

3.2 2.7 0.7 16.4 9.3 2.4

Absolute Return

0.0 1.8 3.1 23.3 20.7 8.7

Private Equity is an Important Element

• Investor since 1973.

• Repeated investments in partnerships formed by a select group of organizations.

• Emphasis on value-added strategies.

• Focus on incentives.

Spectacular Success in Private Equity

• 31% over 29 years--well above benchmarks.

• Success in venture capital, buyouts, and oil & gas.

• Prestige investor.

But Worries About Future

• Recent fund influx:– Private pension funds in 1980s.– Public pension funds in 1990s.– Private equity pool--from $4B in 1980 to

~$300B in 2004.– “Virtual overhang.”

Private Equity Fundraising

0

25

50

75

100

125

150

OtherBuyoutVenture

Billions of 2002 $s Source: Venture Economics and Asset Alternatives.

Private Equity Returns

-25%

0%

25%

50%

75%

100%

125%

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Source: Venture Economics

Venture Capital

Buyouts

Implications of Fund Influx

• Alteration in incentives.

• Relaxation of covenants.

• Concerns about within-fund compensation.

• Quality of deals.

But ...

• Good returns during last fund influx.

• Inter-quartile spreads:– 3% in public equities.– 12% in private equity.

• Private equity small relative to potential: $1:$30.

But…. (2)

• Ways to manage risks:– Top down: Optimizer.

• Drove decision to undertake major hedging effort in 1999.

– Bottom up: What—in Swensen’s team’s judgment—are the interesting areas going forward?

• Swensen: Must use both approaches!– Need for communication and trust with Investment

Committee.

Challenge of Internationalization

• 10% of Yale’s private equity, mostly Europe.

• Poorer returns.

• Organizational worries and difficulties of assessment.

• Who to back?

Swensen’s Dilemma

• Is private equity still viable for Yale?– If so, where?– If not, what other asset classes should they

pursue?

• How far can it go in pursuit of returns?

• How dangerous is it to be different?

Yale Investment Office 2006

• Domestic Equity 12%, Bonds 4%!!!

• Private Equity 17%

• Real Assets 27%

• Beat S&P500 in every year since 2002 by Wide margins!! Endowment size $18 billion

How Are VCs Compensated?

• Management Fee – (Little risk)– Like Salary– What are the incentives' for GP?– Why 2% (Usually) of “Committed Capital”

• Carried Interest – (Performance Based)– Like bonus– How to measure performance?– Can this cause problems?

• Let us look at an example

Key Ventures

• Size is $250 million, life 10 years• Management Fee 2% collected at start of each

year. (2%x250 = 5 million each year)• Investment Capital = 250-10x5= 200 • Assume 4 equal take downs (200/4=50)• Assume gross return is 25%• 10% of portfolio value is distributed every year

starting in Year 4 (end of year).• No carry till the entire 250 million is returned to

investors

Year 0 1 2 3 4 5Management Fee 5 5 5 5 5 5Investment 50.00 50.00 50.00 50.00 0.0Estimated Portfolio Value 50.0 112.5 190.6 288.3

0.0360.4 405.4

Distributions 0.0 0.0 0.0 0.0 36.0 40.5Cumulative Distributions 76.6Distribution to Key

Cumulative Distributions to Key

36.00.00.0

0.00.0

Distribution to LPs 40.5Cumulative Distributions to LPs

0.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.00.0 0.0 0.0 0.0

36.036.0 76.6

Portfolio value after capital returned 50.0 112.5 190.6 324.3 364.9Contributed Capital 55.0 110.0 165.0

288.3220.0 225.0 230.0

Invested Capital 50.0 100.0 150.0 200.0 200.0 200.0Cash Flow to Key Ventures

NPV for Key Ventures 82Cash Flow to LPs

5.0 5.0 5.0 5.0 5.0

-55.00 -55.00 -55.00 -55.00

5.0

31.04 35.54

100

95

0.0649.464.9

296.19.29.2

55.7286.9584.4250.0200.0

14.2

50.71

0.0730.5730.5

1026.7146.1155.3584.4871.3

0.0250.0200.0

146.1

584.43

65

0.0456.1

45.6122.2

0.00.0

45.6122.2410.5235.0200.0

5.0

40.61

Key Ventures

What effect would having a 25% carry but management fee only for the first 4 years have?

Year 8 Cum Distribution = 231.2Year 9 first 18.8 (250-231.2) go to LPsRest 46.1 (64.9-18.8) shared 80/20

Key Ventures – Full Analysis

Year 0 1 2 3 4 5 6 7 8 9 10Management Fee 5 5 5 5 5 5 5 5 5 5 0Investment 50.00 50.00 50.00 50.00 0.0 0.0 0.0 0.0 0.0 0.0 0.0Estimated Portfolio Value 50.00 112.50 190.63 288.28 360.35 405.40 456.07 513.08 577.21 649.37 730.54Distribution for the year 0.00 0.00 0.00 0.00 36.04 40.54 45.61 51.31 57.72 64.94 730.54Cumulative Distributions 0.00 0.00 0.00 0.00 36.04 76.57 122.18 173.49 231.21 296.15 1026.68Distribution to Key Ventures 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 9.23 146.11Cumulative Distributions to Key Ventures 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 9.23 155.34Distribution to LPs 0.00 0.00 0.00 0.00 36.04 40.54 45.61 51.31 57.72 55.71 584.43Cumulative Distributions to LPs 0.00 0.00 0.00 0.00 36.04 76.57 122.18 173.49 231.21 286.92 871.35Portfolio value after capital returned 50.00 112.50 190.63 288.28 324.32 364.86 410.46 461.77 519.49 584.43 0.00Contributed Capital 55.00 110.00 165.00 220.00 225.00 230.00 235.00 240.00 245.00 250.00 250.00Invested Capital 50.00 100.00 150.00 200.00 200.00 200.00 200.00 200.00 200.00 200.00 200.00

Cash Flow to Key Ventures 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 14.23 146.11NPV for Key Ventures at 12% discount Rate 82.01Cash Flow to LPs -55.00 -55.00 -55.00 -55.00 31.04 35.54 40.61 46.31 52.72 50.71 584.43IRR for LPs 20.14%