I have spent a number of years negotiating, on behalf of sponsors and investors, the terms of commingled private equity investment vehicles – both venture capital and buyout funds. Starting with the initial Greylock partnership in the early 1960s, through Bain, Chemical Ventures and so on I have ?been there, done that.? And a distressingly large amount of my time as a lawyer has been taken up with debating whether a given provision is ?market,? or ?industry standard?: the notion being that the ?market term? should prevail. I say distressingly because disputes of this kind are essentially sterile, too often consisting of the ?my dog's better than your dog? stripe. The objective of the proponent is to bully the opponent into admitting, logic aside, that the proponent's experience is more extensive. If the opponent concedes, the discussion is over, QED.
Out of a personal desire to derail discussions of this sort in the future, I have decided to take the bull by the horns. Since I may be the oldest active practitioner in this area, I have decided publicly to declare my version of the ?market? standard for a list of what I believe to be the most commonly contested terms in the organisational documents of venture and buyout funds. The list is free from bias in the sense that I represent both sponsors and investors on occasion, but neither side in this exercise. Moreover, the source material I have used goes beyond the anecdotal.
The results are the product of, inter alia, private surveys initiated under the umbrella of the New York University Center for Law and Business; a current survey sponsored by The Private Equity Analyst; the controversial Mercer Report; the 1993 National Venture Capital Associates survey; Michael Halloran's two volume treatise, which contains the most extensive legal analysis of fund organisation; my own treatise, of course, and other third party information and data. The judgments and accompanying commentary are, however, my own.
Without further ado therefore, here is my first batch of Frequently Asked Fund Questions and the market's response.
Frequently Asked Fund Questions
1. How long is the term of the fund?
Ten years from the date of the initial closing (note, not from the date of subsequent closings) plus two one-year extensions at the option of the general partner, such extensions (in many cases) are subject to the approval of the advisory board. Occasionally one sees three one-year extensions but two one-year extensions is the market approach and ten years is universally the market norm.
2. What is a ?market rate? management fee?
Two per cent of committed capital; occasionally one sees two and a half per cent depending on the size of the fund. For a fund that is $50m or less in committed capital, a two per cent management fee is somewhat anaemic. For a $400m capital committed fund, a two per cent management fee is arguably extravagant. There is, however, no market standard for reductions in the management fee as fund size grows from $400m; some billion dollar funds continue to charge the two per cent management fee, measured by committed capital. In short, the market rate is two and a half per cent under $50m committed capital; two per cent from $50m to $400m committed capital; and as negotiated above $400m.
3. Is the management fee reduced in the later years of the fund?
Market practice is to reduce the management fee in the later years of the fund, generally starting at the conclusion of the commitment or investment period (see below) to some number but there is no specific number common enough to suggest an industry standard. The options include measuring the fee in later years not against committed capital but against the fair value of the assets remaining in the portfolio (if there is an industry standard, the asset value test is it) and/or reducing the management fee in increments from 2 per cent to something north of 1 over time. The idea behind the fair value test (and, indeed, behind all the alternatives) is that there is less to do in the later stages of the fund's lifetime and, therefore, the management fee should be lower in the later years. A related point is that the managers have probably raised another fund during this period (see below) and, therefore, have other sources of income. In fact, the commencement of a new fund often triggers the beginning of management fee reductions.
4. How much is the general partner required to invest?
The market figure is 1 per cent. This number is inherited, a hold over from the days it was universally felt that the general partner had to have a 1 per cent commitment to the capital of the fund in order to qualify as a partner for tax purposes. There are other methods of solving that requirement short of an outright commitment of 1 per cent of capital; but, the number persists to the extent it is now regarded as the market norm. Some general partners, as a marketing tool, invest significantly more than 1 per cent, particularly those who have become rich thanks to previous funds, but 1 per cent is the market.
5. What is the initial percentage of capital that the limited partners must put up at the first closing?
If anything, five per cent. ?If anything? because many initial closings are dry closings, meaning that no capital is called until the fund lines up an investment and is therefore able to satisfy the Department of Labor's Plan Asset Regulation and qualify as a Venture Capital Operating Company. The idea is that closings are ?just-in-time? closings, because the later the capital is committed and the earlier the investments are harvested, the greater the investor's internal rate of return.
6. How long can the general partner hold the fund open for additional investors?
The market norm is between six and nine months from the initial closing. The market dictates that subsequent investors pay the management fee as if they had been admitted at the initial closing – a late admission charge. This means interest charged at 8 per cent on the capital component which would have been earned on the investment had they contributed capital at the initial closing, plus a contribution of sufficient capital to true up, vis-à-vis any investment the fund has made in the interim, their capital accounts alongside the capital accounts of the initial investors. The assets are not, however, ?booked up? (meaning unrealised profits and losses allocated to capital accounts) if the last closing occurs within six to nine months of the first closing.
7. What is the frequency and size of subsequent capital calls?
The market approach is ?just-in-time,? meaning on 10 to 30 days notice prior to the making of an investment.
8. What is the penalty imposed on a defaulting limited partner failing to meet capital calls?
Draconian penalties are specified in partnership agreements generally (e.g., sacrifice of 50 per cent of one's capital account) but there is no market standard worth talking about because those penalties are never imposed. What happens is that the parties negotiate with a defaulting limited partner, against the background of potentially disastrous consequences to the defaulter, for some way of replacing that limited partner's capital. No one has any idea, because the subject has not been litigated in any case of consequence, whether the penalties ostensibly imposed on defaulting limited partners could in fact be enforced.
9. When are capital calls for new investments no longer authorized?
The end of the call or commitment period, during which the general partner must use the committed capital or lose it, is five to seven years, five to six being increasingly the market standard.
10. Can funds borrow in anticipation of capital calls? If, for example, there is a 30 day period a limited partner cannot be contacted, and the general partner has a chance of making a particularly juicy investment?
Yes. It does not appear that temporary borrowings of this sort, repaid as soon as the capital call is honored, create Unrelated Business Taxable Income [UBTI]. Because of the UBTI issue, of course, the only borrowings allowed are temporary borrowings and it is not entirely clear that even those temporary borrowings do not create UBTI. The best thinking of which I am aware is that a short term borrowing is acceptable if the borrowing does not engender investment income.
11. How soon before the managers are allowed to raise the next fund?
As soon as the existing fund is 70 per cent to 75 per cent committed, including funds actually contributed and invested, funds formally committed for investment, funds ?reserved? in the good faith opinion of the general partner for follow on investments and funds, if any, reserved for other purposes. Therefore, once the fund is in fact around 50 per cent invested, say, half way through the investment period or at the end of the second year, the general partner is often out raising another fund.
12. Regarding the distribution policy, must the fund always distribute cash from investments as harvested? Implied in this question is the issue whether the general partner can reinvest some portion of harvested proceeds from the sale of an investment?
The market view certainly is that cash is distributed in sufficient amounts to enable limited partners (even though the bulk may be non-tax paying entities) to pay taxes on partnership income and gains by year end, at the highest federal and state rates potentially assessable. The market approach probably is that, after a limited period of time and allowing for reserves for contingencies and other potential liabilities, cash proceeds are to be distributed promptly. Some experienced practitioners argue that some portion of harvested proceeds should be available for reinvestment, the reasoning being that, given the self-imposed requirement that capital be held back for follow on investments, the nominal size of the fund is actually much larger than the actual capital available for investment. The consequence of not enlarging the capital actually invested is, of course, a more expensive management fee and larger partnership (relatively speaking) expenses since the expenses are an absolute number and the fee is measured by capital commitments. In my view, the market solution, however, is that cash is returned to the original contributors and they are at liberty then to reinvest in the sponsors second, third, fourth, etc. fund. If so, the decision to reinvest harvested proceeds is on a limited partner-by-limited partner basis rather than lodged in the general partner.
Marketable securities are a different story. The market view is that a general partner, at least in venture capital funds, will distribute securities once they become liquid, meaning when the portfolio company goes public, but the general partner has discretion to hold back the stock position if it has reasonable cause to believe that it can further enhance, as a value added investor cum director, the fortunes of the company. The market position on this is that the hold back period is limited as to time, between one to two years; since the stock is usually locked up contractually for 180 days post the IPO, the hold back is often not of great economic concern to the limited partners.
13. Does the general partner share in all distributions pari passu?
The answer to this is a qualified no. The market method is to hold back distributions to the general partner if the fund is performing poorly in order to collateralise the general partner's so-called ?claw back? (see next question) obligation. The market test is that if the investments of the general partner (taking into account prior distributions) are valued at some percentage, usually 125 per cent of cost (a requirement sometimes referred to as a ?high water mark? requirement), then and only then does the general partner get distributions. The theory is obvious: if the fund has been performing well, the general partner probably will not have to honor the so-called ?claw back,? and vice versa. The qualification is obvious too: if the general partner's allocation stayed behind limited partner recoupment plus a hurdle rate, then escrowing distributions to the General Partner is less important.
14. Is the general partner subjected to a ?claw back??
Universally yes, although the ways of subjecting the general partner to that obligation may vary. The most direct way, and this is a market term, is to provide that the general partner must restore capital to the partnership in order to insure that, upon ultimate liquidation, the limited partners have received 80 per cent (assuming an 80/20 per cent profit split) of the partnership's net profits. Some practitioners believe that it is more elegant to provide that the ?claw back? not be explicit as an end-of-the-day adjustment but that losses be posted to the general partner's capital account in the same proportion (i.e. 20 per cent) as the profits are posted (versus the more typical IPO). The general partner has then, at the end of the day, a limited obligation to restore the deficit balance in its capital account so that the outcome is cumulative (a so-called ?true up?), meaning 80 per cent to the limited partners and 20 per cent to the general partner. The market position should be, in my view (and this can be hotly contested), that the individual principals personally guarantee, and jointly, the claw back.
Joe Bartlett is a senior partner at Morrison & Foerster LLP in New York. He is also the Founder Chairman of the Board of VCExperts.com, the premier US website for entrepreneurs and professionals in the venture capital industry. The author would like to acknowledge and thank Charles S. Farman, partner at Morrison & Foerster for reviewing this material, although the conclusions are his own.