End Game: PE, VC Firms Seek Overtime On Funds
Laura Kreutzer and Russell Garland
July 01, 2010
Both buyout and venture firms are facing ticking time bombs embedded in their fund documents – albeit ones with different clocks.
Buyout firms are coming up against the end of their investment periods for the funds raised from 2005 to 2007. These funds typically have four-to-six year investment periods, and the economic downturn in late 2008 means that many of them haven’t been able to put all the capital raised during the boom period to work.
Venture firms, meanwhile, are facing end-of-fund-life deadlines for vehicles raised during their own earlier boom-and-bust cycle in the late 1990s. Funds typically have deadlines of 10 years to dispose of all their companies and wind down, but many VC funds from the late 1990s still have a substantial number of companies within their portfolios.
The typical path to dealing with such issues is to ask for extensions of investment period or fund life. But investors aren’t in a forgiving mood these days. As such, buyout and venture professionals find themselves in delicate negotiations, with the fate of their firms resting on the outcome.
In recent months, buyout firms including BC Partners Ltd., Elevation Partners and Montagu Private Equity have all sought extensions on their boom-era funds after seeing their investment pace slow in 2008 and 2009.
BC Partners, which raised 6 billion for BC European Capital VIII LP, recently secured a one-year extension of the fund’s investment period until June 2011. BC European Capital VIII LP was only around 68% invested as of December 31, 2009, according to performance data from Washington State Investment Board. That would indicate it still had close to ¤1.9 billion left to deploy as of that date.
Montagu secured an extension until July 2011 on its ¤2.26 billion debut fund, which still has around 650 million to invest, according to sister publication Private Equity News.
Elevation, meanwhile, is currently seeking a one-year extension. Elevation Partners LP raised $1.9 billion in 2005 and still had roughly $200 million left to invest as of late June. The fund’s investment period is scheduled to end in August.
In the past, requests for investment period extensions weren’t that common, and granting them was typically routine. “The general partners were very methodical about it,” said Fernando Vazquez, managing director at Conversus Asset Management. “It was pretty surgical, with a very well laid-out specific plan for why [they needed it] and where the money would go over a reasonable number of months, not years.”
But these days, given the downturn and LP frustration over management fees and other boom era practices they believe were excessive, things aren’t so routine. “If you’re a GP and you have to go back to the LPs for any type of request, it opens up a negotiation,” said Michael Taylor, a managing director at fund-of-funds manager HarbourVest Partners LLC.
Investors’ decisions on whether to grant an extension in large part rests on fund performance, their perception of the fund managers’ judgment, and whether or not they feel they have been treated fairly on the fees front. “People’s reaction will depend in part on how they feel the sponsor is performing,” said Michael Harrell, co-chair of the private equity funds group at law firm Debevoise & Plimpton LLP.
One limited partner of BC Partners said he agreed to the firm’s extension request in part because he felt the firm’s portfolio was on fairly solid ground, compared with some of its competitors.
Investors also are likely to dig into why a firm has money to spare, and are more likely to favor extensions if they feel that the GP kept a level head during the boom. “There are a number of cases in recent years where someone has a four-year investment period and closed their fund in 2006 but stayed disciplined,” said Scott Higbee, partner at Partners Group. “We’re much more objective in giving groups like that time to put that money to work, because in hindsight they did the right thing.”
However, too much caution can also irk investors. “[If] you’ve got a distressed fund that hasn’t put the capital to work in the period that just passed, we’re going to be pretty unforgiving,” Ethan Falkove, managing director in the secondary practice at Neuberger Berman, said at LP Summit.
Differences in priorities among LPs can complicate extension requests. Some investors, like fund-of-funds managers, can’t do anything with returned capital except return it to their own investors. But others, like public pension funds or endowments, may be biased toward wanting capital back, to help address potential liquidity issues.
“We can’t redeploy that capital. Our bias is we would like to see that extension,” Julie Ocko, managing director at HarbourVest, said at the recent Dow Jones Private Equity Analyst Limited Partners Summit. But “there are other LPs that are just focused on reducing their [exposure]. What you have sometimes is not a two-way negotiation but a three-way negotiation.”
Even when LPs don’t have full confidence in the GP seeking an extension, saying no can be tough, as investors fear firms that are denied extensions will plow ahead with deals that they otherwise wouldn’t have done just to get capital into the ground. Some LPs say that pressure on GPs to deploy capital has already begun to show up in rising purchase price multiples for deals. “What you don’t want are artificial deadlines in the partnership agreement distorting the timing of investments,” said Debevoise & Plimpton’s Harrell. An investment officer at one large West Coast pension fund pointed to one compromise solution. “Say 30% of the fund is not invested. You may grant an extension for 15% of the fund but ask them to reduce the fund size by the remaining 15%,” he said.
Even when LPs decide to grant extensions, the battle over what the terms will be has gotten much tougher. Investors are likely to seek reduced management fees at the very least, and other terms – such as a changed transaction fee split – are coming up as well.
Most private equity firms charge management fees on committed capital during their investment period, with fees stepping down once that investment period ends. These days, LPs want to see a step-down even if they grant the extension. “They’ve seen this as an opportunity to reopen the LPA document entirely,” Jonathan Costello, executive director at Morgan Stanley Alternative Investment Partners, said at LP Summit.
Attorneys say that GPs understand the dynamic, and are making concessions. For example, Elevation is offering its investors a management fee break in exchange for the one-year extension, according to its backers, although none would give details on exactly how the fee break works.
The End of The Line?
The problem VC firms face is a little different, having to do with end of fund life, not end of investment period. The industry is reaching the end game on the huge wave of funds it raised during the dot-com bubble. From 1999 to 2001, 1,203 venture funds closed on $178.7 billion, and many of these funds still hold companies that investors think have potential.
U.S.-based venture investors currently have 3,929 U.S.-based companies in their portfolios that received their initial equity investment seven or more years ago, according to Dow Jones VentureSource. That represents 28% of all U.S.-based
portfolio companies of U.S. VCs.
VC funds can generally buy a year or two more beyond their 10-year life without LP approval, but they can’t just keep managing the fund forever. The situation sparked some humor at the LP Summit event. “I don’t think that there’s a 10-year venture fund in existence,” said Eric Fitzgerald, director of venture capital at MetLife.
As with the investment period extension discussions with buyout firms, talks about extending fund life tend to center on management fees. Extensions beyond year 12 are mostly fee-less, but the issue can be tricky.
If the general partners have no chance of collecting carried interest on the remaining companies and no chance of raising another fund, they need some source of income to keep going. But if carry is within their grasp or the firm has newer funds, the management fee might not be an issue. “It’s structurally really nettlesome,” said Kenneth Sawyer, a managing partner at secondary firm Saints Capital.
There are a few examples of firms that have successfully extended their fund life beyond the routine extensions, including Allegis Capital, CMEA Capital and Worldview Technology Partners. But for the most part, LPs feel that after 12 years, VC managers can’t do much more to extract value from their funds. Investors would rather just put the bad memory of investments made during the venture bubble behind them.
“LPs are not very tolerant of requests for extensions unless there is clear, demonstrable evidence that material value can be realized for the fund,” said HarbourVest’s Taylor.
“When I look at exits over the last nine months, 85% to 90% are in companies that were started in 2003 or more recently,” Jason Andris, a managing director of fund-of-funds manager Venture Investment Associates, said at LP Summit. “The fresher companies built with a revised model for today are what’s providing the liquidity for us, not the ’99 [portfolio companies].”
GPs have some leverage because most LPs don’t want to deal with private company stock, which is what they would get if a venture fund is liquidated before exiting all its investments. Furthermore, as with buyout funds, LPs are not always on the same page when it comes to winding down a fund.
Garage Technology Ventures, which began life as an accelerator, found a way to manage all these issues. It turned to secondary firm Industry Ventures to work out conflicting limited partner interests and enable it to close out a $6 million fund, which still held promising assets after 10 years. Industry Ventures engineered a deal to distribute company shares to LPs who wanted them and to buy the rest.
Hans Swildens, founder and principal of Industry Ventures, said well-established venture funds aren’t receptive to his firm’s pitch unless they’re having trouble raising cash to support companies in an older fund. Less-established firms or those whose days are numbered are more open. Still, even that is progress. “I don’t think the marketplace has accepted them as much as you would think,” said Robert Fore, a partner at Goodwin Procter LLP.
But “the fact that they’re not being ignored is progress in my mind.” Some say buyout investors should pay attention to what is happening among venture funds, as five years from now, LBO firms may find themselves dealing with a similar crunch.
One secondary buyer spoke of a 1994 fund that his firm acquired as part of a larger secondary transaction back in 2003. The fund has secured three extensions, and has gradually whittled itself down, but is still collecting management fees.
“They’ve slowly bled out to just one general partner and his assistant,” this investor said. “He’s done a good job of managing out those last couple of investments, but here we are 16 years later and he’s still getting management fees of some sort. It foreshadows what we’re going to see going forward.”
(c) 2010 Dow Jones & Company, Inc.