Initials:______

Midterm Exam
VentureCapital250/750:Fall2011
ProfessorDavidWessels
SampleExam

Name: __________________________

CircleClassTime: 10:30am 1:30pm

3:00pm

Youhaveonehourand20minutestocompletethisexam.

Thisisaclosedbookexamtobedoneonyourown.Youcanusea
calculator,butnotacomputer.Youcanhaveaonesidedsheetof8x11
notes.IexpectyoutofollowPennshonorcodeduringthisexam.

Therearefivequestions.Thetotalexamisworth60points.Youcanusethe
backofthepreviouspageforadditionalroomonanygivenquestion.The
examhas9pages(includingcover).

MakesuretoattemptEVERYquestion;doNOTgethunguponanyone
question.Creditwillbegivenforpartialwork.Ifyoudonothaveananswer
availablefromapreviousquestion,makeoneup!Remember,thelesswork
youshow,themoreriskyoutakeoflosingpoints

Initials:______
Question1(8points)
Namethreemechanismsthatthelimitedpartnercanemploytoencouragegoodbehaviorbythe
generalpartnerwhenmanagingtheLPsmoney.Goodbehaviorisdefinedasactinginthebestinterest
ofthelimitedpartner,evenwhenconflictsarise.

Mechanism1shorttitle:

whichencourages:

andisproblematicbecause:

Mechanism2shorttitle:

whichencourages:

andisproblematicbecause:

Mechanism3shorttitle:

whichencourages:

andisproblematicbecause:
2

Initials:______
Question2:(20points)
Youruna$50millionfund.Thefundcharges2%inmanagementfeesperyear(forsimplicity,assume
year4managementfeeispaidinyear3).Thecapitaldrawdownsanddistributionsareasfollows.
$millions

Date

Year1

Year2

Year3

Year4

Capitaldrawdown

1Jan

10

30

10

Distributions

31Dec

20

25

15

a. ContractA:If25%carriedinterestispaidoncecommittedcapitalisdistributed,whatisLPpayoutby
year,theGPcarrybyyear,andthenetvaluemultiplefortheLP?Thecompensationcontract
containsaprovisionthatrequiresexcessdistributionsabovethecarrypercentagemustbereturned
tothelimitedpartneronDec31ofYear4.

b. ContractB:If25%carriedinterestispaidoncecontributedcapitaltodateisdistributed,whatis
LPpayoutbyyear,theGPcarrybyyear,andthenetvaluemultiplefortheLP?Thecompensation
contractcontainsaprovisionthatrequiresexcessdistributionsabovethecarrypercentagemustbe
returnedtothelimitedpartneronDec31ofYear4.

Initials:______
Question2(continued):
c. AssumethenetvaluemultiplesarethesameforcontractsA&B.Inthiscase,wouldthecontract
structurematter?Ifso,whichcontractonthepriorpagewouldtheGPprefer?Why?Ifthe
contractstructuredoesnotmatter,writenopreference.

d. Whatisthegrossvaluemultipleofthefund?

e. ContractCstatesthat25%carriedinterestispaidonlyaftercommittedcapitalplusacompounded
hurdleof6%isreturned.Thecontractstatesthatthehurdlereturniscalculatedoncommitted
capital.TheGPhasa100%catchupondistributionsoncethepriorityreturnisexceeded.Whatis
LPpayoutbyyear,theGPcarrybyyear,andthenetvaluemultiplefortheLP?

Initials:______
Question3(8points):
Twostartupshavethefollowingexpectationsandcomparables(inthepublicmarkets):

CompanyA

CompanyB

Internalrateofreturn

20.0%

15.0%

Annualvolalitityofcomparable

37.5%

52.5%

Marketbetaofcomparable

1.50

1.05

Assumetheriskfreerateequals4%andthemarketriskpremiumis5%.Marketreturnsareexpectedto
haveanannualstandarddeviationof15%.

a. Iftheventurefirmbelievesthenumbersabove,andisbackedbyLPcapital,whichinvestments
shoulditapprove?Assumetheventurecapitalistactsinthebestinterestofthelimitedpartner,
whichholdsawelldiversifiedportfolio.

b. Ifthefounderbelievesthenumbersabove,whichisinvestmentisthemostattractiveonarisk
rewardbasistothefounder?Assumethefoundermustfullycommittooneprojectorthe
other.

Initials:______
Question4(12points):
KaplanandSchoar(2005)intheJournalofFinanceprovidestatisticsonprivateequityfundpersistence.
Basedonregressionresults,currentfundperformanceisafunctionofitsvintageyearanditspriortwo
fundsusingthefollowingequation:

IRR f Vintage Year (.36)IRR f -1 (.42)IRR f -2

wherevintageyearrepresentsasetofvintageyeardummyvariables,IRRf1representstheIRRonthe
VCslastfund,andIRRf2representstheIRRontheVCsfundbeforethat.Assumeepsilon(i.e.the
unexplainedproportionoffundperformance)isi.i.d.normallydistributedwithameanofzeroand
standarddeviationof22.5%.
AssumethattheaverageIRRforfundsstartedin1999was31%,in2001theaverageIRRwas4%,in
2004theaverageIRRwas17%,andin2005theaverageIRRwas5%.Theaveragereturnovertheentire
samplewas12.5%.

a. YouareexaminingtwoVCfunds(asoftoday).RedCapVenturesearned25%inits1999fundand
15%inits2004fund.BlueLightVenturesearned3%inits2001fundand8%inits2005fund.Based
ontheKaplanandSchoarresearch,whatistheexpectedreturnofeachVCsnextfund(asraised
today)?

b. WhatistheprobabilitythatRedCapwillgenerateahigherIRRthanBlueLightontheirrespective
nextfunds?Anormaltableisprovidedonthelastpageofthisexam.

Initials:______
Question4continued:
c. Inpartb,weassumethattheepsilonforeveryfundisi.i.d.normallydistributed,i.e.thatthe
unexplainedportion(knownasepsilon)representsrandomnoise.IfRedCapandBlueLightinvestin
thesameindustry,thismaynotbethecase.IfyoubelievethecorrelationofepsilonsforRedcap
andBlueLightis50%(i.e.theybothdowellorbothdopoorlyinunison),whatistheprobabilitythat
RedCapwillgenerateahigherIRRthanBlueLight?

Initials:______
Question5(12points)
YouworkasanassociateforamajorLP.Youarepresentedwithasetofhistoricalmonthlyreturnsfor
aninvestmentfundthatyourbossisconsidering.Youdecidetorunthefollowingregression.

R f = + b0 R m + b1R m (t-1)+ b 2 R m (t-2)+

whereRmisthereturnofthemarketinthesamemonthastheinvestmentfund,Rm(t1)isthereturnof
themarketonemonthprior,andRm(t2)isthereturnofthemarkettwomonthsprior,wherethe
marketisproxiedusingtheMSCIworldindex.

a. Iftheb0aboveisgreaterthanzero,whatdoesthisimply?

b. Ifb1and/orb2aboveisgreaterthanzerowhatdoesthisimply?

c. Ifthealphaaboveisstatisticallygreaterthanzerowhatdoesthisimply?

d. Ifthealphaaboveisgreaterthanzero,butisnotsignificant,whatdoesthisimply?

Initials:______

StandardNormal(Z)Table
Probability(RandomVariable>Cutoff)
Z
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0

0.00
0.500
0.540
0.579
0.618
0.655
0.692
0.726
0.758
0.788
0.816
0.841
0.864
0.885
0.903
0.919
0.933
0.945
0.955
0.964
0.971
0.977

0.01
0.504
0.544
0.583
0.622
0.659
0.695
0.729
0.761
0.791
0.819
0.844
0.867
0.887
0.905
0.921
0.935
0.946
0.956
0.965
0.972
0.978

0.02
0.508
0.548
0.587
0.626
0.663
0.699
0.732
0.764
0.794
0.821
0.846
0.869
0.889
0.907
0.922
0.936
0.947
0.957
0.966
0.973
0.978

0.03
0.512
0.552
0.591
0.629
0.666
0.702
0.736
0.767
0.797
0.824
0.849
0.871
0.891
0.908
0.924
0.937
0.948
0.958
0.966
0.973
0.979

0.04
0.516
0.556
0.595
0.633
0.670
0.705
0.739
0.770
0.800
0.826
0.851
0.873
0.893
0.910
0.925
0.938
0.950
0.959
0.967
0.974
0.979

0.05
0.520
0.560
0.599
0.637
0.674
0.709
0.742
0.773
0.802
0.829
0.853
0.875
0.894
0.912
0.927
0.939
0.951
0.960
0.968
0.974
0.980

0.06
0.524
0.564
0.603
0.641
0.677
0.712
0.745
0.776
0.805
0.832
0.855
0.877
0.896
0.913
0.928
0.941
0.952
0.961
0.969
0.975
0.980

0.07
0.528
0.568
0.606
0.644
0.681
0.716
0.749
0.779
0.808
0.834
0.858
0.879
0.898
0.915
0.929
0.942
0.953
0.962
0.969
0.976
0.981

0.08
0.532
0.571
0.610
0.648
0.684
0.719
0.752
0.782
0.811
0.837
0.860
0.881
0.900
0.916
0.931
0.943
0.954
0.963
0.970
0.976
0.981

0.09
0.536
0.575
0.614
0.652
0.688
0.722
0.755
0.785
0.813
0.839
0.862
0.883
0.902
0.918
0.932
0.944
0.955
0.963
0.971
0.977
0.982