How VC Fund Structures Affect Investor Behaviour
Venture Capital – Supporting Investment
How do investment funds structure their capital, and what does this mean in practice for the companies in which they invest? Whilst it might seem an obscure question, the reality can have quite some impact. In this article we consider 3 common fund structures found in the UK, and some of their principal implications for investee companies.
Traditional LP structure
A traditional VC fund is not actually a physical pool of money as one might expect. It is a partnership agreement between fund investors (normally Fund-of-Funds acting on behalf of pension funds and the like) known as Limited Partners. The partnership is governed by a General Partner (normally a nominal company to separate fund liability) and investments are managed by a Management Company (a “Fund Manager”, or your VC).
The partnership agreement will lay down each Limited Partners’ commitment to funding future investments (including Fund Manager’s fees) up to an agreed total (the quoted fund size). The agreement will include heinous penalties for any Limited Partner not stumping up the cash when required (such as complete loss of any rights to a share in the fund, even for investments already made). It therefore effectively guarantees the Fund Manager access to capital to make planned investments as required, providing they act within the original mandate.
Perhaps the most fundamental impact of this structure is that the investment clock is not ticking from day 1 of the fund. The Fund Manager will be measured from the date on which capital is drawn down to make each individual investment. If capital is not invested until year 4, then the Fund Manager is not required to generate any return on that capital during those 4 years, despite it being effectively committed to use during the period.
As a consequence LP fund cycles are forced to conform to pre-designated timelines. The partnership agreement will outline the time period over which the Fund Manager must invest the commitments (and be paid full fees), and a time period for “run off” in which it is expected that the investments will be exited (and the Fund Manager is paid a partial fee). These timelines can often impact on a Fund Manager’s behaviour, for example bringing additional pressure to investee companies to force an exit when entering the final years of any run off agreement.
In the same sense as commitments, any funds received by way of an exit, are immediately returned to LPs in pro rata to their fund contributions over the lifecycle of the fund. The defined life cycle of the fund therefore forces the Fund Manager to make upfront assessments as to the calls on capital. Most often the consequence here is a mis-allocation of capital for follow on investments, usually with the fund being left with insufficient capital to back well performing investments at later growth stages. Given the conflicts involved in investing companies across funds, this is a significant driver of sub-optimal Fund Manager performance. For investee companies caught at the end of a fund life-cycle this can be a significant obstacle.
A number of funds, particularly in the UK raise funds directly from retail or HNW investors. In general they utilise tax efficient wrappers – either EIS (Enterprise Initiative Scheme) or VCT (Venture Capital Trust). These schemes and the funds they have given rise to, have played a central role in developing the VC industry in the UK.
EIS funds are generally ever-green in nature, that is they continuously accept contributions from retail investors. Terms of such funds vary, but the EIS scheme itself requires an individual investor to hold shares not in a fund but directly in the underlying investment (a “look through”), and tax rebates are granted only when these underlying investments are made. As such, an individual retail investor’s contribution to such a fund will be allocated to subsequent investments over an agreed timeframe or agreed ratio. Often there is a commitment to the individual from the Fund Manager to invest contributions within 12 months for tax planning purposes.
The dynamic nature of such a fund has several implications for investee companies. Firstly, follow-on funding from the same fund is complicated by the requirement of the Fund Manager to represent the interests of two different sets of fund investors – those that comprised the first investment, and the different set who comprise the subsequent one. The potential conflict will be felt most acutely in down-round scenarios. Secondly, the capacity of such Fund Manager to invest will fluctuate in line with deposited funds held on behalf of its investors. For investee companies, this means that the actual commitment of such Fund Managers to investment rounds may fluctuate through the course of negotiating an investment. Thirdly, certain exit opportunities may be restricted. Individual tax benefits in such schemes are crystalised only after holding shares for a given period of time. This can have the effect of altering incentives for a Fund Manager should exit opportunities present themselves within the hold period, perhaps most pertinently in paper (share) transactions where a value is crystalised but cash is not, thereby yielding an uncovered tax liability for underlying retail fund investors.
VCT structures avoid a number of these implications being more like their LP counterparts – generally raised on an annual or periodic cycle with tax benefits granted to the individual directly on investment in the fund. Both structures will be limited in their ability to invest with government defined restrictions relating to geographic situation, company age, and lifetime limits on tax advantaged investment.
Listed funds are a relatively novel feature of the European venture Capital industry. Instead of raising private capital via LPs, such funds raise their capital via the public markets. Shares will initially be issued at par value, and track the Net Asset Value of the underlying investments. Subsequent capital can be raised through new or rights issues.
Such funds therefore have “permanent capital”, that is, invested capital will remain in the fund in perpetuity or until such time the fund operation is wound up, as opposed to being gradually returned to fund investors in the event of exits. If the fund is at scale therefore, it need never seek further capital as realised exits are reinvested. Furthermore, liquidity in public markets allows fund investors to realise their investments at a point of their own choosing through secondary transactions.
This single continuous investment vehicle yields new opportunities. Given the “single-shot” nature of capital investment in an LP fund before it is returned to LP investors, traditional LP Fund Managers are irretrievably bound to a certain investment profile – one that has the long term capability of returning the fund (as described in this previous article). Short term exit propositions (eg pre IPO funding), turnarounds and a range of other potential investment opportunities are therefore often overtly missed by a traditional LP fund. The listed fund is however IRR, as opposed to cash-on-cash multiple driven. It need deliver returns only in excess of fees to generate value for its investor base. A 5x target return for a traditional LP fund over say, 8 years can instead be delivered by redeploying the same capital 5 times over the period in 2x yielding assets. A whole new universe of propositions is enabled.
A listed fund will have no artificial investment timelines embedded into its structure. So whilst shorter term investments are enabled by continuous recycling, so too invested capital can be “patient”. The fund will have no “run off” period, and consequenty no Fund Managers with incentives to press for a potentially sub-optimal exit. Furthermore any follow-on capital will come from the same continuous vehicle with no cross-fund conflicts to consider. Finally, for those successful assets within a listed fund portfolio, the listed vehicle enables a preview of how capital markets will view their own company prior to any IPO.
There are of course disclosure requirements of public funds which require limited disclosure of fund holding and invested capital in each investment. This limited public disclosure would allow for the Fund Manager’s implied valuation of any company in the fund to be estimated.
Entrepreneurs accepting venture funding should be aware of the dynamics of the fund that is investing in their company. Getting the capital to fuel the vision is of course the major part of the battle, but being aware of the advantages and limitations of any particular fund structure might help an entrepreneur better understand the motivations of their Investor Director.
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