|Leverage for the Environment - A Guide to the Private Financial Services Industry (WRI, 1998, 108 pages)|
A venture capital fund is set up to raise equity capital for investing in enterprises by a group of investors seeking significant capital gains offset by high risk of loss. Venture capital is an important source of capital for enterprises when financing from commercial banks or other traditional financial institutions is unavailable due to high risk. In contrast to mutual funds, which almost exclusively invest in publicly traded securities, venture capital funds tend to invest in not-yet-profitable companies that are not traded in the public market. Venture capital is typically associated with "early stage," cash-poor, or rapidly expanding companies. In general, venture capital is attracted by attributes of individual entrepreneurs rather than those of companies, in support of the belief that it is the individual or management team that determines a company's success. Figure 8.1 summarizes four key characteristics of venture capital investing of particular importance to the public interest community.
Size and Leaders
Venture capital began in the United States in the late 1940s, spread to the United Kingdom in the 1980s, and became a fledgling industry in the rest of Europe in the 1990s. Currently, a fluctuation seems to occur in industry terminology between venture capital and "private equity," especially in reference to international investing, where the type of finance for privately held companies is generally "later stage" (e.g., lever-aged buyouts) rather than "early stage." According to The Private Equity Analyst, U.S.-based private equity funds totaled US$ 33.6 billion in 1996 and global private equity commitments totaled US$ 47.8 billion (1). Venture capital (private equity) continues to evolve and now offers a variety of investment funds of different sizes - e.g., funds targeted at different stages of financing and funds offering different types of partnerships.
The typical U.S. venture capital firm manages between US$ 50 million and US$ 99 million in assets (2). Some of the largest venture capital firms are Warburg/Pincus Ventures, New Enterprise Associates, and Hambrecht and Quist (H&Q). Nearly 90 percent of the venture capital invested comes from institutional investors, particularly pension funds and foundations (3).
A venture capital fund is managed by a venture capital firm or other financial institution. Venture capital firms often manage several funds at once. Venture capitalists typically seek to realize profits within three to seven years through an exit strategy, such as when the portfolio companies "go public" in an initial public offering (IPO) (see Chapter 3, Investment Banks), are merged with another company, or are liquidated. Venture capitalists seek returns of up to 10 times the original investment, or a 40- to 60-percent annual return. Only about 7 percent of investments reach this optimum level. Those that do succeed, however, provide sufficient profit to make venture capital a potentially highly lucrative industry.
A recent phenomenon in venture capital/private equity finance is the creation of so-called "funds of funds," which resemble mutual funds with diversified investments in various private equity assets. The number of "funds of funds" has more than doubled since 1994. They offer stability for private equity partnerships because the agreement locks in the investors for up to ten years. Significant "funds of funds" have been established by Goldman Sachs, capitalized at $900 million, and Merrill Lynch Private Equity Fund, at $200 million.
In contrast to other financial vehicles or institutions, venture capital is not regulated by any securities regulatory body. The limited partnership structure of venture capital is a form of private placement and requires no formal registration. However, venture capital funds are subject to capital gains tax laws in the United States.
Attention to Environmental Issues
The mainstream venture capital industry has no relevant experience with or historical concern for environmental issues. A handful of small venture capital firms, however, now specializes in environmental technology funds. The International Finance Corporation (IFC) has begun to mobilize financing for a few small funds dedicated to environmentally sustainable enterprises, such as the new Terra Capital Fund for Biodiversity (see Box 8.1) and the Renewable Energy and Energy Efficiency Fund currently being capitalized.
Relevance to Developing and Transition Economies
The surplus of equity capital in the United States, particularly with institutional investors such as pension funds, has driven the growth of private equity investment in other regions. In Latin America, private equity commitments have grown from negligible amounts in 1990 to 3.2 percent of global equity commitments in 1996. Commitments in Asia fluctuated through the 1990s and by 1996, accounted for 6.3 percent of global commitments (4). The private sector arms of various bilateral and multilateral development banks, such as the IFC, are increasingly involved in international private equity investment as limited partners (in terms of committed capital and no fiduciary responsibility), and serve an important advisory role in due diligence and technical assistance in a fund's creation. The IFC has encouraged private equity investment in the developing world, both by investing some US$ 570 million of its own funds in more than 35 countries, and by attracting other institutional investors and venture capitalists as limited partners in various ventures (5). The IFC has established 15 major private equity funds with US$ 2.38 billion total committed capital and 53 small venture capital funds with US$ 1.55 billion dollars in total committed capital. In the United States, the Overseas Private Investment Corporation (OPIC) occasionally extends guarantees on U.S.-based venture capital funds investing in the developing world.
Latin American private equity partnerships raised US$ 1.5 billion in 1996, compared to just US$ 735 million in 1995. The major investors of private equity in the region are commercial banks, bond and equity investors such as ING Barings' Latin America Enterprise Capital Corporation, large U.S. venture capital funds, and local venture capitalists. Asian private equity raised US$ 3 billion in 1996, down by nearly half from the US$ 6.7 billion raised in 1995. Some of the notable Asia funds favored by U.S. investors include HSBC Private Equity Fund and H&Q Asia Pacific Ltd. (6).
VENTURE CAPITAL DIAGRAM
Figure 8.2 illustrates the operation of a venture capital fund. Venture capital begins with a venture capital firm that has limited capital seeking high-risk/high-return investment opportunities. The firm decides to raise capital from various investors for a particular venture capital fund, which may have a sector or regional focus, with the intention of investing in 10 or more entrepreneurial efforts. The venture capital firm is considered the "general partner" (GP), or may be referred to as the managing partner, while the investors that it persuades to invest are the "limited partners" (LP). The LPs generally consist of various institutional investors. Pension funds and foundations are the most common institutional LPs. The private sector arm of a bilateral or multilateral development bank, such as the IFC, may also be a limited partner. The GP usually contributes about 1 percent of the fund's capital, while the LPs contribute 99 percent of the capital. The GP also receives an annual fee of about 2 to 3 percent of the total committed capital.
For international investing, a public sector guarantor, such as OPIC, may extend a guarantee to the fund.
The GP then considers entrepreneurs/unlisted companies that need financing as companies approach the venture capital firm for capital. The firm screens them for their investment potential and negotiates each deal. The GP also conducts due diligence on the companies. The finance stages vary from "start-up" and first-stage financing for illiquid companies to second-stage financing and expansion capital.
An ongoing symbiotic relationship exists between the venture capital firm and the venture capital fund. The entrepreneurs/unlisted companies benefit, not only from the infusion of capital, but from the expertise and networking provided by the GP, who also may acquire a seat on the company's Board of Directors.
Once the fund's capital is invested, the search for new investors and new investment opportunities slows down. Thus, the investment activity of the venture capital firm is only visible at certain times of the venture capital cycle, and information may only be available on a fund during the fundraising/creation stage and when the exit strategy for a portfolio company is being implemented.
The successful exit strategy, which is normally three to seven years after the venture capital firm enters, is where the big returns are made on initial investments. The "exit" may be by an IPO, a strategic merger (sometimes merged with a limited partner), an acquisition, or liquidation of the company. Upon the sale of equity, the venture capital fund distributes the return on investment among the partners and collects a management fee according to the contractual covenants of the partnership.
Development Bank's Private Sector Lending Arm (such as the IFC) - Reputational/Bottom-line leverage. As the largest direct and indirect provider of equity capital to small companies in the private sector throughout the developing world, the IFC is in a strong position to require adherence to environmental standards and information disclosure requirements for its own investments and those of the private equity funds that it helps to establish. In addition, the IFC can help mobilize finance for environmentally positive enterprises.
Limited Partners - Values-based leverage. Institutional investors, particularly pension funds and foundations, could exercise influence over venture capital funds by proactively financing "green" venture capital funds or by making their financial commitments contingent upon fulfillment of environmental conditions.
Tax Laws - Policy leverage. By providing tax relief or incentives, governmental agencies can significantly influence how venture capitalists act in various countries around the world. For example, tax breaks could be provided for investments in companies that comply with environmental protocols.
Box 8.1 The Terra Capital Fund: A New Biodiversity Investment Vehicle for Latin America
Background: Consumer awareness has driven a growing market for products and production practices that protect biodiversity For example, the demand for organic produce, sustainably harvested timber, and ecotounsm are all expected to grow at double-digit rates Yet, there is limited financial support for small- and medium-scale enterprises engaged in these sectors Available support is piecemeal and has come from nongovernmental organizations (NGOs), foundations, and aid agencies Private equity capital for biodiversity is scarce - most commercial banks are not familiar with this sector, many projects are too small for direct financing, and existing venture capital funds have focused on other high-return sectors
Action: The International Finance Corporation (IFC) has been instrumental in bridging this funding gap IFC, together with the World Bank, developed the concept of a biodiversity venture capital fund and retained external consultants to evaluate investor interest in a pooled venture capital fund aimed at biodiversity investments IFC then brought together expertise in fund management and biodiversity project development from within the World Bank Group to further develop the concept A major obstacle to the competitiveness of such a fund has been the high cost of financial and technical due diligence required to meet biodiversity criteria IFC resolved this problem by obtaining US$ 5 million from the Global Environment Facility (GEF), to be used exclusively to meet the incremental operating cost associated with biodiversity-related investments of the fund
Outcome: The "Terra Capital Fund," to be capitalized at US$ 20 million to US$ 50 million, is expected to commence operation shortly to fund biodiversity-related projects in Latin America. IFC will be a core investor with an investment of up to 20 percent of the fund's total equity commitments. The fund will be based in Brazil and managed by a company whose shareholders - among them IFC - combine experience in venture capital, investment banking, and biodiversity project management. A Biodiversity Advisory Board will be created to prepare investment criteria and provide advice on particular projects.
Analysis: The Terra Capital Fund will allow investors to take advantage of bottom-line opportunities in biodiversity-related investments. The developmental role of IFC was critical in bringing equity financing to biodiversity-related ventures. In addition, the GEF funds required to meet the incremental cost of ensuring biodiversity gains were an indispensable component of the project. The success of the fund will demonstrate the viability of biodiversity projects and should enhance private flows to this sector in the future.
Sources: Global Environment Facility. "Latin America Terra
Capital Fund." Project Document. June 1997; and Global Environment Facility.
"Work Program Proposed for Council Approval." October 6,
1. The Private Equity Analyst. Vol. VII No. 7. July 1997.
2. Mitchell Berlin. "That Thing Venture Capitalists Do." Federal Reserve Bank of Philadelphia. Available online at: http://www.phil.frb.org/econ/br/brjf98mb.pdf
3. Jon F. Greer, Jr. "The VC Boom." Financial World. November 18, 1996, p.5.
4. The Private Equity Analyst. Vol. VII No. 7. July 1997.
5. Leslie Crawford. "International Venture Capital." Financial Times. March 17, 1997.
6. The Private Equity Analyst. Vol. VII No. 7. July 1997.
National Venture Capital Association: http://www.nvca.com
Assets Alternatives, (617) 431-7353
European Venture Capital Association: http://www.evca.org
The Asian Venture Capital Journal: http://www.asiaventure.com
Capital Venture: http://www.capitalventure.com
Venture One, VC, and private equity research and information: http://www.vl.com
The Private Equity Analyst (Assets
The Asian Venture Capital Journal
The Latin America Private Equity Analyst
Galante's Venture Capital and Private Equity Directory
Asad, Musa. "Innovative Financial Instruments for Global Environmental Management." The World Bank Environment Department. Global Environment Facility (GEF) Coordination Unit. September 1997.
Berlin, Mitchell. "That Thing Venture Capitalists Do." Federal Reserve Bank of Philadelphia. Available online at: http://www.phil.frb.org/econ/br/brjf98mb.pdf
Bygraves, William D. and Jeffrey A. Timmons. Venture Capital at the Crossroads. Boston: Harvard Business School Press. 1992.
Crawford, Leslie. "International Venture Capital." Financial Times. March 17, 1997.
Gladstone, J. David. Venture Capital Handbook. Reston, VA: Reston Publishing Co. 1993.
International Finance Corporation (IFC). Investment Funds in Emerging Markets. Washington, DC: The World Bank. 1996.
McDonald, Mary and John Perry. Pension Funds and Venture Capital, The Critical Links Between Savings. Ottawa: Science Council of Canada. 1985.
Schilit, W. Keith. "Venture Catalysts or Vulture Capitalists?" The Journal of Investing. Fall 1996. Vol. 5. No. 3. p. 86.
Silby, D. Wayne. "Social Venture Capital: Sowing the Seeds of a Sustainable Future." Journal of Investing. Vol. 6. No. 4. Winter 1997.
Star, Marlene Givant. "IFC Report Details Emerging Markets Boom." Pensions & Investments. September 30, 1996.
"U.S. Utilities Form Venture Capital Fund for Renewables." Global Environmental Change Report. Vol. 7. No. 8. April 28, 1995.