Funny money

Even though the IPO market is less than a shadow of its former glory, in-kind distributions ? returns distributed by general partners to their limited partners in the form of listed securities, as opposed to cash ? continue to dominate the venture capital market. Even buyout firms are beginning to go the in-kind route, thanks to pressure from investors for distributions.

General partners like in-kind distributions because of the flexibility, tax incentives, and favorable accounting treatment they afford. Limited partners, on the other hand, tend to prefer cash, and are increasingly searching for ways to prevent an in-kind distribution from becoming a losing hand.

According to a 1997 research paper written by Harvard Business School professors Paul Gompers and Josh Lerner, Venture Capital Distributions: Short-Run and Long-Run Reactions, in-kind distributions offer general partners significant advantages:

  • ? General partners, like all corporate insiders, are restricted by SEC rules to selling shares each quarter equivalent to no more than the greater of 1 per cent of the outstanding equity or the average weekly trading volume. By distributing shares of publicly traded portfolio companies to limited partners, the general partner can dispose of large blocks of restricted shares more quickly.
  • ? If general partners first sell the shares of portfolio companies and then distribute cash, taxable limited partners and the general partners themselves are subject to immediate capital gains taxes. By receiving distributions in-kind and selling the shares at a later date, these taxes can be postponed.
  • ? General partners may lock in better compensation for themselves by making in-kind distributions. Most private equity firms determine the value of a portfolio company at the time shares are distributed to limited partners. The GPs then base their carry on that value.
  • Even if shares plummet in value once they are in the hands of LPs, GPs can reward themselves based on the higher valuation.

    In a bull market, in-kind distributions are plentiful and welcome, as share prices tend to go up instead of down. But now, valuations are falling and IPOs are few. The current venture-backed IPO market is not only merely a shadow of the boom years, it even compares poorly with the pre-bubble era.

    In 2002, 19 venture-backed companies debuted in the public market, raising $1.6bn, according to research group VentureOne. In 2001, 21 venture-backed companies held their public-market debuts, raising $1.7bn. By comparison, $18.4bn was raised in 193 venture-backed IPOs in 2000, and $19.1bn was raised in 244 venture-backed IPOs in 1999. In 1998, 77 venture-backed companies went public, compared with 135 in 1997.

    ?It is in the GPs' interests to have a stock hold up, because as insiders, they can't exit if its value begins tanking.?

    The lack of private equity-backed IPOs has decreased the number of in-kind distributions, but the method still dominates the venture scene. Over the past ten years, venture capital firms returned 65 per cent of profits to their investors in the form of in-kind distributions. In 2000, at the height of the boom, this rose to 77 per cent. ?The minute these things came off lock-up the venture capitalists were distributing them,? says Stacey Brenner, a partner and managing director at distribution manager Shott Capital. In 2001, venture capital firms returned 55 per cent of profits via in-kind distributions, according to Shott Capital numbers. But over the past year, responding to pressure from their LPs, venture capital firms have been swinging back to making in-kind distributions, according to Brenner.

    On the buyout side, distributions have traditionally been 85 per cent in cash and only 15 per cent in stock. According to Joe Lyons, treasurer of the Wilton Private Equity Fund-of-Funds, a joint venture between DuPont Capital and State Street Global Advisors, there has traditionally been resistance to buyout firms making distributions in-kind, largely on the basis of scale. ?Usually you're talking much larger investments in much larger companies, and the exits for that class of investments would typically be trade sales,? Lyons says.

    However, even buyout firms are beginning to ponder inkind distributions under current market conditions. ?LPs are looking for some sort of return, some way to reduce their exposure and increase their cashflow,? Lyons says. ?I would expect they're pounding the table a little bit looking for some sort of action from the GPs. But I don't see inkind distributions as being a reasonable response to that kind of appeal.?

    In-kind distributions are largely a US phenomenon. ?There is really no equivalent to NASDAQ overseas, and when we see foreign companies that are distributed, 90 per cent of the time they are listed on the NASDAQ in the first place,? Brenner says.

    US buyout firms currently employing in-kind distributions

    Bain Capital
    Castle Harlan
    Cherry Tree Ventures
    DLJ Merchant Banking
    Geocapital Partners
    SK Equity Fund
    Thomas H. Lee
    Warburg Pincus Source: Industry practitioners

    Mitigation through aligned interests
    Demanding all cash distributions from a venture capital firm may be unrealistic. But investors can ask for compromises that will take the sting out of many in-kind distributions. Hugh Evans, a vice president at T. Rowe Price, and lead portfolio manager for the firm's in-kind distribution management service, suggests LPs build some defenses into partnership terms and conditions. One solution would be to make GPs value their securities based on the average closing price ten days after the distribution (?ten days forward?). This way, the IRR (and subsequent carry) is based on the market prices after the volume of stock has been distributed. It also represents a truer picture of what LPs would get for their stock if they chose to sell on distribution.

    There is of one big mitigating factor: as long as GPs continue to own shares in the portfolio company in question, they, too, will be concerned about putting too much pressure on share price. ?Unless they throw the whole thing out there, the GPs are still holding a significant amount of the stock,? a source says. ?It is in their interests to have that stock hold up, particularly since, as they are insiders, they can't exit the stock if its value begins tanking.?

    The alarm should go off when GPs distribute their entire position in a company. Last year, for example, a healthcare specialist venture capital firm made a distribution of its entire position in a pharmaceutical development portfolio company, according to one source. Five trading days after that distribution, the company announced it had failed to secure FDA approval for a highly touted new product. The company's stock promptly plunged 68 per cent, to close at $1.91 per share, down from $2.83.

    The source says scenarios like the one described above fall into the gray area of insider trading. Had the SEC come calling, the venture capital firm, even though it had a seat on the board of directors of the company, would have had a ready-made defense against allegations of insider trading: ?We didn't sell those shares; we distributed them to the limited partners, and they sold them.?

    Lyons believes that, in the final analysis, the selfregulating nature of the market provides the most effective safeguard against GP abuse of privilege. ?One of the things that does work well within the private equity industry is there is a general alignment of interests,? he says. ?For a GP to distribute securities in-kind, for a security they know is not accurately priced on the distribution date, which works to the detriment of their LPs, they are going to be out of business very shortly if they ever want to raise more than one fund.?