Exit Strategies of Investments by Venture Capital Funds
Historically, the majority of the return earned by venture capital funds results from portfolio companies either reaching the public market by way of an offering or being bought out by other companies. On average, at the time of public offering, venture capital funds hold more than 30% of the company's equity, with the leading investor holding more than 15% of the company and appointing approximately one-third of the representatives to the company's board of directors. This rate is preserved (mainly due to lock up clauses in the offering arrangement) for approximately one year after the offering.
An interesting phenomenon is that highly regarded venture capital funds have an impact on increasing the valuation of shares comparable to similar companies going public at the same time. The argument is that good venture capital funds know how to choose more successful companies and/or that the best investment opportunities are typically presented to them as well. In addition, offerings of companies which are backed by venture capital funds are often made by underwriters with more experience in the particular type of company in question, and the holdings of institutional investors in the company after the offering are higher.
After the lock up period, which is usually dictated by the underwriters, funds tend to distribute their profits from the investments among the investors. The funds may sell the shares on the stock exchange and distribute the sale proceeds, join a second offering alongside the company and sell shares to the public or, alternatively, may distribute the shares among their investors (payment in kind).
In many cases, distributing the shares among the investors somewhat complicates the measurement of the return on the investments. Since such a distribution is not an actual sale, it need not be reported to the SEC, and it is almost impossible to track based on publicly available information only. In addition, various research has suggested that the return on the shares after they are distributed to investors tends to be negative, although these findings depend on the index used as a standard for measuring the returns. The return to investors for the purpose of the "carried interest" calculation is usually measured according to the price at the distribution of the shares among the investors, since after the distribution they are free to sell the shares.
The Return on Venture Capital Funds
The large investments made in venture capital funds over the last decades resulted from a change in institutional investors' estimation of the returns and risks involved in venture capital. As a result, more resources were directed to this field.
The returns demonstrated by the venture capital industry are characterized by considerable volatility. As described previously in this chapter, the most conspicuous phenomenon in the history of the fund industry is the inverse relation between the funds' returns and the amount of money invested in them. Periods characterized by a relative shortage of capital for funds, and hence to companies, are also characterized by the highest returns. Empirical evidence points to a positive connection between the pace of investments in the field and the value of companies in the investment rounds, and hence reduced returns over time.
The IRR of venture capital funds greatly depends on the year in which the funds were established. For instance, funds established in the years 1981–1984 earned single-digit returns. Until the mid-1990s, the average return on funds which had operated for at least four years was around 14% per year, with the median fund yielding about 8% only. The prosperity in the capital market in the late 1990s, until the 2000 crisis, inflated the annual returns on funds to unprecedented dimensions. In 1999, the average return on funds was approximately 160%, but the crisis sweeping the capital market now considerably reduced the funds' cumulative returns. In the absence of stock-exchange exit alternatives, funds are concentrating on seeking mergers and acquisitions for their portfolio companies. However, as mentioned in other chapters, many companies which used to buy smaller companies suffered sharp declines in their stock prices and therefore face difficulties when contemplating acquisitions in consideration for shares or cash.
Over the years, venture capital funds have demonstrated returns which appear to be considerably higher than the returns required by investors in investments carrying a similar risk. Generally, the return demonstrated by large and experienced funds is higher than the average return in the private equity industry by about 10% per year.
Funds specializing in mezzanine-loan investments demonstrate substantially lower returns, since their investments are a blend between investments in short-term debentures and a certain equity component. The risk in an investment in debt is considerably lower than that entailed by an investment in equity, and therefore any return above 10% per year is considered good. However, it should be noted that these funds tend to suffer in times of crisis in the stock exchange, because they usually make the investment in the company shortly before the IPO, and when the IPO is postponed or cancelled, the risk profile of the company in which they invested deteriorates (or changes), and they become investors in a company which has a different risk profile from the one in which they invested.
The industry as a whole is going through one of its more difficult times in recent decades, as the opportunities for IPOs or mergers of portfolio companies have significantly been reduced. For example, during the first quarter of 2002, only four IPOs in the United States were VC-backed, raising a total of less than $400 million, compared with around $500 million in the first quarter of 2001 and over $7 billion in 2000.
Similarly, there was a significant decline in the magnitude of acquisitions of VC-backed ventures. During the first quarter of 2002, such activities constituted less than $2 billion, compared with around $5 billion in the same period in 2001, and over $7 billion in 2000. It is not clear if this decline pattern will continue, but at the current level of activity, the industry is at a shakedown, which is expected to bring the long-term returns in the industry back to their historical averages.