To market, to market

Part II of Joe Bartlett's overview of best market practice for negotiating the terms and conditions of venture capital and buyout funds. The first installment of his catalogue of Frequently Asked Questions appeared in the previous issue of PEI.

1. What is the standard carried or promoted interest?
Twenty per cent, meaning a pure 20 per cent. That is, 20 per cent to the general partner and 80 per cent to the limited partners, based on capital contributions, thereby making the general partner's capital contribution the equivalent of the limited partners' capital contributions, and the carry or promote a pure carry or promote. There are higher splits for the managers of trophy funds, of course, and several funds are driving for higher splits during the life of the fund if performance so warrants; but, the market rate is 80/20. Parenthetically, there has arisen a group of recent funds seeking to enhance their carry by measuring it against ?investment profits? as opposed to ?net profits,? the former being profits from investment before deducting for partnership expenses, including the management fee. This is another way of enhancing the carry without doing so obtrusively.

2. Is it customary to impose a so-called ?hurdle? obligation on the general partner?
Yes in buyout funds and no in venture capital funds, for reasons that are presumably lost in history. The market rate for the hurdle rate today is eight per cent. If the fund is even remotely successful, the hurdle rate only has to do with the time value of money. This means that profits are allocated 99/1 until the limited partners' capital has been returned plus an eight per cent compounded interest component, then 99/1 to the general partner until allocations of profits are in harmony (80/20 on a cumulative basis) and then 80/20 thereafter. For some reason, the hurdle rate is a one time event; that is, if the general partner hits a winner early in the partnership's lifetime, when the investors have contributed, say, only 15 per cent of their committed capital, and the investors recoup that 15 per cent plus 8 per cent interest, the hurdle obligations is forever satisfied. The market standard is that the hurdle rate is not calculated on a year-by-year basis throughout the life of the fund.

3. Are profits from idle funds separately allocated?
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 investment returns playing a major role in the division of profits between the general and limited partners is remote.

4. After idle funds profits have been allocated, how are profits and losses allocated thereafter, within the parameters of 80/20?
Ignoring the hurdle rate for the moment, the first allocation is to reverse prior allocations so that each new period starts, to the extent possible, from zero. Thus, if the fund is universally profitable through its life (or, indeed, in each period suffers losses), there are no reversals. But if there are losses in the early years (as is often the case) 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 so-called ?distribution drive? system, which means that the allocations to capital accounts are not separately stated but that the distributions are described and monitored the way allocations previously were. That is to say, the general partner is required to make distributions, in the 80/20 proportion, of available cash and liquid securities and the allocations then follow necessarily how distributions are made. The distribution drive procedure, while it has the virtue of simplicity, is not yet a market term, mainly (I believe) because most practitioners do not fully understand it.

5. Who is responsible for the expenses of the partnership?
The general partner is responsible for the salaries and benefits paid to the partnership's employees and for the rent, heat, light, administrative services, communications, etc of the partnership's offices and most (if not all) travel expenses. All other expenses, with the exceptions noted below, are allocated to the partnership itself, which means largely to the limited partners since they put up the money. Bearing in mind that those expenses should not ordinarily be significant, they nonetheless include legal and accounting fees on an ongoing basis, the cost of distributing reports, holding meetings of the limited partners, preparing tax returns, etc. There are two types of expenses which can be significant and which are not susceptible of the imposition of a market standard, the first, being consultant's fees. Since, in buyout funds, a general partner may go outside for significant surveys and modeling, consulting costs can mount into the hundreds of thousands of dollars. Consultants fees are therefore subject to some negotiation, sometimes the difference being narrowed by specifying that the general partner pays for the consultants unless it is clear the subject is an exotic specialty. The second significant cost relates to ?wet? and ?dry hole? costs: 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 and related fees can be capitalised and added to the cost of the investment, which means that the limited partners pick up the lion's share. Or the partnership agreement can require that the general partner absorb out of the management fee all consultant's expenses, under the theory that the general partner 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 (since the fund is putting up all the money), a significant portion of those legal fees are economically the responsibility of the fund and, therefore, the limited partners. 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 case the allocation between general and limited partners is a moot point. This discussion is to indicate that certain expenses are often glossed over in the fund document and not fully negotiated, so that there is no market standard. If an expense is not negotiated, it is pretty certain that the partnership (i.e., the limited partners) bear the same, rather than the general partner.

6. Is ?no fault divorce? a market standard or not?
Yes and no. It is certainly a market norm to empower the limited partners, either a majority or some supermajority, to compel the general partner to withdraw for Cause, as defined in the partnership agreement. However, since Cause is rarely capable of being proven, the question whether a supermajority can discharge or clip the wings of the general partner for any reason has yet to be answered with a market standard. And it appears that, even in the trophy funds, the limited partners usually have to clip the general partner'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 first time funds, where negotiation power lies far more with the limited partners, a supermajority of the limited partners routinely has the right to compel an unsatisfactory general partner to stop investing and may even have the right to liquidate the fund. Limited partners in these funds may even in some cases be able to compel the general partner to withdraw. If the general partner does have to withdraw, it's worth noting that a series of complexities arise. Does the general partner 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 the general partner had been a limited partner in the first instance? Alternatively, are the assets of the fund ?booked up? (see below) and the withdrawing general partner in effect turned into a creditor of the fund, without any participation in future results? There are no market rules on this particular issue.

7. Are the assets of the fund ?booked up? annually, meaning are the unrealized gains and losses posted to capital accounts?
The market says no. Ordinarily, a standard fund document provides that only realized gains and losses are posted to capital accounts, meaning that distributions are made only to the extent the fund has a certain profit. This is an approach driven by the notion that the general partner should have no authority to distribute cash or property unless the fund has actually 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, then, assuming a successful fund, the new partner would obviously receive a windfall and by the same token a withdrawing partner would suffer an unfair diminution 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, balancing accounts up at the end of the day to avoid a heads I win, tails you lose advantage to the general partner.

Once an occasion arises where the fund books up unrealized appreciation or depreciation, it would seem awkward to me that the fund should return to the practice of only posting realized gains and losses thereafter. Accordingly, the market view may move in this regard towards posting unrealized gains and losses annually, or more often as required. In other words there would be a process of booking up from the beginning, but making sure that the general partner does not line its pockets by overdistributing.

8. How are illiquid securities to be valued?
The market position is that the general partner makes the initial valuations but, because those valuations in turn can drive the ability of the general partner to make distributions to itself (see the ?high water mark test? above) and the size of the management fee if and when the base shifts to asset value, all valuations are reviewed independently by the advisory committee. 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 as yet a market norm.

9. What is the function of the advisory committee?
The advisory committee is currently an amalgamation of what used to be a true advisory committee (people with experience in the industries targeted for investment) and the evaluation committee (representatives of the limited partners). It has 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). Second, and more importantly, the advisory committee functions as a buffer between the general partner and the limited partners, reviewing valuations of illiquid securities (see above) and resolving conflicts of interest.

10. What constraints are imposed on the individual member the general partner, and the general partner itself, to guard against conflicts?
There is generally no market position on this. As various practitioners have pointed out, the severity of the conflict constraints varies inversely with the reputation of the managers. Particularly in some of the larger institutionally affiliated funds, the conflicts section of the documentation is merely precatory. That is to say, the individual members of the general partner are allowed to spend so much time on a given fund's affairs (balanced against responsibilities they may have to other funds and to the institution itself) as they deem in their own discretion necessary and desirable. Likewise, a fund may co-invest with other funds in the pantheon of the institution's portfolio as the managers, sorting out the various equities at their own discretion, deem appropriate. The managers themselves may also co-invest in fund portfolio opportunities and may in fact, be interested (outside the four corners of the fund) in portfolio opportunities. And, finally and most importantly, the mangers are able to present only those so-called corporate opportunities (portfolio investments which fit within the fund's stated investment screens) to the fund which they deem appropriate – implying the ability to divert those opportunities elsewhere at the manager's discretion (e.g., to other funds in the fund pantheon). The market view on this is not entirely free form. For instance: the principals cannot trade for their own account with the fund as counterparty without Advisory Board approval and may co-invest, if at all, only on level terms.

For first time funds, the situation is 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 instant fund. In fact the profit interests of the individual members of the general partner may be subjected to vesting to make sure each stays in harness throughout the life of the fund, and the limited partners may decide to review the vesting schedule. All so-called 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 (see below) all income accruing to the managers from portfolio companies, including the fair value of director's warrants, are credited against the management fee.

11. If individual members of the general partner and the general partner itself obtains consideration from portfolio companies, does that consideration belong to the general partner or to the fund?
The market position is that at least 50 per cent, and ideally in my view (for venture funds, at least) 100 per cent, management fee offset should occur. This means that all consulting, advisory and other income accruing to the general partner or to affiliates of the general partner (including for example, an investment bank with which members of the general partners are affiliated) are a 100 per cent offset to the management fee. It should be noted that the funds do not directly benefit because of the tax problems such would cause to tax exempt limited partners. This includes the fair value of warrants when issued to an individual member of the general partner for serving as a director of the portfolio company. In some of the larger funds, particularly the trophy buyout funds, the general partner is allowed to keep this income or at least a substantial portion thereof. It thus becomes a significant source of income to the general partner.

12. Is the partnership (i.e., the limited partners) responsible for placement agent fees?
No. Placement agent fees are the responsibility of the general partner 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 per cent and the placement agent's fee is 2 per cent, the general partner pays the placement agent 50 per cent of its management fee in each of the first two years of the fund's existence. The one exception to this is that, if organizational expenses are capped at a specific number (and the current market rate is circa $250,000 for funds under $200m), it is up to the sponsors to allocate that allowance any way they see fit. Thus, if legal fees are around $150,000 (which is close to an industry standard for a fund under $200m), there is a $100,000 left over for the sponsors to split up any way they want, including paying a portion of the placement agent's fee.

13. Can the fund's sponsors set up a so-called side fund, which invests pari passu (up to some stated limit) with the principal fund available to ?friends? on an unpromoted basis?
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). The market approach to this is to sanction up to five per cent of the principal fund's investments being diverted to the side fund. The side fund usually is not subject to a carried interest, meaning that those investors get a significant break over the investors in the principal fund. The market view, however, is that the side fund should pay its share of the management fee. East Coast funds, by and large, do not contemplate the establishment of a side fund, except for institutionally affiliated funds (a Morgan Stanley fund for example), which insist on a side fund for the benefit of employees of the institution who are being thereby 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., exit an investment before the main fund does.

Joe Bartlett is a senior partner at Morrison & Foerster LLP in New York. He is also the Founder Chairman of the Board of, the premier US website destination 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.