The Missing Preferred Return

1
The Missing Preferred Return
Fall 2006 Venture Capital and Private Equity
Victor Fleischer ASSOCIATE PROFESSOR OF LAW
2
Recap of Last Class
Fall 2006 Venture Capital and Private Equity

• Venture Capital Industry market by uncertainty,
  information asymmetry, and risk of opportunism
• Investors rely on active intermediaries to manage
  these risks and create positive, risk-adjusted
  returns
• Use of agents means another layer of agency costs
• GP-LP contract managers these agency costs
  through (1) limited life of the fund / mandatory
  distribution (accountability), and (2) financial
  incentives (carried interest)

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
3
Intermediation
Fall 2006 Venture Capital and Private Equity
LP
LP
Yale
LP
GP
Fund / Intermediary
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Victor Fleischer ASSOCIATE PROFESSOR OF LAW
4
The Puzzle
Fall 2006 Venture Capital and Private Equity

• In Private Equity (e.g. Francisco Partners)
• Managers normally get 2 20, but subject to a
  preferred return / hurdle rate
• In Venture Capital
• No hurdle rate
• Time value of money is the same either way, so
  why the difference?

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
5
Fall 2006 Venture Capital and Private Equity
Victor Fleischer ASSOCIATE PROFESSOR OF LAW
6
Fall 2006 Venture Capital and Private Equity
Clawback
Fund Vintage Year 1998
LP
LP
LP
LP
GP
20
Fund / Intermediary
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Home Run
Strike Out
Strike Out
Strike Out
Strike Out
2000
2001
2003
2001
2001
Victor Fleischer ASSOCIATE PROFESSOR OF LAW
7
Clawback
Fall 2006 Venture Capital and Private Equity

• Assume 10 investments of 10 MM each
• Company 1 hits for 70MM
• Profit of 60 MM x 20 12 MM carry
• Company 2-5 strikeout
• Even w/o preferred return, clawback

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
8
Clawback
Fall 2006 Venture Capital and Private Equity

• Alternative Give back LPs full capital
  contribution first
• GP gets no carry until 100MM returned
• Or more, if preferred return is used

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
9
Problems w out of the money carry
Fall 2006 Venture Capital and Private Equity

• GP Incentives
• Recruiting and retaining talent for GP

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
10
Fall 2006 Venture Capital and Private Equity
LP
LP
LP
LP
GP
Fund / Intermediary
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Portfolio Company
Venture Capital
Private Equity
Victor Fleischer ASSOCIATE PROFESSOR OF LAW
11
Bargaining Power vs. Incentives
Fall 2006 Venture Capital and Private Equity

• Preferred Return is like a cost-of-capital
  indexed option
• Good Deal Flow Incentives
• Only good portfolio companies will pay off

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
12
Puzzle
Fall 2006 Venture Capital and Private Equity

• So why isnt it used in venture capital?
• Why a hurdle rate, instead of a true preferred
  return?

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
13
Tax
Fall 2006 Venture Capital and Private Equity

• All of lifes questions are answered in the tax
  code.
• Partnership Profits Interests
• Management Fee (OI) vs. Carry (CG)

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
14
So why doesnt buyout do the same?
Fall 2006 Venture Capital and Private Equity

• Greater moral hazard risk
• No such thing as a low-risk, low-return
  technology start-up

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
15
Summary
Fall 2006 Venture Capital and Private Equity

• Preferred return may help align incentives
• By reducing share of compensation as capital
  gains, may be tax-inefficient
• Details about industry characteristics are
  necessary to understanding the contract

Victor Fleischer ASSOCIATE PROFESSOR OF LAW
16
Francisco Partners
Fall 2006 Venture Capital and Private Equity

• How should Francisco Partners allocate the
  profits from its investments?
• Should it give back the management fee before
  taking carry?
• What to do with break-up fees?
• Tax issue (UBIT, ECI)
• credit against management fees

Victor Fleischer ASSOCIATE PROFESSOR OF LAW