Collective Benefits of Co-Investments

For private investors seeking maximum returns, co-investments are key to attractive investment multiples. Before we dig into the details, it is worthwhile to clarify the relevant terminology in this article:

  • A fund investment is an investment made by an LP into a VC/PE fund (e.g. Family Office invests in Venture Fund)

  • A co-investment is an investment where LPs allocate additional capital directly into companies alongside or following VC/PE investors (e.g. Venture Fund invests in Portfolio Company; Family Office also invests directly in this Portfolio Company)

  • A direct investment is an investment made directly into a private company without the participation or involvement of a VC/PE fund (e.g. Family Office invests in Startup; Startup is not in the portfolios of any of the Family Office’s invested Venture Funds)

Figure 1. Equity Co-investment & Direct Fund Investment Diagram

Figure 1. Equity Co-investment & Direct Fund Investment Diagram

There are multiple benefits to co-investments. For one, you are able to gain more insight into portfolio companies through current fund exposure, data, and performance than you do with individual direct deals. You can cherry-pick the winners, increase your equity stake, and ultimately increase investment multiples. An added perk of co-investments is that they typically have zero or reduced fees (compared to the typical 2% management fee / 20% carry on fund investments). We can observe these benefits in the following chart:

Figure 2. Survey of fund managers comparing co-investment performance to fund returns     Source: Prequin

Figure 2. Survey of fund managers comparing co-investment performance to fund returns

Source: Prequin

For GPs, offering co-investments provides them with an additional capital source to make larger investments. This can be particularly useful when a fund is close to being fully deployed and when follow-on capital requirements exceed reserves as per portfolio construction models. GPs typically only offer co-investments to anchor LPs and other LPs with whom they have an established relationship. This practice improves the overall marketability of the fund as LPs are provided more lucrative co-investment opportunities.

Figure 3. Co-investment vs. Direct Investment Deal Value (2012–2017)     Source: McKinsey, Pitchbook

Figure 3. Co-investment vs. Direct Investment Deal Value (2012–2017)

Source: McKinsey, Pitchbook

With these benefits, co-investing activity has been rising in the past few years. According to McKinsey, co-investments have doubled from $45 billion to $104 billion since 2012 while direct fund investments have remained relatively stagnant. As more investors and fund managers recognize the benefits of co-investment opportunities, we can only expect this trend to continue.

That being said, while co-investment opportunities presented may seem favorable, LPs should still ensure that proper due diligence is conducted. Depending on the transaction size, these types of investments may disproportionately increase concentration relative to  fund investments, as capital gets allocated into a single company rather than into a fund’s diversified portfolio. The associated risk should be carefully evaluated, both on an individual deal basis and as part of a broader portfolio.

If you are interested in learning more about equity co-investments and how LVAM can help with this process, free to contact us at lvam@laconiacapitalgroup.com.

Originally published in the April 2019 LVAM Newsletter.

Unicorns: The Lengthy Gallop towards IPO

$23 billion, $120 billion, $7.1 billion, $35 billion, $12 billion, and $41 billion. What do all these numbers have in common? They are valuations of some of the largest tech companies poised to enter Wall Street this year or next.

Lyft, Uber, Slack, Airbnb, Pinterest, Postmates, and Palantir were all founded roughly at the same time of the ‘08 financial crisis, and after a decade of investor pitches, regulatory pressures, and sleepless nights, these companies have almost “made it” to the big ranks. While these companies are poised to IPO this year or next, it is important to recognize that the road to their massive valuations was lengthy and not always smooth sailing.

 

Founding Dates of Unicorns Poised to IPO in 2019-2020

 

One of the most significant risks these companies have faced has been regulation — not surprising given that so many of them are industry disruptors. Uber, for instance, is the perfect example of a company that has been forced to strategically pivot in many markets due to roadblocks imposed by stakeholders such as the regulatory bodies or unions. In its early days, Uber struggled to operate in states with preexisting limo and taxi service laws. In Miami, the company was initially forced to charge a minimum of $80 per ride as it was classified as a limousine service; as a result, they chose not to operate there. Airbnb faced similar regulatory pressures in hospitality. Hotel worker union efforts have resulted in many forced compromises such as host restrictions in markets including NYC and Chicago.

In addition to regulation slowing down the time to IPO, the amount of dry capital deployed in VC has increased significantly. In previous generations, companies with valuations as high as these would have long resulted in an IPO or direct listing. However, there has been an influx of new capital. According to PitchBook, between 2009 and 2015, the number of US-based VC investments more than doubled from 4,487 to 10,740 with deal value almost quadrupling from $27.2 billion to $83 billion. This trend has led to longer time to liquidity in recent years as companies hold out for more venture capital to attract higher exit values.

Andy Rachleff, CEO of Wealthfront and Co-Founder of Benchmark, estimates that more than 6,000 shareholders of the upcoming IPOs will join the 7-digit club starting with Lyft’s IPO today. As the saying goes — high risk, high reward.

If you are interested in learning more about venture-backed IPOs, feel free to contact us at lvam@laconiacapitalgroup.com.

Originally published in the March 2019 LVAM Newsletter.

The Babe Ruth Effect: What drives fund performance?

“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.” –Babe Ruth

Babe Ruth was one of America’s finest baseball batters, having played 22 seasons with 714 career home runs and 1,330 strikeouts out of 10,622 pitches. While venture capitalists face vastly different types of pitches, the home run mentality coined “the Babe Ruth effect” has seen widespread permanence throughout the venture industry. In Chris Dixon’s article, “The Babe Ruth Effect in Venture Capital,” he analyzes the performance of successful venture capital funds and determines that higher multiple fund performances are derived from higher proportions of investments returning >10x. As expected, there is also a strong correlation between investment return size and overall fund performance.

 
Screen Shot 2019-02-28 at 12.42.31 pm.png
 

What makes the Babe Ruth effect difficult to come to terms with for many unfamiliar with the venture asset class is the high level of “strikeouts” that come with the strategy. Dixon analyzed the same cohort of funds and found that even funds with great performance had a relatively high proportion of investments that lost money.

Screen Shot 2019-02-28 at 12.45.41 pm.png

A dangerous trend, especially with earlier funds, is emulating the investment strategies of billion dollar funds such as Sequoia, Andreessen Horowitz, and Softbank without building a differentiated competitive advantage. Often this imitation manifests itself in competition for “unicorns”, defined as privately held companies valued at over $1 billion. Regarding this “unicorn fever”, PitchBook noted that in 2018, startups achieved billion dollar valuations in less than 4.5 years, down from an approximate seven years in 2013. While unicorn valuations are nice to flaunt at dinner parties and are generally positively correlated to fund performance, there are many other key drivers of fund returns. What these funds need are not necessarily unicorns with billion-dollar valuations, but high exit multiples on select portfolio companies that can return the fund. Dan Primack, a business editor at Axios, recently tweeted:

To Dan’s point, some key factors to consider when defining your investment strategy to hit multiples include (but are not limited to):

  • Ownership stake (driven by check sizes, pre-money valuations, pro rata rights, and follow-on reserve capital)

  • Projected exit value

  • Deal terms (such as liquidation preferences)

  • Portfolio company capital efficiency

Rather than hunting for unicorns, investors and fund managers should focus on conducting proper due diligence (market opportunity/size, capital efficiency, potential upside investment returns), obtaining attractive deal terms (ownership stake derived from investment size, initial valuation and available follow-on capital), and providing portfolio company support to achieve higher multiples at exit. It’s also critical for emerging funds to properly define their investment thesis from a stage, industry, and business model perspective, enabling them to hone in on a competitive offering.

In addition, if you are investing in venture funds, make sure they have a distinct strategy to capture a unique segment of the VC pie whether it be in sourcing, vertical expertise or post-investment value-add. If you are interested in learning more about the Babe Ruth effect and the world of unicorns, please feel free to contact us at lvam@laconiacapitalgroup.com.

Originally published in the February 2019 LVAM Newsletter.

Further Readings:

Who was Babe Ruth?

Unicorns aren't special anymore

The Babe Ruth Effect in VC

Coming to Terms: Understanding the Vocabulary of Term Sheets

A term sheet is often exactly that: a sheet full of terms. As an investor, these terms go beyond simply outlining the percentage of equity received. Investor rights establish the non-equity provisions that investors have to protect against downside risks, manage strategic decision-making, and mitigate future dilution. It is also imperative to understand the meaning of these terms to understand how your investment fares against other investors from preceding or succeeding rounds.

Being a Fund-of-Funds

Generally speaking, a fund-of-funds is any group that invests in other funds. In venture capital specifically, funds-of-funds function as limited partners (with very few exceptions). Those limited partners receive reports and due diligence documentation whenever the fund is making a new investment as well as periodic reports on the performance of the portfolio as a whole.

Investing in venture capital funds either directly as a limited partner or through a single fund-of-funds can be a great way to diversify your overall portfolio. The high level of risk associated with direct startup investments can make it difficult to start a venture capital arm of your own. Investing in or as a fund-of-funds mitigates that risk tremendously as you are investing in the venture capital fund’s entire portfolio, which could represent dozens of startups. You still have the ability to capitalize on the oversized returns that come from successful venture investing without having to take on the same degree of risk.

Due Diligence for Venture Capital

Venture capital can be a daunting asset class to analyze. If you are familiar with private equity, you are probably used to judging a company based on detailed financial modeling. With venture capital deals, the numbers and parameters you have for mature companies just don’t exist yet. That doesn’t mean that you can’t conduct a thorough analysis of a company before investing. What it does mean is that you need to have a formal and disciplined process for due diligence that is tailored specifically to early stage companies and startups.

How Venture Capital Differs from other Alternative Assets

If you are looking into venture capital as an investment opportunity, you are likely aware of other options like private equity and real estate. While these alternative asset classes share some similarities (illiquidity, long investment holding periods), there are distinct differences in structure and investment strategy that are important to consider as you dive into venture capital investing.