Venture capitalists are licking their wounds—and their lips

VC funds invest with a longer term investment horizon and returns to their limited partners (LPs) are not possible unless they exit from their investments.  Attractive returns serve as incentives to the LPs to contribute to future funds floated by VC firms.  While India has never seen more than 20 VC exits in a year - in the first three months of 2010 alone, there have been 10 VC exits (against 3 last year) and analysts see at least 50 exits in the next six-nine months reports Mint.  Attractive exits through IPOs would help establish India as an investment destination for VC / PE funds and the trend in both US and India appear similar with many VC / PE firms waiting to exit and the market also supporting IPOs of VC / PE funded companies.  Highlighting the US scenerio, The Economist reports:

In the first quarter of the year there were almost as many IPOs of venture-backed firms as in all of 2009 (see chart). At the end of March another 43 venture-funded businesses had registered with America’s Securities & Exchange Commission to go public. Encouraging stuff, though some fret that any hiccup in equity markets could scupper these plans.

Source:  The Economist

In the US, while the tough fund-raising environment is forcing more and more VC firms to close down their activities, Steven Kaplan of the University of Chicago’s Booth School of Business and Josh Lerner of Harvard Business School in a recent paper entitled “It Ain’t Broke: The Past, Present and Future of Venture Capital”, point out that VC funds raised when capital is scarce have outperformed those put together when VC firms were flush with cash. Looking at the increase in valuation, VC firms with money to invest, worry about how to get into deals while the rest worry about exiting from the investments already made before the markets tank again.

PE Investors push for more favourable fees and terms, and get them

CalPERS persuaded Apollo Global Management, a large PE firm, to scrap $125m in fees over five years reports The Economist.  Highlights from the article:

• CalPERS plans to bargain aggressively with other PE firms (known as “general partners”) to bring down fees and has urged other investors (“limited partners”) to do the same.

• Institutional Limited Partners Association (ILPA), a network of institutional investors in PE, issued a set of best practices that general partners should consider accepting if they want limited partners’ business.

• ILPA calls for greater transparency, more favourable contractual terms and more generous profit-sharing. 

• PE firms have typically charged investors a 2% management fee, which is intended to cover the basic costs of running their business. Limited partners insist that management fees shouldn’t be a source of profit for general partners, and in some cases are demanding to sit down with them to find out what their real costs are. 

Overall, it is an interesting development that is bound to strengthen the hands of the limited partners.  Some of these, like lower management fees etc have started happening in India too.   It would be better if there are some regulatory guidelines, more specially insisting on a decent level of paid-up capital for the general partner (hopefully this would avoid the temptation to make more money out of management fee) and some form a link/correlation between actual expense and management fee.  The intention should be to align the interests of the GP with the LP.  If VC/PE business aims at long term capital appreciation, then the GP should also aim to make long term money (along-with the LP) instead of higher annual management fee which is delinked from actual expenses at the ground level.