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Entries in Private Equity (9)


A Look at South African Private Equity Fundraising


Two major factors seem to have manifested themselves in the major trends in capital-raising for South African private equity firms.  One is the continued worldwide economic slowdown, which has not spared the South African private equity industry.  Despite a lagged effect on the industry, an impact was clearly felt – particularly in 2009 when no exclusively South African-focused firm raised capital, according to the Emerging Markets Private Equity Association (EMPEA). The second major trend (which also plays into the 2009 results) is the gradual shift away from South Africa being the sole focus of most South Africa-based private equity firms.

As the chart above indicates, South Africa was the dominant destination for capital raised by all private equity firms in Sub-Saharan Africa from 2002 to 2004 (EMPEA, 2012).  However, as time has progressed, many firms have begun looking at cross-border opportunities – so much so that most traditional South Africa-focused firms have recently pushed for allowances in their fund documents permitting them to invest up to a specified portion of their funds in other African countries, typically in the range of 20%-30%.  This trend is exemplified by the fact that fewer and fewer funds with a sole South African focus have been closing in recent years.  Further advancing this trend is the fact that the South African government has enacted tax and exchange control regulations meant to lure private equity firms who want to domicile in South Africa’s less risky environment while venturing out to invest across the sub-continent.  As a result, South Africa has become a major hub for many pan-African firms.  

Over the past few years, traditional South African firms, instead of jumping into new regions, have started to back South Africa-based companies with a regional footprint or potential for cross-border expansion – to reap the benefits of lower risk while also building experience and expertise in other, faster-growing countries.  Many of the aforementioned firms with new allowances to invest specified portions of their most recent funds outside of South Africa have taken this route.  

In terms of the sources of capital, Government agencies and Development finance institutions (DFIs) account for the largest portion of funds raised by South African private equity firms, nearly 40% (according to the South African Venture Capital and Private Equity Association, SAVCA).  It is believed that these types of organizations play a larger role (and account for a larger proportion of capital raised) in South Africa, and even more so the reset of the continent, than in any other emerging market.  Their developmental and social goals are aimed to be fulfilled not only directly though their investments in private equity funds, but also indirectly by acting as a catalyst for the private equity industry and the firms in which they invest.  For this reason, these organizations will often be looked at to take the lead on investments in funds sponsored by new firms – to “give comfort to others” as one DFI has put it.  Their goals, however, also necessitate more detailed reporting on the part of fund managers.  

Other major types in investors, or limited partners, in South African private equity firms include insurance companies, pension funds and family offices – each representing between 16% and 17% of capital raised (SAVCA).  Insurance companies, predominantly domestic, have long been a source of capital for South African private equity firms.  Pension fund capital has been slow to participate in South African private equity, particularly international pension funds.  Recent legislation has increased the cap on the allocation to private equity for domestic pension funds and is expected to lead to a rise in their role in the private equity industry in South Africa.  Funds of funds have recently emerged on the scene in South Africa in a big way - in fact the capital invested by funds of funds doubled from 2009 to 2010.  This, in many ways, can be taken as a sign of the South African private equity industry’s maturation since funds of funds, particularly those that are regionally focused, generally only emerge when a region’s private equity industry can support an attractive diversified portfolio of private equity funds.  

Finally, it is important to note that the majority of capital, around 58%, is sourced from abroad (SAVCA).  This means that private equity plays an important role in garnering foreign direct investment (FDI).  It also means that South African private equity firms have to spend time and money traveling around the world to attain commitments from investors because of the limited availability of local capital.  This can present a number of challenges, particularly for younger firms who not only have to battle the risk perception of being an African private equity firm, but also the risks investors associate with first-time fund managers.  The bulk of international capital is sourced from Europe which accounts for almost a quarter of call capital raised (including the UK).  European countries’ often closer ties to Africa explain their heightened role.  Meanwhile, Asian, and North and South American countries have been slow to warm to South African private equity, in part because of better perceived risk-adjusted returns available closer to home. 

As the market continues to mature and Africa as a continent becomes more and more of an attractive destination for private equity and venture capital investment, fundraising trends will undoubtedly change. Nonetheless, current characteristics will continue to shape near-term progress and while leaving their mark on the industry for years to come.  


South African Private Equity - Firms Listing as Holding Companies


I recenlty returned from a trip to South Afirca where along with a team of students, I engaged in a study of the country's private euqity industry. My next few posts will be comprised of some interesting trends and data we picked up on while there. The first will be on the topic of private equity firms listing as holding companies: 

In mid-2011, Brait, the leading South African private equity firm, unveiled a change in business model so dramatic in its structure and scale that it was viewed by many as a seminal moment for the industry.  The firm announced it was evolving its business model from being a manager of third party funds to becoming an investment holding company.  Instead of only raising private capital from third party investors to fund its private equity investments, Brait would now also raise capital from time to time in the public equity capital markets and invest this capital directly into private equity deals.  There had been speculation that Brait was struggling to raise capital from traditional limited partners and that perhaps the holding periods for its investments were longer than what investors were expecting.  The new structure allows the firm to maintain the existing strengths of the private equity model while, for the first time, tapping into the strategic benefits of raising funds from the public equity markets.  This means there is less pressure on exiting deals within certain timeframes.  The move necessitates Brait’s business model changing from a fund management business with annuity income streams (from fees and carry) to an investment business underpinned by the valuation of the underlying portfolio of its assets.  As a result, the net asset value (NAV) of the firm’s investments will be the most tangible means through which the firm’s performance can be measured.  

Another example of a South African firm shifting to holding company status is Chayton Capital, a global firm with an African agriculture private equity investment arm based out of Cape Town.  In early 2012, Chayton sold 81% of its agriculture private equity vehicle, Chayton Atlas Agricultural Company, to South Africa-based investment company Zeder for $46.7million.  Much of the capital is set to be released in stages as needed to fund acquisitions across sub-Saharan Africa.  Chayton’s focus made it challenging to meet private equity investor’s expectation of a typical five-year investment cycle.  Similar to Brait (who invests across multiple sectors), raising capital became more difficult as a result.  Holding company status affords firms like Chayton more flexibility with their investment model and can make raising capital easier.  

According to South African private equity professionals we met with, more and more firms will list this way in the future, in large part because there are fewer regulatory issues and the pool of available capital is larger.  It may even be feasible for first-time managers in South Africa to raise capital via listing as a holding company, either public or private.  If more firms choose to list as holding companies, the landscape of the South African private equity industry could be in for a major restructuring, making this trend well worth monitoring. 


Private Equity in Peru

I recently returned from a week-long class trip to Peru and so, as I’ve done in the past when I’ve visited other countries, I thought I’d share my thoughts about the private equity opportunity there. Aside from the requisite (and spectacular) visits to Machu Picchu and Lake Titicaca, our group spent a lot of time in the capital city of Lima, as well as a lot of time traveling via bus and making stops throughout the Peruvian countryside. The wide scope of our trip gave me a really good feel for the country. Right away, what struck me was that the overall growth in Peru has not yet trickled down to the more rural and localized areas of the country. Despite Peru’s strong GDP growth of nearly 9% in 2010 and a projected 7% in 2011, there is a stark difference between life in Lima and smaller cities and villages in the countryside.

While a similar story can be painted for other emerging countries, I thought in Peru the differences were larger and that there maybe was an overconcentration of growth and modernization in one metro area (Lima). As opposed to a lot of other emerging countries, people in rural areas did not at all seemed concerned with growth or with the outside world – the main thing that mattered to them was maintaining their way of life (It’s important to note that around 45% of Peru’s population is indigenous). It was a type of legit indifference that made me realize no matter what kind of shocks the worldwide macroeconomic environment undergoes, a significant portion of the Peruvian population would see no impact and might even be oblivious. I didn’t sense complacency though; rather it was that people seemed to take greater pride in social change as opposed to economic growth (even if economic growth was a byproduct). I realized that this is actually a good characteristic – it means that the economy is insulated. I also felt some of the same characteristics regarding change vs. growth in Lima and other larger cities which have larger foreign populations.  Insulation, on many levels, is attractive for emerging market private equity investors because it actually reduces risk and volatility while providing another line of diversification.

Peru has been a net exporter for over a decade, driven in large part by a vast set of natural resources. At first glance, natural resources might seem like a good way for PE firms to invest in Peru. However, I think that because of the insulation of the country’s growth, sectors addressing broader consumption such as banking, retail, construction and manufacturing might be more attractive. Further, apparently there have been tax issues with mining in the country and of course even if all is well, investing in natural resources and exporting them means investment returns would be more correlated to the worldwide macroeconomic environment.

Private equity in Peru is still in its nascence. Private equity penetration, as measured by PE/VC investment relative to GDP, was a mere 0.05% in 2011, compared to 0.27% for neighboring Brazil. I expect that most investment that has occurred thus far has been in the form of growth equity, not venture or buyouts. While the private equity industry is very young, I think it has be ability to grow very fast. Earlier this year, Peruvian private equity leader Nexus Group launched its first international institutional fund. The fund raised $320 million (well in excess of its $250 million target), to make “control or co-control” investments in “opportunities provided by the Peruvian macroeconomic landscape.” Industry focus thus far seems to be on consumer goods, services, finance, retail and education. Larger firms are also entering Peru. Carlyle, for example, recently announced plans to open an office in Lima via joint venture. What’s clear about this move (as well as with Nexus) is that local expertise is a prerequisite for private equity success in Peru, just as it is in just about every other emerging economy.

Overall, I was more impressed with the potential of Peru than I expected. The country possesses better infrastructure than many of its Latin American counterparts; there seems to be more political stability than other countries; the population is diverse and globally aware; accounting, legal and corporate governance systems seem to be fairly adequate; and while private equity-specifics such as tax treatment fund formation aren’t yet up to par, the country’s attractive growth profile is already attracting investors. While there are issues to be addressed, I fully expect Peru to emerge as one of the leading destinations of private capital in Latin America – the growth story and potential for uncorrelated returns are too important to ignore. 


The Real Impact Of Overlooked Fund Return Considerations

The Private Equiteer recently brought up an aspect to private equity and venture capital returns that is often overlooked and unaccounted for: The fact that investors (limited partners) in funds have to set aside or plan around the capital they have committed to a fund. For those less familiar with private equity, investors in funds do not pay in the full amount they decide to invest in a fund right away. Instead, capital is called by the general partner as the fund makes new investments. Rarely do limited partners set aside their full commitment to a fund and hold cash to meet capital calls as they come. Most model around expectations provided by fund managers and hold only the amount of cash necessary to meet capital calls.

The Private Equiteer argues that opportunity cost of holding cash, or the risk of default associated with reserving inadequately should be factored into private equity returns. I would agree that there is some opportunity cost involved, but the simple fact is that virtually no limited partner holds the full amount of a commitment to a fund it has decided to invest in as cash – only for short periods to meet imminent capital calls, which in the grand scheme probably has a negligible effect on returns. There’s also a very limited chance that a limited partner defaults on a capital call. It’s extremely rare, and even if it does happen, there are remedies that would allow the limited partner to continue investing in the fund – rarely would all value be lost.

The reason these two issues aren’t talked about too much is probably because they’re not really major  issues to begin with. Putting aside the risk of default (which is incredibly small), let’s take a look at the effect holding committed capital as cash would have on a fund’s return. If you remember, in my model for a crowdsourced venture capital fund, I suggested that all committed capital would have to be called at the onset of the fund to make things logistically simpler – perhaps as the private equity and venture capital industries evolve, we’ll see more of this. Below I’ve modeled out a hypothetical private equity or venture capital fund’s cash flows under a normal model (which assumes that cash comes in right at the time of a capital call) and also for a model where cash is held/called at the onset of a fund (same impact on returns). I’m using 5% as an interest rate for the cash and the rest of the cash flows for both models are the same. Here’s what we get:

As you can see, there is clearly an impact on the fund’s IRR - a difference of around 1.3% in this case, but with a return multiple of 1.6x under both scenarios. Is this a significant difference?  I would say it’s definitely material, but it depends on the investor. The difference is probably significant enough to impact investment decisions and overall portfolio performance, and its why funds do not call capital upfront (negative impact on IRR, even though all other performance is the same) and why limited partners don’t hold cash. They assume they can earn even more than the 5% I modeled in on their cash. The only benefit derived from calling capital upfront or holding a commitment as cash is eliminating the risk of default, but as I mentioned before, it’s such a small risk in the first place that it does not make sense to protect against in such a way.  That said, I do stand by the idea that for different models such as a crowdsourced fund, you would still want to call all capital upfront, even if you sacrifice a bit of your IRR. 


VC’s: How To Benchmark Yourselves Properly

Plenty of VCs are guilty of deceitfully presenting fund performance – especially when it comes to benchmarking themselves against their peers in marketing materials. There’s a reason why so many LPs complain about almost every VC claiming to be “top quartile.” When raising new funds or providing updates, you too frequently find venture capitalists benchmark their performance improperly, often in an attempt to make themselves look better. Instead of these attempts, existing and prospective LPs would probably find it much more amicable if VCs candidly presented their relative performance - in fact, being candid in presenting performance and benchmarking goes a lot further than you would think with most LPs.  Here’s a guide on how to go about benchmarking properly and in a way that LPs will surely appreciate:

Selecting a Benchmark:

Use the Cambridge Associates Benchmark Statistics - don’t even consider any alternatives. Their benchmarks are far and away the most comprehensive. A common alternative you see is the ThomsonReuters (Venture Economics) benchmarks but they fall so short of Cambridge in terms of sample size that their statistical validity is questionable - sophisticated LPs are aware of this issue. The Cambridge benchmarks exhibit slightly higher returns because of their selection bias (all funds that Cambridge clients are in get pulled in so some consider it more of an “institutional quality benchmark”), but they are the industry standard and using anything else immediately raises doubts for LPs.

Don’t have access to their quarterly benchmark statistics? Simply contact them and participate in their quarterly survey and you’re receive the benchmark statistics free of charge. You’ll have to provide your quarterly financials to them but don’t worry, all data is kept confidential and your performance remains anonymous. They’ll even sign an NDA if you ask them to.

What to Present:

Determining the Proper Vintage Year: Cambridge Associates determines a fund’s vintage year based on the partnership’s date of legal formation - not by when a fund holds its final close and not by when a fund started investing. This means that under most circumstances you should do the same, unless there’s a special case where a fund took over a year to raise or if the fund was legally formed so late in a year and didn’t start investing until late in the next year that its most logical to use the next vintage year. If either case applies, make sure you footnote the situation properly.

 Determining the Proper Asset Class: Usually it’s not difficult deciding whether the venture capital or private equity benchmark is most appropriate. But in some cases where a fund has a later stage or growth equity strategy, LPs like to see it benchmarked using private equity benchmarks. If you have a strategy that straddles venture and private equity, consider using both benchmarks.

 Performance: You must of course show IRR, but make sure it is the IRR NET TO LPs (net of fees and carry) not the gross fund IRR. Nothing is worse than a VC that either purposely or inadvertently shows just gross IRR and then even worse, benchmarks it against the net to LP benchmark. It’s ok to show a fund’s gross IRR but if you decide to do so, you must also show the net IRR as the next line item. Generally, when benchmarking you want to show just the Net IRR because if there’s a large discrepancy between the net and gross, it draws attention to the effect management fees and carry is having on the return to LPs.

 In addition to the IRR also show and benchmark the distributed/paid-in and total value/paid-in multiples. Showing fund level cash flows is a plus too. The reason for showing the multiple is to help iron out some of the effects timing has on the IRR and give a truer sense of the fund’s performance. This goes back to being candid – you don’t want to omit multiples if IRR has been boosted by a quick exit, and conversely, for older funds you might actually be doing yourself a disservice by not including the multiples if IRR has been dragged down because of timing.

 Not Meaningful Performance: A general rule you can follow is that a fund’s performance is not meaningful and thus okay not reporting on and benchmarking if there has been less than three years of activity. Just make sure you footnote why you have decided that a fund’s performance is not meaningful and why it hasn’t been benchmarked. But also be sure to have the performance handy and expect to provide it if an LP asks for it.

Here’s an example of how fund benchmarking should look (note: figures are fictional):


Note that these guidelines apply to sharing fund level performance only and that the guidelines for sharing company level returns are much different – something I’ll eventually post about later. In the meantime, feel free to provide feedback or ask questions about these guidelines.


SharesPost Gains Traction - Issues Remain With Private Exchanges

A few days ago I received the first member update e-mail from SharesPost, one of the newest online private exchanges providing liquidity to holders of private company shares. I covered how the exchange works in a previous post – essentially, holders of qualifying private company stock can post to sell a block of stock to accredited investors who are allowed to purchase these shares through a bid/ask system. Participants pay a $34 month fee for the right to post (buyers and sellers) and transactions incur a $2,500 escrow fee (to both buyers and sellers).

Sharepost is one of the most open answers to the liquidity problem faced by holders of pre-public private tech company shares (including founders, employees and investors such as venture capital firms) in the face of a narrow IPO window. According to the e-mail I received, the service has signed up over 4,000 members and is adding hundreds more each week (registration is free). There have already been transactions involving LinkedIN, eHarmony, Linden Lab, XDX, Tesla Motors, and SugarCRM, with postings out there for the sale of stock in at least seven other companies, led by Facebook. In fact, there are 250,000 shares of Facebook up for sale and bids out for over 900,000 shares, though a transaction has yet to close.

One feature of SharesPost I did not touch on in my last post is the free research reports offered on select companies. These reports provide insight into the valuations of private companies - information that is usually kept a bit more private, although generally attainable if you dig around. The figures always have to be taken with a grain (or handful) of salt since it’s so difficult to accurately ascertain the true value of private companies. This is where I think SharesPost, or most any other private exchange falls short. There is a lack of controls and transparency typically associated with public exchanges – a buyer can easily be taken advantage of because the seller has so much more information on the true value of the shares. There’s not enough volume to determine fair value for a company’s shares either and I’m not sure private exchanges will ever get there.

A potential source of volume, particularly on the sell side, could be venture capital firms (which most private exchanges are trying to attract), who, just like the founders and employees of many pre-public tech companies are facing liquidity issues with their portfolio companies. But the problem I see there is, why would companies/VCs looking to reward their employees by providing some early liquidity simply post, or allow employees to post, shares on a private exchange like SharesPost? The term “private exchange” then becomes an oxymoron. Instead, there are other options available to less publicly provide liquidity, such as direct secondary funds. These funds are private equity funds formed for the sole purpose of providing liquidity to the shareholders of pre-public companies. Think of them as large buyers on SharesPost, except with more capital, the ability to “buy in bulk” and access to more information since they maintain privacy of the transaction. These types of funds have been growing in number and size of late, meaning sellers still maintain the ability to get bids on the shares they want to sell.

The CEO of SharesPost has also suggested the exchange could be used by venture firms looking to wind down funds. One of my earlier posts on this blog was about the huge issue looming over vintage year 1999 and 2000 venture capital funds. These funds will soon be desperate to unload investments - so, yes, they will be hungry for liquidity, but will a private exchange like SharesPost be the solution? I’m not so sure. The question is who will buy the companies’ shares? And why? If after 10 years the companies are still not “exitable” then VCs will be forced to sell at huge discounts. Not only that but selling on SharesPost provides no guarantees in terms of a complete sale or timing.

While SharesPost and other similar private exchanges might be good for individual sellers of private company shares, they are still very much targeting a small niche. They have their place and could even thrive, but I don’t think they are the solution to any of the venture industry’s liquidity issues.



Exploring Private Exchanges

It’s no secret that the venture industry is reeling from a liquidity crisis – we’re constantly reminded that venture-backed IPO and M&A activity is at historic lows. And while there have been recent glimmers of hope via the IPOs of OpenTable and SolarWinds, we’re far from the proverbial IPO window being open again. To address the issue, the National Venture Capital Association (NVCA) laid out a “Four Pillar Plan to Restore Liquidity” back in late April. As part of the plan (the second “pillar”), the NVCA encouraged the use of enhanced liquidity mechanisms such as private market exchanges. While yet to gain much traction, a number of these newer private exchanges have garnered attention of late. They might turn out to be great for the venture industry, but I see a few issues, including the fact that they all seem to be doing very similar things meaning the space is very fragmented right now, and volume is much too low to put a dent in the liquidity issue. Here’s a rundown of some of the major new players:

Backed by venture firm Draper Fisher Jurvetson, XChange will use a bid/ask pricing system to allow the sale of private securities to qualified institutional brokers. I’m not clear on whether or not this includes LP interest in venture funds or just shares in a start-ups employees or venture firms may hold. XChange will also offer companies the ability to do a primarily issuance of shares (they’re calling it an “XPO”). Still new, the exchange is not yet fully operational.

With the support of the NVCA, a number of venture capital firms (Oak, NEA, Venrock, Versant, DCM to name a few) and apparently 200 institutional investors, InsideVenture might be the private exchange with the most industry support right now. InsideVenture offers “Hybrid public-private offerings” in which start-ups would have to file the same way as they would for a regular IPO, but the shares would first be offered to investors that are affiliated with InsideVenture. It does not seem like there is the options to do smaller secondary sales of direct ownership stakes in companies like with XChange. InsideVenture is open to only institutional, PE and accredited investors.

SecondMarket is one of the better established private exchanges. They claim to have 3,000 market participants, with $10 billion in traded assets. In addition to shares of private companies and limited partnership interests in private equity funds, the exchange is for all types of illiquid assets including auction-rate securities, bankruptcy claims, CDOs, and MBSs. To help attract bidders for these illiquid assets, SecondMarket has developed a proprietary "ManhattanAuction" which essentially pays bidders for bidding. The exchange is open to institutional and accredited investors only.

The newest private exchange on the block is SharesPost. In fact, it just went live with its public beta release yesterday. The interface is much more open than other private exchanges - after a basic registration process, you are able to view the shares of top venture-backed companies that are for sale, what the bid and ask prices are and, for some companies, the implied valuation (more on this later). It costs $34/month to post or interact with other posts (buyers and sellers), there are no commission fees, but there is an escrow fee of $2,500. Sellers remain anonymous except to the buyers of shares (who must be institutional or accredited), but all SharesPost members can view restrictions sales are subject to and prior agreements once even one trade is made on a company. The minimum proposed transaction size is $25,000.


Of the four private exchanges I've highlighted (there are plenty more that are not as sexy, including NASDAQ's PORTAL Alliance, the NYPPEX, and TSX Venture Exchange), SharesPost stands out the most due to its openness. Both SharesPost and SecondMarket only allow for the secondary sale of private company holdings. InsideVenture seems to do just primary (semi-public) issuances and XChange looks to do both. All complete the mission of providing liquidity, particularly for employees and smaller shareholders (save for InsideVenture), but I still think the larger liquidity issues will remain. It’s unrealistic to expect many substantial full-blown venture-backed exits through any of these exchanges, at least to the point that it alleviates the industry’s liquidity issues. They’re more of stop-gaps in my opinion, and I think they know that.

The fragmentation I mentioned earlier probably hinders all of them which is why I think there eventually will have to be some consolidation in the space to allow for more efficient marketplaces. For now, they will all face competition from not just each other, but traditional IPO and M&A exit avenues (if/when they come back) and a growing crop of direct secondary and traditional secondary funds which have the upper hand when it comes to negotiating terms since they can make purchases in larger chunks while keeping the transaction private. Speaking of which...

It probably hurts companies that list on a more open exchange like SharesPost if they are looking to obtain additional rounds of funding. It’s understandable why SharesPost went the more open route (because it should attract more buyers and sellers), but a lot of private equity and venture capital firms would not be comfortable with investing in a company that has so much of its information public (sorry, but obligatory: “it’s called private equity for a reason”).

One interesting piece of information that ends up out there is a company’s valuation – and even if it’s not out there or accurate, there are implications for venture capitalists invested in the companies beyond just maybe having that information public. A layer of complexity could be added to valuating companies under FAS-157, which has established the framework for measuring fair value. Under FAS-157, investors have to mark an asset to market, which I think would mean that venture and private equity investors in companies listing on a private exchange would have to take into account transactions occurring on those exchanges when it comes to quarterly reporting to LPs. Not a fun prospect.

It will be interesting to see what impact these exchanges have. I’d like to do a follow-up examining each one in more detail if possible. I’d also like to examine the SharesPost model a bit further in a future post because of the tie-ins to my previous look into crowdsourced venture capital; the purely on-line transactions, openness of information, and allowing regular individuals to participate.



Crowdsourcing Venture


I somehow stumbled upon this book today and it got me thinking about how crowdsourcing would work if applied to the venture capital model. Crowdsourcing allows you to tap into the collective knowledge of a community to carry out a task or find a solution to a problem and is most widely used in the development of new web technology (Wikipedia has a pretty sold entry on it if you want background). But a big drawback I see is that contributors rarely get compensated adequately for their participation - the company something is crowdsourced for stands to benefit the most, all from the hard work of others. What if people could actually have "skin in the game," wouldn't the results be much better? And even more, if applied to venture capital investing, wouldn't you be able to create not only a huge brain trust, but a huge investor base as well?

I wasn't aware of anyone else out there that had made an attempt at crowdsourced venture capital or was thinking about trying it, but after doing some quick research I found the idea did have some legs:

  • Steve Newcomb, co-founder of Powerset, was featured over a year ago in a Wired article which shared his plan for a crowdsourced cleantech venture fund. His idea for the fund involved investor commitments as low as $100, with a maximum of $1,000 and investments decisions made by bringing in venture professionals to vet investments and then letting the investors choose from there. I'm assuming it would have been open to as many investors as they could get, perhaps in the millions. Not sure what's happened with this idea, but it seems Newcomb's attention is now probably on his new company, Virgance.
  • The closest thing, by far, to a legit crowdsourced venture idea I found was VenCorps. VenCorps was originally an offshoot of crowdsourcing site Cambrian House. The original model involved ideas being vetted by the public for an initial vote, and then moving on to a due-diligence process and a more formal vote, where an “elite group” would do the decision making (not sure of the capital structure). But since, Cambrian House sold VenCorps' assets toNew York private equity firm Spencer Trask. Now, it looks like startups will share their businesses plans, then professionals and amateurs would help select the best in periodic “showdowns.” Winners of showdowns would receive a $50,000 investment (convertible debt, but I'm not sure how participation would work for those who have voted and have interest in investing).

I have a feeling these two groups hit legal issues at some point. If you want a true crowdsourced venture fund with full participation, you immediately run into SEC issues. I'm no expert when it comes to the detailed legal aspects of private equity, but I'm pretty sure to keep an entity private you would have to stay under a certain number of investors, wouldn't be able to solicit investors openly, and the investors you do get would have to be accredited (i.e. institutional or high net worth). I'll have to do some more research, (would love feedback here) but perhaps there are ways around all this - maybe via pass through entities for groups of investors, or offshore or other forms of organization.

For fun though, let’s says there were legal loopholes or no legal issues at all - here are some elements of my ideal crowdsourced venture capital fund:

  • Standard fund structure, with the GP consisting of actual venture capitalists and the LPs consisting of the "crowd."
  • The LP base, or "crowd" would preferably be selective, perhaps through a vetting/application process or by targeting a specific groups. Ideally, if making tech investments, I'd want a knowledgeable set of individuals, something like the TWiT Army, behind me. I'd like to set a commitment range, let’s say between $1,000 and $10,000.
  • The fund would be completely web-based. All administrative aspects, reporting, voting on investments, communication, etc. I think it would be easier to take each investor's commitment up front via fund transfer and hold the cash in an interest-bearing account. Each investor would have their own capital account page, through which they could monitor their balance, vote on whatever the GPs wanted them to vote on, see their share of the investments, etc.
  • As for the investment process, I'd allow LPs to suggest potential investments, but the GPs would also source deals. Everything would have to be very transparent (GPs staying in touch via forums, messaging, blogs and podcasts). GPs could continuously poll the LPs to gauge their thoughts while evaluating companies, even putting potential investments up to vote, but in the end the ultimate investment decisions are made solely by the GPs.
  • Once investments are made, the fund has the benefit of instantly having thousands of individuals with a vested interest in the companies' success. This could be huge for internet companies. And while owned by the fund, LPs could make suggestions or offer up help to aid each company's development.

...that’s it for now but I will definitely be revisiting this topic again.


Indian Private Equity: Conversation with a CEO

I recently had a conversation with the CEO of an Indian industrial forging company that specializes in automobile and oilfield related products. Here’s what I picked up on the venture and private equity opportunity in India from someone with direct experience operating a middle-market company there:

He conceded what many already know – that venture capital, particularly for high technology, really doesn’t work well in India. Aside from the lack (or enforcement) of intellectual property rights, there’s simply too much of a “copycat mentality.” Innovation happens more with processes or at the business level, because innovation in technology lacks the right risk/reward profile. For example, most young IT professionals would much rather work for an outsourcing firm and take the compensation the jobs provide rather than risk trying to innovate. For this reason, private investment in India will not be heavy in venture capital for some time.

There are many companies and industries that will be able to ride the country’s GDP growth to success. But beyond that, at the operational level, what competitive advantages does India have that make a compelling case for private equity investment? For most Indian businesses, low cost labor is the core advantage. In fact the CEO I spoke to said low cost labor might be his company’s only advantage in the global marketplace. Energy, raw materials, equipment and technology costs are pretty much level globally, but when it comes to the much more lucrative business of exporting product, labor cost savings are a huge advantage. And it’s not just the direct cost of labor, but all other related or dependent costs, such as insurance or transportation (drivers, handlers) that collectively provide a huge advantage.

In most industrial and manufacturing businesses, labor unions are still not a major issue, but they are beginning to crop up in larger Indian cities such as Mumbai, Delhi and Bangalore. Smaller, more rapidly growing cities should be able to stave off issues related to labor unions for another decade in his estimation. So, the long term potential for growth and profitability still remains even if purely based on the low cost of labor, you just have to go to the right places. In this respect, the biggest impact should be for manufacturers, particularly those who export. In fact, exporters receive incentives from the Indian Government in the form of credits which can then be sold to importers on the open market. Domestically, he identified industries such as financial services and consumer products and services that target India’s growing middle class as areas of growth. Infrastructure plays too can take advantage of the low cost of labor.

When I asked about potential detractors for private equity investment in India, the biggest drawback he saw was the trouble PE firms have in obtaining controlling ownership (or even any ownership stake at all) in companies that are family owned. It’s one thing to buy smaller stakes in large companies, but if the buyout model is to really take off in India, it’s going to take gaining the trust of families who own a large portion of the private businesses in India.

Another issue for investors is bureaucracy. Conducting business in India can be slowed extremely by bureaucratic policies and procedures. These can differ state to state and even city to city. To navigate it all efficiently takes experience and relationships, something impossible for outside investors to bring with them. This point can’t be stressed enough and is why the most successful private equity investments in India will have to involve Indians with opperating exerpience in the various regions of the country.