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 15-21 of the 29 questions and issues I have most frequently encountered in this context and my view of the 'market standards'.
- QUESTION: Is the GP subjected to a 'claw back?'
MARKET STANDARD: The 'market standard' is 'Yes', although the ways of subjecting the GP to that obligation may vary. The 'market standard' way is to provide that the GP must restore capital to the partnership in order to insure that, upon ultimate liquidation, the LPs have received 80% (assuming an 80/20 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 GP's capital account in the same proportion (i.e., 20%) as the profits are posted. The GP would then have a limited obligation to restore the deficit balance in its capital account so that the outcome is cumulative (a 'true up'). The 'market standard,' in my view (and this can be hotly contested) is that the individual principals personally and jointly guarantee the claw back.
- QUESTION: Does the GP share in all distributions pari passu to the LP's?
MARKET STANDARD: The 'market standard' is to hold back distributions to the GP if the fund is performing poorly in order to collateralize the GP's so-called 'claw back' obligation. The 'market standard' test is that if the investments of the GP (taking into account prior distributions) are valued at some percentage of cost (usually 125%, sometimes referred to as 'high water mark' requirement), then the GP can get distributions. Thus, if the fund has been performing well, the GP probably will not have to honor the so-called 'claw back,' and vice versa. However, if the GP's allocation stayed behind LP recoupment plus a hurdle rate, then escrowing distributions to the GP is less important.
- QUESTION: What is the standard carried or promoted interest?
MARKET STANDARD: The 'market standard' is 20%. That is, 20% to the GP and 80% to the LPs based on capital contributions, thereby making the GP's capital contribution the equivalent of the LPs' capital contributions, and the carry or promote a pure carry or promote. (Note: There are higher splits for the managers of trophy funds and several funds are driving for higher splits during the life of the fund if performance so warrants; but, the 'market standard' is 80%/20%.)
- QUESTION: Is it customary to impose a so-called 'hurdle' obligation on the GP?
MARKET STANDARD: The 'market standard' is 'Yes' in buyout funds and 'No' in venture capital funds. The 'market standard' for the hurdle rate is 8%, and the hurdle rate is not calculated on a year-by-year basis throughout the life of the fund. If the fund is even remotely successful, the hurdle rate only has to do with the time value of money. So, profits are allocated 99/1 until the LPs' capital has been returned plus an 8% compounded interest component, then 99/1 to the GP until allocations of profits are in harmony (80/20 on a cumulative basis) and then 80/20 thereafter. Oddly, the hurdle rate is a one time event. If the GP hits a winner early in the partnership's lifetime, for example when the investors have contributed only 15% of their committed capital, and the investors recoup that 15% plus 8% interest, the hurdle obligation is forever satisfied.
- QUESTION: Are profits from idle funds separately allocated?
MARKET STANDARD: The 'market standard' is 'Yes'. Before any other profits are allocated, the profits generated by temporary investments in cash equivalents are allocated 99/1 in accordance with capital contributions. Given 'just-in-time' capital calls and the fact that yield on temporary investments should ordinarily be counterbalanced by partnership expenses, the likelihood of idle funds investments playing a major role in the division of profits between the GP and LPs is remote.
- QUESTION: After idle funds profits have been allocated, how are profits and losses allocated (assuming a 20% carried interest)?
MARKET STANDARD: The 'market standard' is to that the first allocation is to reverse prior allocations so that each new period starts from ground zero (ignore the hurdle rate initially). Thus, if the fund is universally profitable through its life (or suffers losses in each period), there are no reversals. But, if there are losses in the early years allocated to capital accounts, then all subsequent profits are first allocated to reverse those losses by allocating the profits to the extent previously losses have been allocated; then and only then profits are allocated 80/20. This is a method of helping to insure that the 'claw back' procedure is less likely to be required.
An alternative system, championed by Bill Hewett at Reboul MacMurray, is the 'distribution drive' system. Under this system, the allocations to capital accounts are not separately stated but the distributions are described and monitored the way allocations previously were. That is, the GP is required to make distributions of available cash and liquid securities, and the allocations then follow necessarily how distributions are made. While the 'distribution drive' procedure has the virtue of simplicity, it is not yet a 'market standard' term, mainly because most practitioners do not fully understand it.
- QUESTION: Who is responsible for the expenses of the partnership?
MARKET STANDARD: The 'market standard' is that the GP is responsible for the salaries and benefits paid to the partnership's employees, as well as overhead and travel expenses. All other expenses, with the exceptions noted below, are allocated to the partnership itself, which means largely to the LPs since they put up the money. There are two types of potentially significant expenses which that are not susceptible to the imposition of a 'market standard', the first, being consultant's fees. Since, in buyout funds, a GP may go outside for significant surveys and modeling, consulting costs can mount into the hundreds of thousands of dollars. Therefore, consultants' fees are often a jump ball, sometimes the difference being narrowed by specifying the GP pays consultants unless it is clear the subject is an exotic specialty. The second is 'wet' and 'dry hole' costs, which are the legal, consulting and travel expenses associated with due diligence into and negotiating the terms of, an investment.
Note that there are a variety of ways these expenses can be allocated, sometimes quite subtly. Thus, if an investment is made, the consulting fees can be capitalized and added to the cost of the investment, which means that the LPs pick up the lion's share. Or, the partnership agreement can require that the GP absorb out of the management fee all consultant's expenses, under the theory that the GP was hired to know what it was doing in making investments. If the investment is a 'wet hole,' i.e., it is in fact made, the legal fees associated with that investment are usually the burden of the portfolio company, meaning that a significant portion of those legal fees are economically the responsibility of the fund. Some funds negotiate for the portfolio company to agree in advance to pay the expenses of the fund's evaluation and due diligence if the investment is not made, in which the case allocation between GPs and LPs is a moot point.
Certain expenses are often glossed over in the fund document and not fully negotiated, so there is no 'market standard'. If an expense is not negotiated, it is fairly certain that the partnership (i.e., the LPs) bear the expense, rather than the GP.