The rigorous process required to fulfill the fiduciary's duty of oversight in the new complex reality
Sophisticated trust portfolios often benefit from direct exposure to active and passive investments made in venture capital (VC) and private equity. However, if a trustee isn't a lead sponsor of such investments and can't control the terms of subsequent financings, challenges often arise in determining whether to continue to fund these investments and how to properly assess the economic impact of a pending financing. As a result, it's critical that the fiduciary show the completion of a process of diligent review prior to making such decisions to fulfill a trustee's duty of oversight. Looking forward, ongoing investment participation may also benefit from a trustee's active board representation or, if a trustee isn't a professional experienced in assessing, managing and exiting illiquid investments, delegation of such duties to one who is.
The complex reality of the global financial crisis poses particular problems for professional trustees and other family office fiduciaries that may be responsible for the illiquid private equity investment in a trust. No fiduciary will make the right call all of the time when it comes to deciding whether to continue to support or walk away from a private equity investment. But the absence of process in reaching this decision not only opens up the specter of litigation from angry beneficiaries, it also may lead to inappropriate conclusions based on incomplete data. Trustees will benefit from expert advice that is unburdened by personal relationships and other entanglements that may make arriving at a decision even more difficult than it should be. It's unlikely that we will see a secular rising equity tide lifting all private equity ships anytime soon. As a result, applying rigorous process discipline to illiquid investment evaluation, supported by experts, can optimize future investment outcomes during these challenging times.
A New Reality
One of the unintended consequences of the global financial crisis for venture-backed and other private equity companies is increased stress among investor syndicates. Investment failure rates are up, and reaching precious liquidity events takes considerably longer than ever before for private equity investors. For example, among VC funds raised in 2000, one of the two worst vintage years in the history of venture capital since 1981, Boston's Cambridge Associates reports that the total value to paid-in-capital to limited partners (LPs) on a net basis aggregates to only 94 percent, with just 45 percent of this value actually distributed to LPs as of Dec. 31, 2009. Not only does this lack of liquidity place stress on LPs, but also it exposes syndicate fatigue among institutional co-investors due to underlying strategic and economic misalignments among investor groups. According to statistics released by the National Venture Capital Association (NVCA), in the VC industry alone, the median age of venture-backed companies going public in 2009 peaked at 10.6 years and is currently 8.2 years. More importantly, initial public offerings (IPOs) remain elusive, currently accounting for approximately 13 percent of liquidity events over the past decade, in contrast to 56 percent of exits between 1992 and 2000.1
Over the years leading up to the global financial crisis, many large family offices, wealthy individuals known as “angel investors” and other private investing institutions have participated as passive co-investing syndicate partners with active institutional sponsors in venture-backed companies and buyouts. Few of these investors expected so many of their direct investments to still be private today and in need of additional capital. Compounding their dilemma, the general liquidity crisis has dried up natural pools of risk capital, leaving these investors to face stark choices when deciding whether to fund an unanticipated additional private round of financing.
The financial crisis has also reduced the number of externally led financings. The new reality is that for many private companies that need additional capital, insider rounds are the order of the day. Lacking validation of a company's current pre-money value from a new investor, passive co-investors are put at an even greater disadvantage. The private equity game is back to featuring complex “pay-to-play” provisions with onerous terms. Valuations are impaired as significant “down rounds” are crafted to provide “incentives” for everyone to cover their pro rata participation.
In many cases, the lead investors who drive the terms will benefit disproportionately because the effect of having co-investors drop out will improve the capital structure for those who remain.2 A common occurrence is for non-participants to be “washed out” by being automatically converted to common stock and dropping below the preference stack of the senior preferred equity. It should be no comfort to these new common shareholders that the management team also owns common stock because, in an exit that doesn't “clear preferences,” the current management team will negotiate a “carve out” and move to the front of the line along with the senior preferred investors (who often are the last money in).
Does This Sound Familiar?
This complex reality poses particular problems for professional trustees and other family office fiduciaries that may be responsible for the illiquid private equity investment in a trust. Consider, for example, the following questions:
- Was the investment originally made by a trustee or at the request of a beneficiary through an introduction from a friend who is a professional in one of the sponsor groups for the investment?
- Are the beneficiaries of the trust the children or grandchildren of the trustee? Are they unconnected to the relationships behind the investment but highly concerned about taking on inappropriate risk in the trust?
- Were all of the trustees and beneficiaries involved with and supportive of the initial investment, or do tensions and disagreements exist among the family members that may find fertile ground in a losing private equity bet?
- Is the percentage of the trust assets invested in this and other private equity investments material?
If you, as a fiduciary, decide not to invest in the cur- rent financing and the company becomes a great success, you may open yourself to liability, especially if you didn't document a robust due diligence process in arriving at this decision. On the other hand, if you make the pro rata investment and the company fails, fingers may be pointed at shortcomings in the evaluation process that you may or may not have followed.
The fiduciary duty of oversight demands a rigorous process, particularly in evaluating direct, illiquid investments, whether they are emerging technology companies or established operating businesses. As a professional trustee, you may also consider whether you should require formal board representation or observation rights as a condition of moving forward with an investment.
Evaluating Private Equity Investing
The liquidity bottleneck for small capitalization company IPOs in the United States, combined with the longer time to achieve liquidity, has made the risk-reward equation for illiquid investments far more difficult to justify. For example, the 10-year returns for the VC industry have deteriorated precipitously in the past few quarters. As of Dec. 31, 2008 the 10-year VC index net return as measured by Cambridge Associates was +35.0 percent. But by Dec. 31, 2009, that return had fallen to +0.9 percent. Over the same period, an investment in the boring, and very liquid, Dow Jones Industrial Average (DJIA) would have returned a relatively robust +1.3 percent per annum with far less risk. Over the past five years through Dec. 31, 2009, the VC industry has returned just +4.3 percent compared to +0.8 percent for the NASDAQ Composite and +1.9 percent for the DJIA. This hardly represents a sufficiently compelling risk/reward premium for illiquid, high risk investing to attract capital into new ventures.
Prospects for monetization in the U.S. equity capital markets for emerging growth companies are akin to a ghost town if your company's market capitalization is less than $500 million. When you consider the risks associated with starting up a new company in the United States today, you really have to ask yourself, is it worth taking these risks to get the reward? It isn't so easy to say “yes.” But simply quoting these statistics and walking away from commitments to investments that may turn into major winners in the future don't fulfill a fiduciary's duty of oversight.
Unlike investments in the public markets, illiquid investments lack the transparency around operational metrics, tone of business and valuation required by standard reporting regulations. While strides have been made to improve the consistency of book valuation reporting, many illiquid asset investors, particularly those not on the board or management team, lack sufficient information and don't have the pattern-recognition experience necessary to accurately assess the prospects of these investments. While some chief investment officers may have private equity experience, few intimately understand how to adjust and maximize the risk/reward equation for investments to determine which investments represent potential winners and which investments need to be written-off. This is particularly relevant during the current period of stress among professional sponsors where established firms are dropping out of syndicates for reasons that have nothing to do with the underlying prospects of their investment in any given company.
When analyzing investments in private companies, professional trustees and other fiduciaries should focus on a common set of business performance criteria. Some of these elements include:
Business model and market analysis.
- Analysis of industry/market, stage of development and progress based on paid-in-capital to date.
- Assessment of specific business and market economics that underlie business.
- Assessment of future capital needs of the company and liquidity options for the asset.
- Determination of value for company or asset based on entity-specific and market-driven factors.
Management team analysis.
- Are the right people in the right positions for the company today and into the future? If not, how can the team be optimized?
- How will the hiring plans need to evolve over time?
- What is the culture of the company and is it working? If not, what has to be changed?
- How aligned is the board and the senior management team in working towards a corporate goal?
- After completing interviews of all senior team members, how consistent is the perception of the company, its status, its strategic goals and the team's ability to execute?
- Analysis of company capitalization and exit paths.
- Creation of sensitivity analysis for financials.
- Agreement on milestones that determine next steps in the future.
- What is the composition of the shareholder base and how has that affected decisions in the past?
- What is their consensus opinion and where are people in disagreement?
- Is there a clear sense of what each shareholder believes is important and what they are willing to “give up?”
- What are the goals of the major shareholders?
- Based on the capitalization table, where is there general economic alignment and misalignment between constituents at a range of enterprise valuations?
Another critical element in the oversight process is to have candid discussions with the sponsor firms that actually drive the actions of the board of directors. While great CEOs add far more value than their boards, a dysfunctional board can bring a company to its knees and destroy shareholder value in very short order.3
Conflicts and Governance Issues
When engaging in such discussions with the principals of a VC or private equity firm, for example, it's also important to recognize that VC funds, as partnerships, are governed very differently from their portfolio companies, which are corporations.
The fund may have one managing partner that sets the tone and controls the entire firm, or it may have a collegial distribution of governance among several senior partners. The best way to understand how a fund is governed begins with an analysis of the fund's investment committee, its deal due diligence process and the specific allocation of the fund's investment capital among the individual partners.
Finally, there are legal ramifications for both the roles of LPs and general partners (GPs) that must be considered and not forgotten. If you made a direct co-investment in a private equity company in which you also are invested as an LP through the fund, you should know your rights to access information from the general partner under Delaware law.
Section 17-305 of the Delaware Revised Uniform Limited Partnership Act (the Act), which governs LP information rights according to Delaware law, also allows the GP to withhold from LPs “any information the GP reasonably believes to be in the nature of trade secrets or other information the disclosure of which the GP in good faith believes is not in the best interest of the Fund or could damage the Fund or its business or which the Fund is required by law or by agreement with a third party to keep confidential.”
This language captures the GP's fiduciary duties and confidentiality obligations with respect to not disclosing portfolio company information without the consent of the company. The Act provides for a specific list of information that LPs are entitled to, and funds historically disclose that same information to its LPs. Most sophisticated limited partnership agreements allow the GP to override the information rights LPs have pursuant to the Act, permitting the GP to “adjust” identifying information given to the LPs to protect the identity of a fund's portfolio companies. This often is an issue in the case of LPs subject to Freedom of Information Act disclosure requirements. In addition, most partnership agreements allow the GP to withhold information from LPs if the GP has concerns that the LP will disclose the information in a way that could be harmful to the partnership or its portfolio companies.
This article contains information on financial topics; however, it is not financial advice. This content is provided for illustrative purposes only and is not intended for trading purposes. Always seek advice of a competent financial advisor with any questions you may have regarding a financial matter.
- National Venture Capital Association, www.nvca.org.
- “For Some New Companies, the Last to Invest Shall be First,” Wall Street Journal, Dec. 2, 2003.
- “After the Term Sheet: How Venture Boards Influence the Success or Failure of Technology Companies,” November 2003, www.levp.com/news/whitepapers.shtml.
Pascal Levensohn is the managing director of Presidio Strategic Services, a division of San Francisco-based wealth management advisory firm Presidio Financial Partners