Part 2 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 6-14 of the 29 questions and issues I have most frequently encountered in this context and my view of the 'market standards'.
- QUESTION: What is the initial percentage of capital that the limited partners (LPs) must put up at the first closing?
MARKET STANDARD: The 'market standard' is 5% of capital, if anything. However, because many initial closings are 'dry closings,' they are able to satisfy the Department of Labor's Plan Asset Regulation and qualify as a Venture Capital Operating Company. In these cases, no capital is called until the fund lines up an investment. These funds have 'just-in-time' closings because the later the capital is committed and the earlier the investments are harvested, the greater the investors' IRR.
- QUESTION: How long can the GP hold the fund open for additional investors?
MARKET STANDARD: The 'market standard' is 6-9 months from the initial closing. The 'market standard' dictates that subsequent investors pay the management fee as if they had been admitted at the initial closing. This amounts to a late admission charge. New investors pay interest at 8% on the capital component they would have earned on investments, had they contributed capital at the initial closing. Plus, they pay a contribution of sufficient capital to true-up their capital accounts with those of the initial investors, vis-à-vis any investment the fund has made in the interim. The assets are not, however, 'booked up' (meaning unrealized profits and losses allocated to capital accounts) if the last closing occurs within 6-9 months of the first closing.
- QUESTION: What is the frequency and size of subsequent capital calls?
MARKET STANDARD: The 'market standard' is 'just-in-time,' meaning on 10-30 days notice prior to the making of an investment.
- QUESTION: What is the penalty imposed on the defaulting LP failing to meet capital calls?
MARKET STANDARD: There is no 'market standard'. Draconian penalties are specified in partnership agreements generally (e.g., sacrifice of 50% of one's capital account) but no 'market standard' exists because those penalties are never imposed. The parties typically negotiate with a defaulting LP for some way of replacing the LPs capital, against the background of potentially disastrous consequences to the defaulter. Because the subject has not been litigated in any case of consequence, no one has any idea if the proposed penalties imposed on defaulting LPs would be enforced.
- QUESTION: When are capital calls for new investments no longer authorized? (Note: The capital call refers to the end of the call or commitment period, during which the GP must use the committed capital or lose it.)
MARKET STANDARD: The 'market standard' is 5-7 years, with 5-6 becoming increasingly popular.
- QUESTION: May funds borrow in anticipation of capital calls? For example, if there is a 30-day period when an LP cannot be contacted and the GP has a chance at a particularly juicy investment?
MARKET STANDARD: The 'market standard' is 'Yes', funds may be borrowed. Temporary borrowings of this sort, repaid as soon as the capital call is honored, do not appear to create Unrelated Business Taxable Income. Because of the UBTI issue, the only borrowings allowed are temporary borrowings, but it is not entirely clear that temporary borrowings do not create UBTI. Many experts believe that a short-term borrowing is acceptable if the borrowing does not produce investment income.
- QUESTION: How soon after raising a fund are the managers allowed to raise the next fund?
MARKET STANDARD: The 'market standard' is as soon as the existing fund is 70% to 75% 'committed'. Committed funds include:
Funds actually contributed and invested
Funds formally committed for investment
Funds 'reserved' in the good faith opinion of the GP for follow on investments, and
Funds, if any, reserved for other purposes.
Therefore, once the fund is approximately 50% invested, the GP is often out raising another fund. This is usually halfway through the investment period or at the end of the fund's second year.
- QUESTION: Regarding the distribution policy, must the fund always distribute cash from investments as harvested? Implied in this question is the issue whether the GP can reinvest some portion of harvested proceeds from the sale of an investment?
MARKET STANDARD: The 'market standard' is that cash is distributed in sufficient amounts to enable LPs to pay taxes on partnership income and gains by year end, at the highest federal and state rates potentially assessable. In addition, the 'market standard' 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 (e.g., Jonathan Axelrad at Wilson Sonsini) argue that some portion of harvested proceeds should be available for reinvestment. The reasoning is 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 consequences of not enlarging the capital invested are higher management fees and larger partnership expenses, since expenses are fixed and fees are variable based on capital commitments.
The 'market standard' solution, however, is that cash is returned to the original contributors and they are at liberty then to reinvest in the sponsors next fund. If so, the decision to reinvest harvested proceeds is on an LP-by-LP basis rather than lodged in the GP. (Note: Individual GPs may be strong in favor of reinvesting the proceeds from harvested investments in view of their ability to postpone tax if the proceeds are invested within 60 days under Section 1045 of the Internal Revenue Code.)
- QUESTION: Regarding the distribution policy, must the fund always distribute shares of securities to the LP's as portfolio companies go public and the shares become liquid?
MARKET STANDARD: The 'market standard' is that a GP in a venture capital fund will distribute securities once they become liquid. However, the GP has discretion to hold back the stock position if it has reasonable cause to believe that as a value added investor it can further enhance the fortunes of the company. The 'market standard' is that the hold back period is limited to 1-2 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 LPs.