Setting the Market Standards (Part 3)
Joseph W. Bartlett, Founder of VC Experts.com
Part 3 of a 4 Part series.
2 and Part
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:
- The controversial Mercer Report, by
- 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
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
QUESTION: Are profits from idle funds
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%
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.