Part 1 of a 4 Part series.
I have spent a number of years negotiating the terms of commingled, private equity venture capital and buyout investment vehicles. Distressingly, a large proportion of my time has been taken up debating whether a given provision is 'market,' or 'industry standard,' the notion being that the 'market term should prevail'. The goal of these debates is for one side to bully the opponent into admitting that the proponent's experience is more extensive. If the opponent concedes, the discussion is over.
The problem is that discussions of this nature are often a dispute without end, as one party contests that a certain term is 'standard', while the other side argues it isn't. Moreover, both sets of lawyers desperately want to win, regardless of the importance of the point, because a loss concedes that the other lawyer knows more.
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 living active practitioner in this area, I have decided to declare my version of the 'market standard' for a list of what I believe to be the next commonly contested terms in the organizational 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, and is culled from personal experience. While all judgments and accompanying commentary are my own, the 'market standard' list is the product of:
- 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, by Mercer Associates.
- The 1993 National Venture Capital Associates survey.
- Michael Halloran's two volume treatise, which contains the most extensive legal analysis of fund organization.
- My own treatise: 'Equity Finance: Venture capital, Buyouts, Restructurings and Reorganizations'.
- Other third-party information and data.
The following are, in no particular order, numbers 1-5 of the 29 questions and issues I have most frequently encountered in this context and my view of the 'market standards'.
- QUESTION: How long is the term of a private equity fund?
MARKET STANDARD: The 'market standard' term is 10 years from the date of the initial closing (Note: not from the date of subsequent closings) plus two (possibly three) one-year extensions at the option of the general partner, with the extensions often subject to the approval of the advisory board.
- QUESTION: What is 'market standard' management fee?
MARKET STANDARD: The 'market standard' management fee is 2% of committed capital, but this varies based on the size of the fund. The 2% fee is too small to support smaller funds, and excessive in larger fund. So, the 'market standard' is 2.5% under $50 million committed capital; 2% from $50 to $400 million committed capital; and as negotiated above $400 million.
- QUESTION: Is the management fee reduced in the later years?
MARKET STANDARD: The 'market standard' is to reduce the management fee in the later years, generally starting at the conclusion of the commitment or investment period, but there is no 'market standard' target fee. The options include measuring the fee in later years against the fair value of the assets remaining in the portfolio and/or reducing the management fee in increments from 2% to 1%+, over time. The idea behind the fair value test and other 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 companion idea is that the managers have probably raised another fund during this period, and therefore have other sources of income. In fact, the commencement of a new fund often triggers the beginning of management fee reductions.
- QUESTION: Is the management fee increased by a cost of living allowance?
MARKET STANDARD: The 'market standard' is 'No', although that feature is sometimes seen.
- QUESTION: How much is the general partner (GP) required to invest in the fund?
MARKET STANDARD: The 'market standard' is a 1% investment. This number is a hold over from the days it was universally felt that the GP had to have a 1% 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% of capital, but the number persists.