Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Private Equity: Venture Capital and Mezzanine Debt – Part 3

The previous article in this series described leveraged buyouts — where a private equity firm initiates a purchase of a public company with the intention of increasing the value of that company and selling for a profit in a short period of time.  Another often referenced form of private equity is venture capital.  Venture capital describes investments which provide money to companies in the earlier stages of a new venture in the hopes that the startup will become successful and repay the investment many times over.  Venture capital investments have some characteristics similar to those of buyouts, but they differ in many ways.  The various forms of venture capital will be the topic of this Investment Product Review.

Venture-capital

The process of gathering money for venture capital (VC) funds is essentially identical1 to that of buyout funds, but the operations of the fund are quite different.  Venture capital funding can be provided to a startup company at several different stages in that company’s development.  The earliest possible stage of investment is called “angel investing”, at which point the potential company is usually little more than an idea of a single entrepreneur (or a small group), with no formalized business plan or infrastructure.  This stage of development is extremely uncertain, and only the most intrepid VC funds will consider acting as angel investors.  Once an entrepreneur has created a business plan and has started to construct a management team and conduct preliminary market analysis, they begin to look for “seed capital” which is generally the earliest level at which VC firms become interested.  Because the business plan may be mainly theoretical at this point, the VC firm must base their investment decisions on the strength of that business plan and the key personnel of the fledgling company.

Startup companies use seed capital to create and test their product, as well as to fill out the management team and create vital firm infrastructure.  If the product appears viable, the company will now be ready for early-stage venture capital.  This next level of financing allows the startup to establish production capabilities and begin distribution of their product.  At this point, if the company is going to be viable it will generally be generating revenues (though likely not profits).  Once the firm has shown that it is a going concern, it is ready for late-stage or expansion capital.  The idea is that this particular round of financing should allow the firm to establish itself to the point where it is self-sustaining.  At this point in the development process, many companies are well enough established to issue equity through an IPO.  Having a startup company go public is generally the end goal of VC funds, allowing the venture capitalists to turn their initial investment into a profit by selling their share of ownership.

Not every company will be in position to go public after the expansion round of capital.  At this stage, another option available to the startup firm will be issuing mezzanine2 debt.  Mezzanine debt is specially customized for each issuance, but there tend to be several characteristics common to most instances of mezzanine financing.  Mezzanine debt is unsecured (not backed by company assets), subordinate to senior debt (meaning lower priority credit), and tends to involve an equity “kicker,” usually in the form of warrants3 or convertible debt.4  Because mezzanine debt is inherently risky due to the structure of the debt and the typical profile of the issuing company, the required return to investors tends to be much higher than normal debt securities.   Thus, coupons are typically in the 10-15% range. Unlike normal corporate debt, mezzanine debt has no prepayment protection, and the high coupon payments provide the issuing firm with an incentive to repay the debt as soon as possible. This is another factor that needs to be considered by potential investors.

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Companies other than startups can issue mezzanine debt, though few choose to because it is quite costly relative to other methods of gathering capital.  Established companies that can only raise money through mezzanine debt issuance tend to be so called “fallen angels” or companies that have fallen on extremely hard times, often having defaulted on existing debt.  Like all other securities, the quality of the mezzanine debt will be determined by relative strength and prospects of the issuer, which should be considered extremely carefully by potential investors due to the inherent riskiness of the asset class.

While the goal of every venture capital investment is for the receiving company to become profitable and go public, VC firms know that this is not always a reasonable expectation.  The earlier in the process the investment is made, the less likely it is that the venture will be successful, but at the same time the greater the potential profit for the investor.  It is not uncommon for half or more of the companies in a VC fund’s portfolio to fail to pan out. However, this does not mean the fund will not be profitable.  Some investments will perform modestly and offer returns of 2-3 times the initial investment, and occasionally the fund will unearth a hidden gem that creates returns of 25 times the investment or more (e.g., Facebook).  Average long-term returns for VC funds have been very strong, returning 30% annually over the previous5 20 years, more than triple that of public equity indices like the S&P 500 and Russell 3000.  However, VC returns are extremely volatile and fund-dependent.  Unlike with public equity funds, private equity fund performance tends to be persistent over time, particularly in the case of venture capital.  Unfortunately for most investors, the best-performing VC funds are over-subscribed and rarely open up to new investors.  This, along with long holding periods and high minimum investment requirements, makes VC investments highly speculative and not particularly appropriate for many investors, especially those in or nearing retirement.  In the next installment of this series, we will cover private real estate, which has characteristics that are very different from those of leveraged buyouts and venture capital.

References
1. For more information on fund structure, see our previous post on private equity: http://www.empirical.net/private-equity-leveraged-buyouts-part-2/
2. The name “mezzanine” refers to the idea that the security is on a level in between equity and secured bonds.
3. Warrants are stock options that are issued as part of a debt offering.  For more on options, see: http://www.empirical.net/derivatives-option-contracts-part-2/
4. For more information on convertible bonds, see: http://www.empirical.net/convertible-bonds/
5. Source: Cambridge Associates LLC US Venture Capital Index, through 9/2013.

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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