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, questions 22-29 of the 29 questions and issues I have most frequently encountered in this context and my view of the 'market standards'.
- QUESTION: Is 'no fault divorce' a 'market standard' or not? MARKET STANDARD: The 'market standard' is to empower the LPs, either a majority or some supermajority, to compel the GP to withdraw for Cause, as defined in the partnership agreement. However, since it is difficult to prove Cause, the question of whether a supermajority can discharge the GP for any reason is not capable of systemizing into a 'market standard'. Also, it appears that, even in the trophy funds, the LPs usually have to clip the GP's wings (meaning to call a halt to fund investment or to require the liquidation of the fund prior to scheduled termination), at least upon a supermajority. In the first time funds, where negotiation power lies in the LPs, a supermajority of the LPs routinely has the right to compel an unsatisfactory GP to stop investing and may even have the right to liquidate the fund or even compel the GP to withdraw.If the GP does withdraw, a series of issues arise for which there is no 'market standard'. These issues include: Does the GP then revert to limited partnership status and enjoy a regular interest in the fund from the date of withdrawal to the date the fund is liquidated as if it had been an LP in the first instance? Alternatively, are the assets of the fund 'booked up' and the withdrawing GP turned into a creditor of the fund, without any participation in future results?
- QUESTION: Are the assets of the fund 'booked up' annually, meaning are the unrealized gains and losses posted to capital accounts? MARKET STANDARD: The 'market standard' is 'No'. Ordinarily, a standard fund document provides that only realized gains and losses are posted to capital accounts, so distributions are made only to the extent the fund has a certain profit. This approach is driven by the notion that the GP should have no authority to distribute cash or property unless the fund has put something in its pocket. However, 'booking up' is required upon mid-term admission and withdrawals, other than one partner simply transferring its interest to another. If the accounts were not 'booked up,' a new partner in a successful fund would receive a windfall, while a withdrawing partner would suffer an unfair reduction in the amount of capital distributed to it. Some funds attempt to solve this problem by allocating profits and losses on an investment-by-investment basis, truing up at the end of the day to avoid an advantage to the GP.Once the occasion arises upon which the fund 'books up' unrealized appreciation or depreciation, it would seem awkward that the fund should return to the practice of only posting realized gains and losses thereafter. Accordingly, the 'market standard' may move towards posting unrealized gains and losses annually, or more often as required or 'booking up' from the beginning, but making sure that the GP does not line its pockets by over-distributing.
- QUESTION: How are illiquid securities to be valued? MARKET STANDARD: The 'market standard' is that the GP makes the initial valuations, but all valuations are reviewed independently by the advisory committee. The review occurs because the valuations can drive the ability of the GP to make distributions to itself and the size of the management fee if and when the base shifts to asset value. Some partnership agreements insist that the advisory committee does not have a reviewing function unless a supermajority of the members thereof specifically object to a given valuation; but, that is not a 'market standard' term.
- QUESTION: What are the functions of the advisory / evaluation committee? (Note: This committee includes people with experience in the industries targeted for investment as well as representatives of the LPs.) MARKET STANDARD: The 'market standard' calls for at least two roles. First, it provides advice on industry conditions, although that advice is increasingly secured from professional consultants (at least by the larger funds). More importantly, the advisory committee functions as a buffer between the GP and the LPs, reviewing valuations of illiquid securities and, secondly, resolving conflicts of interest.
- QUESTION: What constraints are imposed on the individual members of the GP and the GP itself, to guard against conflicts? MARKET STANDARD: There is no 'market standard' in this field. As Mike Halloran has said, the severity of the conflict constraints varies inversely with the reputation of the managers. The individual members of the GP may spend as much time on a fund's affairs as they deem necessary and desirable. A fund may co-invest with other funds in the pantheon of the institution's portfolio as the managers deem appropriate. The managers may co-invest in portfolio opportunities. Finally, the mangers will present only those so-called corporate opportunities to the fund which they deem appropriate, implying the ability to divert those opportunities elsewhere (e.g., to other funds in the pantheon), as the managers see fit. However, the 'market standard' is not entirely free form., at least absent Advisory Board approval, the principals cannot trade for their own account with the fund as counter-party and may co-invest, if at all, only on level terms.For first time funds, the situation is, as Mike Halloran suggests, reversed. Each manager must spend all his or her time, at least until a second fund is authorized to be raised, on the affairs of the first fund. In fact, the profit interests of the individual members of the GP may be subject to vesting to make sure each stays in harness throughout the life of the fund, and the LPs may decide to review the vesting schedule. All 'corporate opportunities' must be presented first to the fund; and the advisory committee's consent must be obtained before the fund turns that opportunity down and the managers elect to take it for themselves. Again, absent advisory committee approval in specific cases, the manager may not be affiliated with anyone doing business with the fund, either selling securities to it, or buying securities from it, rendering services to portfolio companies, etc. And all income accruing to the managers from portfolio companies, including the fair value of director's warrants, is credited against the management fee.
- QUESTION: If individual members of the GP and the GP itself obtain consideration from portfolio companies, does that consideration belong to the GP or to the fund? MARKET STANDARD: The 'market standard' is at least 50%, and up to 100%, ‘management fee offset’. This means that all consulting, advisory and other income accruing to the GP or to affiliates of the GP (for example an investment bank affiliated with members of the GP) are an offset to the management fee. The funds do not directly benefit because of the tax problems such would cause to tax exempt LP’s. This includes the fair value of warrants when issued to an individual GP member for serving as a director of the portfolio company. In some of the larger funds, particularly the trophy buyout funds, the GP is allowed to keep at least a substantial portion of this income. Thus, it becomes a significant source of income to the GP.
- QUESTION: Is the partnership (i.e., the LPs) responsible for placement agent fees? MARKET STANDARD: The 'market standard' is 'No'. Placement agent fees are the responsibility of the GP and usually paid out of the management fee over the first two years of the fund's existence. Thus, if the management fee is 2% and the placement agent's fee is 2%, the GP pays the placement agent 50% of its management fee in each of the first two years of the fund's existence. The one exception to this role is that, if organizational expenses are capped at a specific number (the 'market standard' is $250,000 for funds under $200 million), it is up to the sponsors to allocate that allowance any way they see fit. Thus, if the legal fees are $150,000 (which is close to the industry standard for a fund under $200 million in total capital committed), there is $100,000 left over for the sponsors to split up any way they want, including paying a portion of the placement agent's fee.
- QUESTION: Can a fund's sponsors set up a 'side fund' that is available to 'friends' on an unpromoted basis and invests at an equal rate with the principal fund? MARKET STANDARD: The 'market standard' term is up to 5% of the principal fund's investments can be diverted to the side fund. The side fund usually is not subjected to a carried interest, meaning that those investors get a significant break over the investors in the principal fund. The 'market standard,' however, is that the side fund should pay its share of the management fee. Funds originating in Silicon Valley often contemplate a side fund, which is designed to attract value-added investors (meaning, presumably, individuals who will be able to direct deals to the fund). East Coast funds, by and large, do not contemplate the establishment of a side fund, except for institutionally affiliated funds, which insist on a side fund for the benefit of employees of the institution who are being motivated to direct investment opportunities to the fund. The side fund must invest in lock step with the fund itself, pari passu on the basis of a specified percentage in each investment, to avoid adverse selection, and cannot 'front the market,' i.e., get out before the fund does.