Entrepreneurial Finance and Private Equity

Class # 2 – Tuesday, October 22, 2002

Measuring Returns

Case: Acme Investment Trust (9-296-042)

Reading: “Note on Private Equity Partnership Agreements” (9-294-084)

Network File: none

1. Why is Warburg proposing a new fee structure from the standard arrangement?

2. More generally, why are the incentives offered venture capitalists (Exhibit 4) so similar?

3. What are the financial implications of the shift? In particular, how does Warburg’s compensation change? To examine this question you may wish to compare the net present value of their management fee with the variable compensation. (You may want to use a discount rate of 15%). The following assumptions may help:

· The fund has a 12-year life, with committed capital (the total amount of funds that the investors have promised to provide) of $2 billion.

· The funds are received in six equal installments, at the beginning of the first six years of the fund.

· The management fee is either 1.5% or 1% of capital (not including those funds that are promised but have not yet been provided by the investors), payable in advance at the beginning of the year.

· The fund’s assets (not including those funds that are promised but have not yet provided by the investors) grow at a steady rate each year. Three representative rates are 5%, 20%, and 35%.

· At the end of the sixth year, 20% of the value of the partnership’s assets is returned at that time to the investors. At the end of the each subsequent year, 20% of the value of the assets is distributed. At the end of the twelfth year, all the partnerships’ assets are distributed.

· Warburg receives either 15% or 20% of all distributions, but not until the investors have received distributions equal to their committed capital ($2 billion).