THE NEW IMPROVED VENTURE CAPITAL
(AND BUYOUT) FUND MODEL
by
Joseph W. Bartlett
A combination of factors, a perfect storm if you will, is inhibiting the ability of sponsors/managers
of venture capital funds in their pursuit of the next (or occasionally first) iteration of the fund.
Raising capital for venture funds … indeed, for funds of all types, shapes and sizes except, perhaps,
for funds specializing in distressed securities … has become extraordinarily difficult. Accordingly, in
my view it is time to add the structure and organization of private equity funds to the schedules of
makeovers to be implemented in the U.S. corporate finance sector generally.1
I am proud of the model put together in the early `60s by Ely Bartlett (with me as the rookie
wordsmith) and Breed Abbott, for the first Greylock partnership. However, despite my notorious
lack of modesty, no one is that good … meaning that the 45 year survival of that structure in
substance (with, of course, tweaks here and there) is an anomaly. A bottom up and top down
review of the model is long overdue, particularly in today’s difficult environment. Since I claim
authorship, in part, of the original structure, I think I have a certain right to revisit the same and
propose what, in effect, is an overhaul.
By sheer coincidence, after this paper had been initially drafted, there came to my attention a
publication of the Institutional Limited Partners Association (“ILPA:”) entitled, “Private Equity
Principles” (the “Principles”) which overlap many of the recommendations I am making. I refer
throughout, accordingly, to the Principles and comment thereon. To access the Principles see
http://www.ilpa.org/files/ILPA%20Private%20Equity%20Principles.pdf.
THE PROBLEMS:
1.
Long Lock Ups
One of the inherent difficulties in raising a private equity fund, in fact the principal difficulty, is the
length of the lock up. Ten years, plus two to three year extensions, is a long time for any investor to
commit to a specific asset class and/or individual managers; fashions come and go in corporate
finance. It is true, of course, that, in venture capital, courtesy of research by my faculty colleagues,
Michael D’Angelo, Jesse Reyes and David BenDaniel, the top decile ranking has, over many
decades, largely housed the same fund managers. That said (and leaving the so-called trophy venture
capital funds aside) as the tide comes in and out for returns in private equity, venture capital and
hedge fund, investors are nonetheless being required to commit to a ten to twelve year time horizon.
Not surprisingly, many find that decision difficult. As a consequence, even successful fund raising
initiatives are extended to as much as two to three years, while extravagant due diligence processes
are undertaken, and the road show never ends.
2.
Transparency … Often Not
Private equity (including venture, buyout and hedge funds in this category) has been marked by a
lack of both transparency and proactive collaboration between the general partner and the limited
partners. Many years ago, when I first started in this business, the general partner and its counsel
(including myself) were able to keep the limited partners out of the decision making process entirely
(we feared that too many cooks would spoil the broth) by pointing out that, under then the existing
version of the Limited Partnership Act in Delaware and elsewhere, a limited partner which meddled
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in the affairs of the partnership risked losing its limited liability. The “none of your business”
response to the LPs often remains true today, despite a sea change in the RULPA and the
introduction, if any old fashioned lawyer is nervous, of LLCs.
3.
Lack Of Liquidity
Even if the future prospects for a given fund are rosy, issues arising at the limited partner level may
well require that a given LP needs to reach out for contemporary liquidity. Some partners might, as
happened quite frequently during the dot com meltdown, be unable to fulfill their commitments;
many limited partners went from nouveau riche to nouveau pauvre in 2001 (a fact of today’s life as well)
and limited partners seeking to exit the premises were penalized by the imposition of Draconian
penalties … losing, or at least threatened with the loss of, a significant percentage of their existing
investment. In a typical conversation between fund sponsors and institutional limited partners these
days, the fund sponsor will pitch potential investors on the unique attractiveness of the fund model.
In an instant, pushback is predictable, running along the following lines:
“You want me to commit x million dollars to your fund, a commitment to be
fulfilled over a five year period in investments you select plus follow ons for the 10
year life of the fund? Given the metrics of the venture business these days, a typical
investment will take seven to nine years before I see any money. My problem is that
horizons keep changing, the future is unpredictable to say the least, and you are
asking me to tie up a significant portion of our capital and lock it in for a period
which is far enough distant that I have no real idea what our situation will look like at
that future time. The problem is that I am now trying to exit from three or four
funds, the management of which I am not particularly fond and that has proven to
be a very sticky process. Why should I consider revisiting the scene of the crime, as
it were, and locking up in yet another situation where, seven or eight years from now
it may be necessary for me to untangle the web and get some liquidity for my
investment?”
The secondary market has stepped up to the plate to provide a modicum of liquidity but that market
is inefficient; the pricing has been, traditionally, quite hard on motivated sellers, and trades are often
fire sales.
4.
Excessive Fees
The 2 and 20 system has imposed significant frictional costs on the investment, administration and
harvesting of limited partner capital, costs that would not be remotely countenanced were the
managed assets, for example, public securities, or most other asset classes other than oil and gas
exploration … the 20% percent carried interest having been borrowed by my mentor, Bill Elfers,
from the oil and gas industry. The 2% management fee on capital commitments is the principal
(perceived) villain. As a recent paper points out:
“Paying a full management fee on committed but uninvested capital significantly and
negatively impacts on the internal rate of return performance generated for investors
from fund investments. For example, depending on the rate of investment, at
1.75% management fee levied on committed capital can equate to an effective 3.5 –
5% fee on capital actually increased.”2
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5.
Organizational Costs and Length of Solicitation
A significant impediment facing most individuals or groups considering the organization and
financing of a private equity fund is the extraordinary length of time it takes to round up investors
and reach an initial closing. The period now stretches out, for most fund candidates at least, more
than 12 months and often as long as 24 months; a two year period, indeed, may be facing even those
organizers with a top quartile track record in fund management, seeking to close on fund number,
say, IV. There are exceptions to this rule, of course; top decile funds are over subscribed typically
and can close as fast as they can pull the documents together and the investors can get their
necessary due diligence behind them. But, as a general rule an unusually long, hard road faces the
sponsors of a fund and their advisers, including their lawyers, prior to take off … indeed, if take off
actually occurs.
The chores necessary to paper a domestic venture or buyout fund are not all that complicated. I
occasionally go over the top by boasting that, if the investors were all lined up in the waiting room,
we could get the job done in 24 hours. While there is a certain hyperbole in that statement, it is not,
in my view, significantly off the mark. The process is irrationally attenuated, which in turn drives a
significant uptick in organization costs, the first of which is the legal expense. Were the 24 hour
period to be the duration of the process, the documents, using the model forms in my preassembled package (see Reducing Time and Organization Expense, infra.) and indeed in the
form file of many of the law firms which work in this area, could be wordsmithed and presented for
closing, assuming that the deal terms were within “industry standards,” for a price, say, under
$20,000 to $25,000. That, however, is a romantic notion. The typical expense, driven in large part
by the length of the period the lawyers are in harness, approaches $250,000 to $500,000; in fact, if
one of the elite Wall Street firms is involved, that number can be multiplied by a factor of anywhere
between 2 and 4. Secondly, because the road show for private equity funds entails extended one-onone presentations, the T&E costs, leaving aside the costs of the time devoted to the process, is well
into six figures. In fact one of the recurrent problems in this business arises when the managers of
Fund V go about the business of organizing Fund VI; the limited partners of Fund VI become
legitimately annoyed that the managers are spending all their time on the new fund and not enough
time harvesting the investments in the existing fund.
7.
The Elusive Lead
It is well known in this business that the trickiest part of raising a fund, whether the first time or
sixth time, is to secure the lead, aka anchor or bell cow, investor. Assuming an investor with
credentials in private equity, the fact that the lead has signed up triggers an acceleration of the capital
roundup. Time after time, sponsors of a fund soliciting capital experience a receptive audience and
a “good meeting,” only to hear the potential capital source say something to the effect that “we’re in,
once you have a lead.”
8.
Access to Deal Stream
In the venture space, ground breaking research by David BenDaniel, Jesse Reyes and Michael
D’Angelo3 showed that venture capital is a highly unusual asset class. VC funds are here, there and
everywhere but a select few, the top decile in terms of track record, repeat as winners year after year
… in fact, decade after decade. Typically, asset managers have good years and bad, as styles change.
Not the elite VCs, it appears. Why? Location in Silicon Valley has something to do with it, in turn
implying that access to a wide and deep deal stream is the key. There are only so many deals that
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jump off the page … and elite (and typically long standing) VCs get to see them because they have
established intramural relationships which entail (i) a closed “club” built on long standing personal
relationships; and (ii) an unspoken obligation to share the best deals amongst members of the club,
Fund X showing Fund Y a winner and Fund Y therefore obligated to repay in kind.
The question is how a fund, lacking the requisite pedigree and not located on Sand Hill Road, can
source deals competitively. The managers have only so much time to cover all the trade shows and
the annual JP Morgan (ex-Hambrecht & Quist) event is a little crowded.
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THE NEW MODEL (BARTLETT THE BOLSHEVIK): THE “BB FUND”
How one might go about solving these problems? Well, Bartlett the Bolshevik strikes again with the
following proposals.
1.
Pledge Funds: A Potential Alternative:
There is precedent for GPs, intimidated by the length and expense of conventional fund raising, to
cotton onto the idea of the pledge or a synthetic fund a/k/a “search,” “call” or “fundless” fund … a
fund in which the investors have the ability to play on a case-by-case basis, committing only to pay
the management fee for a period of time and allowed, as each investment is teed up, to play or drop.
See Section 10.14, for material on pledge funds, soon to be enhanced and the subject of Book 22 in
The Encyclopedia of Private Equity and Venture Capital, maintained by VC Experts in the Library
(www.vcexperts.com).
The documentation of the structure is relatively simple. The manager of the fund assembles a group
of investors (14 or fewer, in order to avoid, at least for the present time, the necessity of registering
under the Investment Advisors Act of 1940) and asks each to execute a memorandum appointing
the manager (probably an LLC composed of two or more individual managers) as an advisor to the
investor group. The investors are each identified one to another; each investor agrees to contribute
so much per year to cover the managers costs, thereby qualifying the investor as eligible to
participate in reviewing (and at its option investing in) investment opportunities presented to the
group by the management vehicle.
The relationship between the parties is not, of course, employer/employee or indeed principal and
agent, the only binding provision is that, for the term of the agreement … perhaps as short as a year,
perhaps as long as two or three years (renewable of course, by the parties by mutual agreement) …
the investor kicks in his, her or its share of what amounts to a management fee. The amount is
calculated as sufficient to enable the Managers to open an office and use their network of contacts
to attract, analyze and evaluate investment opportunities. Much of the documentation (although
somewhat abbreviated) mimics the language in the private equity fund agreement. Thus, the
managers enjoy a carried interest in each deal after the investors have recouped their advances from
first profits … perhaps with a stated interest rate as well. The managers owe an obligation to bring
all eligible investment opportunities to the fund; the remaining incidentals (and the devil is in the
details) are covered in the instruments … credit for fees from portfolio companies; indemnification,
distribution of proceeds on realization. However, since we are not dealing with a ten to twelve year
lock up, a number of the provisions can be ignored or are less intense … ‘no fault divorce’ for
example. (The Principles recommend a simple majority for no fault suspension of the
“Commitment” query if they mean investment … period and two thirds for removing the GP.)
Pledge investors have certain advantages, i.e., the right to review deal terms to provide feedback
and/or opt-out; ability to avoid deals with particular attributes (e.g., space, management,
fundamentals, others); ability to control concentration allocations; and the flexibility to manage
liquidity constraints. Thus, there may be a more robust secondary market for LP interests and/or
the portfolio company securities given that responsibility for future capital calls is not attached to
the security.
The GP is responsible for leading the transaction from sourcing and execution to post close valueadd and monitoring. In the early stages of review, the GP will provide several updates on diligence
to the Pledge members, allowing for feedback and questions. Following the due diligence and a
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formal investment review, members will have a week to 10 days to review second round diligence
materials, to sign on to the deal or opt-out.
A tricky aspect of pledge investing centers around the frequent necessity of follow on investments in
the portfolio, particularly if the A round contains ‘play or pay’ language. The pledge agreement,
therefore, typically splits the investment by the pledgor into fractions, x% invested when the A
round closes and the remainder callable, with conventional penalties in case of default, for follow
ons in that specific deal. And, some arrangements incorporate a form of true up, resembling a
clawback, for the benefit of those investors who play (as most do) in multiple rounds.
The problem is that the decision process is somewhat elongated; moreover, pledge funds are not
usually in the mega-million of dollars, so it can be lean times for the managers as the fund gets
started, even with a collective commitment to pay a management fee. On the other hand, the
investors are usually a lot more relaxed about allowing the managers to be paid as well by the
portfolio companies, without recoupment from the management fee. And, the object of the
exercise is, in the first three or four years let’s say, to create enough of a track record that the next
initiative is a real live private equity fund, structured along conventional lines.
(a)
Potential Advantage of Pledge Funds In the Face of Hostile Tax and Securities
Regulation Initiatives. Creeping up on the venture capital industry, like it or not, is the distinct
possibility of two unfavorable changes in the way venture funds do business.
First, as is well known, is the imminent possibility, based on legislation introduced by Congressman
Levin, that the gains allocable to GP members based on their so-called carried interest in fund
profits will be taxed at ordinary income rates, which will reduce performance based compensation
by a quarter to a third in terms of after-tax dollars.
Second is the almost certain imposition on the general partner of committed venture funds with
capital subscriptions (or contributions?) in excess of thirty million dollars of a requirement that the
GP register as an investment adviser under the Investment Advisers Act of 1940 (the landscape is
fluid and there is a distinct possibility venture funds will be excused in some form of language).
While some observers think the latter requirement is not much of a problem, I see a significant issue
as registrants are subjected to an inexorable process known as “regulation creep.” In fact, even
without additional “creep,” according to a Client Alert on the Treasury’s “New Foundation”
proposals by Joe Smith at Dewey LeBoeuf,4 the government plans to impose very strict record
keeping and reporting and compliance requirements on investment advisers, all of which will
translate into monthly and annual frictional expense for venture capital funds. Harvey Bines of my
firm, agrees; counsel’s work will be concentrated, post registration, on the type of advice which
experienced counsel currently tender to the mega advisers in compliance and related areas. Under
the two and twenty system, a two million dollar expense allowance in the form of the management
fee may seem to be relatively lush; nonetheless, if you’re going to do the job and hire a sufficient
number of talented people thoroughly to analyze deal stream and enhance access to the same,
there’s a lot of travel expense involved, plus fees to consultants and lawyers, rent, G&A, etc.
Moreover, the New Foundation proposal will also require that funds managed by SEC-registered
advisers, in addition to the advisers themselves, will be subject to certain requirements with respect
to (i) recordkeeping; (ii) disclosure to investors, creditors and counterparties; and (iii) regulatory
reporting, regular periodic examinations for compliance, etc. Adding to the back office costs of the
smaller funds could keep a number of them out of the business. And, to add insult to injury,
Section 206, which sets forth the general antifraud standard, is, according to Joe Smith, more
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expansive than those in other federal securities laws and has been interpreted broadly by the SEC.
He then lists the practices alleged to violate the standard, in a schedule attached to his analysis and
to this memo (Appendix B). Many of the current practices of VCs, if inadequately disclosed (with
the benefit of a 20/20 hindsight), can fall into one or more of these traps; see the underlined items
in the Appendix B.
The point of this portion of the analysis is to suggest the potential advantages, on both these issues,
of the pledge fund.
First, assuming that the so called modest threshold is $30 million, meaning that the general partner
or manager of a fund in excess of $30 million will be required to register, my current understanding
from a counsel to a pledge fund with which I am familiar is that, even though the pledgors have
exhibited their intention to contribute an aggregate amount well in excess of $30 million, there is no
“fund” as such in any amount, let alone $30 million. If you take that view, the pledge fund is liable
to escape the requirement that the general partner register.
Secondly, on the tax front, my guess is that the economics of the members of a venture general
partner and management company will shift from splitting the pie, through a carry, with the limited
partners and the limited partnership to splitting the pie with all the investors in each portfolio
company, the managers being admitted, one by one, to the company’s stock option plan and other
restricted stock programs. It’s unlikely, the thought runs, the Congress will mount a full scale attack
on stock option and restricted stock compensation. Of course, awards of this nature can generate
ordinary income. On the other hand, awards in each and all the portfolio companies can be more
generous than the carry. If you transfer the economics for the managers to the portfolio, the pain of
dilution (which is what the carried interest amounts to) is shared (as suggested) with all the
shareholders in the portfolio companies and not just the limited partners of the fund investing in the
convertible preferred stock. In fact, it’s often customary in the venture business for the venture
capital fund to shift the dilution arising out of a 15-20% stock option plan entirely away from its
investment, so that the plan dilutes and only dilutes the existing shareholders, making it more
attractive to the LPs and, therefore, potentially more generous to the GP members. And, if the
focus shifts to compensation at the portfolio level, then it is unlikely that any such emoluments will
need to be credited against the management fee. If the management fee system is changed the way
I suggest it will be, and the carried interest is eliminated, then it strikes me that the LPs will be
entirely at peace with company-by-company compensation for the GP and its managers … subject
to checking with the Advisory Committee as per the Principles.
All this a long winded way of saying that, if the compensation element shifts the way I suggest, I
strongly suspect that the IRS, assuming it attacks funds for excess creativity in the tax area (40%
penalties in H.R. 1935), will get around to pledge funds last, if at all, because of the deal-by-deal
“fundless” structure.
The short of the matter is that on both these fronts, it may be the pledge fund model assumes
additional and quite significant attractiveness.
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2.
Hybrid Pledge Funds
I foresee the possibility of a hybrid between the typical committed fund and the pledge fund model.
That is to say LP X will commit, say, $20 million to the fund but “commit” in the sense that $10
million will be committed in accordance with the conventional commitment protocol and $10
million will be “committed” to co-investment with the fund on a deal-by-deal basis. A conventional
management fee will be payable to the management company, but only on the $10 million in fact
committed in the traditional way.
Each LP will be given the opportunity to co-invest, within constraints to make sure all the trains
leave on time and with an upper limit on individual investor appetites to prevent anyone gaming the
system. The co-investments will not be promoted, meaning that, if you put $1 in the BB Hybrid
Pledge Fund and allocate $1 for co-investment, the management fee and the carry is reduced from
20% to 10% of the $2 total investment. This will require some structuring so that the fund
managers can move out with the requisite rapidity in order to nail down the best deals. But, in the
BB Fund, co-investment is not reserved simply for the bell cow investor. The opportunity is spread
pro rata among all the LPs, and only LPs with an appetite for this game are recruited. The bell cow
gets, if necessary, a piece of the GP … and not a benefit at the expense of fellow LPs.
This system, co-investment enshrined in the structure of the fund (and not just in a side letter), will
import the flavor of a pledge fund but without some of the handicaps which a typical pledge fund
entails. The managers will put an investment amount from the BB Fund on the table for investment
in an attractive issuer and then negotiate with the issuer how much (if anything) will be available for
co-investment and how quickly the co-investment opportunity must be availed of. With the advent
of digital due diligence files (password protected), any investor wanting to see the due diligence deck
will be able to review the same in real time. The BB Fund will offer to distribute the placement
memorandum to all the limited partners of each transaction it proposes to favor … or which, at
least, progresses to the term sheet stage, and the term sheet will be circulated as well.
An experienced commentator I often consult, Carl Kaplan, points out that the actual exercise of coinvestment rights has been, historically, rare. Point conceded. The difference is that investors in a
hybrid pledge fund are gearing up for co-investment rights … it’s part of their strategy. And,
another end note on this concept: After the initial draft of this paper, I ran across a note in the
Private Equity Analyst, Stein “CP Energy Breaks from Deal-By-Deal Model with Planned $750M
Fund,” Sep. 17, 2009. CP Energy’s first fund, $350 million, was a pledge fund. The planned fund is
a committed fund because according to the managing director “The benefit of a [committed] fund is
that it gives you the flexibility to go out ahead and move quicker … .” That said, it looks like the
new fund will be a hybrid. Thus,
“The firm has identified a number of projects as potential investment targets and will
offer investors a chance to co-invest in deals, said Brian Redmond, managing
director of CP Energy.
“‘[Limited partners] want to have direct access to the project,’ said Redmond in an
interview. ‘The terms under which they’re willing to provide capital has tightened;
they want to see the specific projects … and the ability to invest directly at project
level.’”
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3.
Friendlier Fees and Costs
As far as the 2 and 20 system is concerned, I urge, first, a return to the old days, at least in venture
capital. The management fee should not be a stand alone profit center, as it is today for funds which
reach a certain size. Rather, in the BB Fund the management fee is a budget item; costs are
budgeted for the forthcoming year and the management fee is called down periodically as cash is
needed. The budget is approved by the LP Committee. (The threat of loss of limited liability for
over-participating in the business has disappeared with the advent of the Revised Uniform Limited
Partnership Act and if this is deemed an issue, the fund can always be an LLC.) The Principles are
in agreement, stating that:
“  Management fees should be based on reasonable operating expenses and
reasonable salaries, so that fees are not excessive.”
Indeed, there is no principled reason for managers to make the egregious profits from the
management fees one sees generated by the huge complexes, particularly in buyouts.5 There has
arisen (as is all too often the case these days) totally clueless and misplaced umbrage in the media
and amongst politicians attacking the favorable tax treatment of the carried interest. Were the veil to
be lifted, the public would understand that the carried interest incentive is critical for fund managers
and, indeed, is taxed fairly and equitably. Where the profits arise … rent in economic terms … is in
management fees, well above costs, which are not earned by the managers in any genuine sense of
the word.
Hence the management fee will be a budgeted item in the tax neutral BB Fund and approved by the
investors, whose capital is tasked with payment of the management fee. Maybe then the urge to
grow exponentially large will disappear. The fact is that many venture, buyout and hedge funds are
way too big. Speaking of hedge funds:
“… it has long been argued that younger [and smaller] funds perform better than those with
lots of assets under management. A new study in the Financial Analysts Journal bears this
out.”6
4.
The Fund Will Be Sized To Fit The Opportunity..
One of the recent problems, as perceived at least, with the current model is that in many (although
by no means all) cases, the venture funds … and indeed buyout funds as well … have grown too
large. Thus, the trade press is awash in instances, CalPERS vs. Apollo for example, where the LPs
are demanding that the managers of a given fund reduce its size. This is, of course, an example of
existing LPs trying to reduce the incubus of future capital commitments. But as well, and perhaps
more importantly, the notion is that funds should be sized to fit the appropriate resources and the
fund’s access to proprietary deal stream.
Reverting to Bill Elfers, his first fund cut off at $15 million, as I recall, because that was all he,
formerly the first officer at AR&D, thought he could profitably invest. In fact, according to Dan
Primak at PEHub (11/18/2009):
“Greylock [now] uses year-by-year budgets to determine management fees, rather
than a predetermined percentage of committed capital (i.e., the industry standard).
It’s a bit more work for both GP and LP, but makes far more sense for both sides
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than setting 2014 costs today. Moreover, Greylock has kept its fund sizes a bit below
industry averages (for a firm of its age), which also engenders LP largesse.”
In thinking of optimum size, there are two separate but complementary issues. It’s difficult for any
venture fund manager (to pick the venture funds for the moment) adequately to supervise and add
value to more than, say, four or five portfolio positions. Flying from one board meeting to the next
in hectic fashion tends to reduce the value element the VC adds. The fund may be so large that its
investments, in order to maintain the four to five board seat rule, need to be in a range which
excludes a number of promising venture opportunities. There aren’t that many $20-$50 million
chances to put money to work in today’s (or any day’s) venture landscape. It is true, of course, that
a billion dollar fund can always hire an entire platoon of VCs. There are plenty waiting in the wings
looking for work. But, then, the problem is how do you manage a herd of cats in a coherent way so
as to reduce intramural disputes (which are often fatal to fund performance) and get all the
individuals with investment discretion pulling more or less in the same direction. Secondly, although
I think this is often the less important of the reasons, if the fund managers do not have access to a
robust deal stream, then it’s important that the fund be sized to fit the amount of investment
opportunities the fund is likely to see during the investment period. Josh Lerner has come up with
some evidence that the ideal size for a venture fund is $300 million (+/-). The New Model will start
from Lerner’s target … $300 million or, depending on the circumstances, considerably lower … and
then, if the target is larger, carefully explain to the LPs the reasons why.
5.
Enhanced Returns
For purposes of this section, please assume that, between a Center for American Progress (“CAP”)
Task Force (of which I am a member … see Appendix A, for a brief description of CAP and the
Task Force), and the NVCA 4-Pillar Program http://www.slideshare.net/NVCA/nvca-4pillar-planto-restore-liquidity-in-the-us-venture-capital-industry-1360905, a crack will appear in the IPO
window. The principal cause is likely to be authorization and encouragement of a smooth and
gradual path for venture-backed companies to go public, with less hysteria and more long term
market support than the current process affords. The options are described in a paper published in
Science Progress, a CAP journal (http://www.scienceprogress.org/2009/08/capital-markets-matter/print/). To
summarize, the trick for the BB fund is to line up, in advance, one or more bankers and secondary
trading platforms, list all (or some of) its portfolio companies on the platforms and agree with the
LPs to point the solid performers in the direction of the Long Runway approach and onto what
Inside Venture (just acquired by SecondMarket) calls the Hybrid Private Public Opportunity
(“HPPO”), or some system functionally equivalent. The hybrid IPOs are likely to include the
enlistment of the so-called cross over investors who will grease the skids for an IPO by taking long
positions in both the Series C Round and the Bridge Round prior to the IPO, by committing to buy
a percentage of the IPO offering (40 percent is a number frequently mentioned) when the IPO
becomes effective, and by agreeing to hold the position for enough time to enable the company to
work its plan.
If the IPO ‘Portfolio Maker” is restored to its traditional place in the fund’s portfolio, then the LPs
can begin to shed the notion there is too much money chasing too few worthwhile gazelle
opportunities. A paper recently published by a Senior Fellow at the Kauffman Foundation, Paul
Kedrosky,7 argues, in “Right Sizing the U.S. Venture Capital Industry,” that:
“It seems inevitable that venture capital must shrink considerably. While there is no
question that venture capital can facilitate some forms of high-growth
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entrepreneurial firms, its poor returns make the asset class uncompetitive and at risk
of very large declines in capital commitments as investors feel this underperforming
asst. While any estimate is subject to much uncertainty, it seems reasonable – based
on returns, GNP, and exits – to expect the pace of investing to shrink by half in the
coming years.”
Kedrosky’s paper fails to control for factors which have inhibited venture returns in the last eight
years. Prominent among the same is the permanent closing of the IPO window in the U.S., which
Kedrosky mentions but without giving it much weight. When you arbitrarily suck half the power out
of the race car’s engine, meaning in this case, the classic ‘portfolio maker’ which has for six decades
made venture an exciting asset class, it’s not hard to see why the car goes half as fast. Hopefully, the
HPPO system, or something like it, will help get that job done.
And, the country needs to create a better deal for the early money … angels and seed stage funds.
Bill Elfers, my mentor, defined early stage as “cash flow break even.” If we can get early … and
smart … money into the system, I argue that the number of deals shovel ready for the VCs will
increase exponentially, because there is no shortage of promising ideas or animal spirits.
Parenthetically, and anent the last point, I, a rank amateur, am preparing a critique of Kedrosky’s
paper, and particularly its conclusion, which critique is out for review by academic colleagues. A
major problem, in my view, with Kedrosky’s conclusion is that the reasoning is bottomed on the
assumption that there is some unseen yet powerful force in the U.S. which limits the available supply
of favorable venture investment opportunities to a fixed quantity. Our resources … people, R&D,
ability of markets to absorb the “next big thing” … are finite and therefore the number of desirable
VC backed deals is finite as well. Once Kedrosky makes that assumption, and then finds that
demand (the amount of committed capital) for a given period exceeds the existing supply, he can
logically point out that (i) returns suffer (too much money chasing too few deals), as they in fact
have; and (ii) the fix, since supply is a given, is to reduce the demand, the amount of committed
capital and/or the number of funds, so that the asset class becomes attractive again. My argument
attacks the finite supply assumption head on. I submit there are a number of fixes on the supply
side of the equation, including reforming the FDA and the choke point impasse on device and drug
development; unblocking the pipeline at U.S. academies between the “bench and the bedside,”
funding the gap (see above) between seed investment and the VC, a/k/a “growth capital,” players;
and enlightened tax policy. In fact, if you seek to focus on inadequate ROI for the buyers in a given
market, the firs step is to inquire what would happen if you held all the other metrics constant but
reduced transactional expense. What would the picture have looked like for the investors in venture
funds if the management fees had been reduced across the board, organizational expenses cut in half
(see infra) and the carry dilution halved through energetic exercise of co-investment rights … i.e.
among the elements available in the BB Fund. Without doing the math, my guess is that returns
would still have been subpar, but not as dismal as reported. But it is remarkable, to me anyway, that
none of the pessimists (at least as far as I know) have tried to quantify the effect of that change.
6.
Improved Liquidity
The BB Fund, assuming a conventional committed fund, will take positive steps to accommodate
those investors who want to withdraw prior to the expiration of the 10 year period. First, the
Draconian penalties in the limited partnership agreement for failing to honor future capital
commitments will be chucked over the side. They are rarely, if ever, enforced anyway. They are
designed to bully investors into satisfying their capital commitments. In the BB Fund, that type of
showmanship will be regarded as a irrelevant and annoying. Rather, the manager will have the right
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to co-market, with the withdrawing investor, the limited partnership unit in question. Each partner,
GP and LP, will agree that it will use its best efforts to find a buyer, the withdrawing limited partner
agreeing to put its unit in play, the first step could be a required listing of the unit on the secondary
platform (see infra) the LP offering to sell to that buyer which offers the best price and is acceptable
to the manager, the manager’s approval in that regard not to be unreasonably withheld. The idea is
to treat the withdrawing investor fairly but to subject its search for a premature exit to the
marketplace, so that the managers and the other limited partners can be comfortable that capital
commitments will be replaced. In order to accommodate and enhance secondary market
opportunities , the BB Fund will make arrangements with a limited number, perhaps as small a
number as one, of secondary funds, keeping (with an appropriate NDA) the selected fund or funds
apprised on a periodic basis of how the BB Fund portfolio is progressing. Both the limited partners
and the secondary buyer(s) inside the charmed circle for this purpose will be consulted and
thoroughly advised of the valuation techniques the managers plans to use under FAS 157 to value
the illiquid portfolio, so that when, as and if an limited partner wishes to pull out, the process will be
at least halfway up the learning curve for the benefit of the secondary buyer.8 The agreement will
extend to a couple of other aspects; thus, before the limited partner interest is marketed to the
secondary marketplace, the existing partners (both the GP and the other limited partners), will be
given a right of first offer. In fact, the lead investor(s) may be offered economics to serve as
standbys, including a right of first offer in consideration of the limited partner agreeing to make a
good faith offer at some price for units which come on the market. Secondly, in terms of valid fair
valuation protocols, the BB Fund (and this is now a plug for my company) will have a standing
contract with VC Experts to provide comparable data from the KIT Data Center, the GP absorbing
(as part of the management fee) the cost of the consulting arrangement with VC Experts … again to
make sure that the parties understand and agree with the methods of valuation the general partner
and the management company of the BB Fund are using to arrive at fair value.9
Next, there will be a standing arrangement with at least one private exchange for disposal of
secondary interests if a negotiated transaction or a limited auction arranged by the general partner
should fail to clear the market or is not preferred in the first instance.
The point of all this is that there is a good deal of capital/dry powder available to purchase both
portfolio investments and limited partner interests. It is not an efficient market; the pricing is
viewed generally as less than magnanimous from the seller’s point of view. On the other hand, it is
often a much better solution than the parties trying to beat up on each other as and when an LP
wants to withdraw. And, the arrangements I have suggested for the BB Fund are designed to give
comfort (although no system is fool-proof), that at least a modicum of liquidity will be available for
limited partners who want, or have to, withdraw prematurely. The thrust is to give comfort at the
start to all the LPs, since none can predict absolutely that a contingency compelling withdrawal may
not occur.
7.
Full Transparency
The BB Fund will promise and implement an understanding with limited partners for enhanced
transparency on several fronts. First, on the question of FAS 157, the managers of the BB Fund will
reach out to each limited partner and consult it and its auditor on the auditor’s requirements of the
limited partner vis-à-vis valuing the limited partnership interests for FAS 157 purposes. This has
proven to be a controversial and troublesome issue for investors in funds.10 It is unclear what the
responsibilities are of a fund investor to go behind the general partner’s assessment of valuation and
dig into the methodologies used by the GP and the management company in valuing each portfolio
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position … an obligation which, for a limited partner invested in a number of funds, could prove to
be impossible to satisfy. In order to relieve the burden, the GP will consult in advance with its
limited partners and their auditors, the ultimate decision makers in this process, and understand and
accommodate, as best the general partner can, the auditor’s requirements so that the process can be
expedited and rendered seamlessly and trouble free. In this vein, limited partner meetings with the
general partner will be more frequent because they will be (because they can be) virtual. The
Principles are explicit on this general point.
Next, the partnership will set up password protected websites, consistent with the GP’s obligation to
its portfolio companies to keep certain details private, so that the limited partners will be able to
check out the portfolio. The general partner understands that the limited partners themselves often
are responsible to investors of their own, to whom they must answer … an obligation the BB Fund
takes seriously. On the password protected sites, the BB Fund managers will aggregate and afford
access to information which will help the limited partners understand where each portfolio position
stands. (The Principles are in accord, including information on, e.g. the burn rate of each holding.)
Indeed, one way of so doing, and the one that the BB Fund will typically adopt, is the spread sheet
method, so that the limited partners are not required to wade through mounds of documents to
understand what the result will be, given various exit outcomes, to the holders of the particular class
or series of securities the limited partnership holds.11 The point of the story is that, to pick Bernie
Madoff as a particularly lurid example from the current past, no longer may investment managers
and investors declare that information on how the investors’ money is being invested is off limits.
As the private equity business is subjected by the government to a much greater degree of sunshine,
the BB Fund will not only anticipate where the government is going (because you play the cards you
are dealt) but will, in addition, go the extra mile, one step further than the government regulation,
because the managers of the BB Fund understand that their investor partners have disclosure
obligations of their own. That includes the detailed items of information, 52 in number, which the
Principles specify as of specific interest to the LPs. Although 52 is a big number, most are items the
Fund has in its inventory, or should have anyway. Thus, see the section entitled “Portfolio
Company Reports” which insists that:

“A fund should provide quarterly a report on each portfolio company with the
following information;

“Amount initially invested in the portfolio company (including loans and
guarantees);

“Any amounts invested in the portfolio company in follow-on transactions;

“A discussion by the fund manager of recent key events in respect of the
portfolio company;

“Selected financial information (quarterly and annually) regarding the portfolio
company including:
o “Valuation (along with a discussion of the methodology of valuation);
o “Revenue;
o “Debt (terms and maturity);
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o “EBITDA;
o “Profit and loss;
o “Cash position; and
o “Cash burn rate.”
The celebrated issues involved in protecting the privacy of private companies will color compliance
with the Principles, but most LPs have the power to keep proprietary information like this in fact in
confidence, as the Principles advise … “must keep sensitive information confidential” and, that fight
being largely over, it is anticipated they can and will.
The point of all this is to emphasize that the limited partners are just that, partners, and are entitled
to be treated as partners. They have their own concerns and issues; the BB Fund will attempt, to the
maximum extent possible, to accommodate those concerns without compromising the investment
strategy and the ability to source attractive deals.
The Principles stress transparency as well without, however, breaking any new ground in my view;
the recommendations have to do with, e.g., clarity in disclosure of fees to the GP from the portfolio
and management fee offsets. The one recommendation of more than usual interest is:
“… the economic arrangement of the general partner, the principals and any other
third-party investors in the general partner …Profit sharing splits among the
principals, including vesting schedules; and Individual commitment amounts by the
principals making up the general partner commitment.”
This used to be in the “none of your business” category … but no more. This is driven by the
reaction of all sides to historical benign neglect of the GP intramural arrangements in turn resulting
primitive drafting of what amounts to pre-nuptial agreements and value destroying disputes amongst
principals which rose in droves post the dotcom meltdown.
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8.
Flexible Investment Strategy: Side Pockets
In order to maximize the manager’s opportunity to invest profitably, the BB Fund has procedures
set up (after consultation with the limited partners) to review and, if deemed appropriate, invest in
opportunities which have popped up as attractive opportunities post the closing of the BB Fund,
and outside the four corners of the Fund’s stated sector preferences. Thus, for example, in today’s
fast moving market there appear to be extraordinary opportunities to invest in small cap public
companies currently locked into the so-called orphanage. That asset class may not have been
specified in the original placement memorandum and fund documents; however, if the general
partner can convince the limited partners that there are prime opportunities in this regard and there
is no reason to continue to keep blinders on, the GP will be authorized to pursue the same. Again
in the spirit of a partnership, if a new asset class is teed up for the limited partners which the limited
partners as a group would like to pursue but one or more limited partners want to opt out, there will
be provisions in the partnership agreement for side pocket investments in which fewer than 100%
of the limited partners participate. This is not a recommended procedure, of course; but there is
nothing conceptually or legally against it … depending, again, on a two-way street in terms of
communication and disclosure. To be sure, many LPs want the managers to declare up front their
preferred market sectors and, as the saying goes, the shoemaker to stick to his last. In fact, the
decision maker at a given state pension fund may feel he or she is not paid enough to make
decisions between attractive investment sectors; the Principles, not surprisingly, emphasize that:
“The investment purpose clause should clearly and narrowly outline the investment
strategy.”
but allow that:
“Any changes or modifications to investment strategy should be disclosed and
approved by a supermajority in interest of the limited partners.”
I recommend not binding any LP to a change from the original statement of investment bias. But, I
see no harm in exceptions to the rule, the GP obtaining Advisory Committee approval, followed by
a two thirds vote. Based on recent experience, however, there should be language to the effect that
a negative vote by a single LP cannot be tied to the LP seeking to trade the vote for a special benefit
… i.e., “Buy me out. I have a hedge fund and I need the cash.” Indeed, most funds already
accommodate investors with particular needs by walling them off from toxic (to them) investments
(see, e.g., bank holding companies), including investors who desire to avoid filing tax returns. The
BB Fund goes farther in this regard. Thus, for example, for the benefit of investors who are
responsible for federal income taxes in the United States, there can be side pocket investments in
limited liability companies, passing the initial losses up the chain to the tax paying investors. This
will give them the same advantage (although these will be passive losses of course) as are enjoyed by
investors directly in an early stage limited liability company. It is noteworthy in this regard that
limited liability company status has become close to industry standard for portfolio companies
because, upon a cash exit by trade sale, the assets can be marked up to the purchase price at the cost
of only one federal tax. Tax exempt investors, using feeders or blockers either organized by
themselves or the Fund, will be invited to participate in the side pockets as well. Moreover, again
for the taxable investments, capital tax gains tax can be postponed upon the exit of a portfolio
investment by reinvesting, at the LP’s request, the proceeds in Qualified Small Businesses, a tax
regime which, it is anticipated, the Obama Administration will enhance and enlarge (and, hopefully,
scrub the AMT drag on Section 1202). In fact, there are other tax benefits which can make fund
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investing quite advantageous to given LPs, including the New Market Tax Credit. The idea is that
the BB Fund will offer all the tax advantages that direct investing might offer but with adult
supervision by a team of dedicated investment professionals.
That said, flexibility depends on (a) communication and transparency; and (b) freedom of (within
limits) choice. If an LP, fully informed, does not want to play in public securities, so be it.
Assuming enough LPs in fact do favor the option, then the managers can devote capital to that
sector. The pledge fund dynamics are imported to this extent, circumscribed as a practical matter so
that the managers are not paralyzed by consensus requirements. If the information flow is both
extensive and timely, the LPs should be able to vote yes or no in real time.
9.
Reducing Organizational Time And Expense
There are at least a couple of small steps that the BB Fund sponsors institute in order to reduce
organizational time and expense. First, I site the DaGrosa package, named for an individual who
had hired me to organize a fund, the process occasioning the assembly by me of the package. The
package, available on line12 contains the model fund documents; the VC Experts/Houhilan
Lokey/Thomson Survey of “industry standard” terms between the general partner and the limited
partners; a questionnaire designed to smoke out in advance, by causing the parties to think about the
same, choices vis-à-vis the intramural arrangements amongst the members of the general partner
and the management company; plus a link to Book 10 of The Encyclopedia of Private Equity and Venture
Capital, which contains just about all anyone would want to know in terms of documents, analysis,
and commentary on fund organization. With the benefit of the survey of “industry standard” deal
terms illuminating for the parties where the market is … for example, the accumulated dividend rate
on the liquidation preference … the negotiation can proceed either to regress to the industry
standard or to identify the reasons for departing therefrom. In other words, a base template is
provided for the parties to the BB Fund process to work against, as the deal terms are negotiated.
The next step has to do with an agreed statement of the managers’ track record with prior funds.
This is, to be sure, a difficult area; many of the placement memoranda crossing my desk are
susceptible of the Garrison Keilor mockery … 80% of the fund placement memoranda I review
suggest that their historical track records are in the top quartile. That being the case, another
constructive step is to pursue transparency and standardization of another critical data point; the BB
Fund will specify in detail the Fund’s method of calculating its “track record,” meaning the IRR
achievement of the asset managers, either as general partners of a prior fund in the parade of roman
numerals or on location at other shops. To that end, we at VC Experts are beta testing a portfolio
management tool which will take the mystery out of track records by anchoring the valuation
process on hard data (including algorithms which enable a real time calculation of the effect of deals
… you own the B but not the C) … on valuation which will pass muster with the most skeptical
investors and their advisers.
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10.
Hooking The Lead
Given the elusive lead, the game is to figure out how to bestow special benefits on the lead investor
which do not discourage the remaining prospects. Routinely the lead investor is offered the
opportunity to appoint the chair of the committee of limited partners overseeing the fund, being
called variously the Advisory Committee or the Valuation Committee (in the old days, it was the
Evaluation Committee). Given the new model of the BB Fund, the chairmanship of that committee
entails additional perquisites, although none involving preferred economics. Secondly, side letters
(now routinely required to be produced for inspection by all the investors) tender special rights, viz:
a first call on co-investments (a right we have ruled out because we think it dampens the enthusiasm
of the limited partners as a whole); most “favored nation protection,” meaning that if special rights
are awarded to any investor at the initial (or at a subsequent) closing, the lead investor will be
automatically offered the same; as a technical matter, special features which are required by
regulation ... opt outs from toxic investments for, e.g., communications companies, bank holding
companies, plus promises to think kindly about, say, New York companies if the New York State
Comptroller is the decision maker, selection of investors counsel, the firm named to be paid the
$35,000 (+/-) fee from the Fund at closing; and, on occasion, a piece of the general partner’s carried
interest. In my view, the last benefit is expensive because I feel that the carried interest should be
the primary incentive for experienced players to line up as members of the general partner, suffering
opportunity cost in terms of current compensation in order to earn a piece of the action as fund
investments mature. That said, the lead investor, as a matter of equity, can be paid in other
currencies for its special efforts. Thus, the BB Fund tenders to the lead include the following: right
of first offer if and as a limited partner interest is offered on the secondary market; recompense
from the organizational expense line item for out-of-pocket expenses spent in negotiating LPA
terms and due diligence, including direct gatekeeper costs; right to participate in all succeeding
funds; chair of all meetings of limited partners; right to nominate the manager/liquidator of
portfolio positions post fund termination; first right to purchase stock in an IPO flotation, prior to
any other limited partners. None of these are game breakers, of course. They are on the wish lists of
knowledgeable professionals advising lead investors, and are negotiated into the documents
frequently. The difference with the BB Fund is that the list is offered up front and in its entirety.
There is no mystery and no hondelling … you lead, this is the minimum of what you get. Any
additional benefits, let’s talk.
11.
Enhanced Access to Deal Stream
The BB Fund adopts an aggressive, vertically integrated sourcing strategy, including feeder-type,
semi-formal links between the BB Fund and one or more angel groups and other early stage
investors … the seed planters The hope is that a given firm or group of individuals can serve as a
filter … feeding to the Fund ideas which the group, after due diligence and elbow grease, has in fact
decided to sponsor. And the Fund in turn will encourage the angel investors to submit the best in
breed once a Series A is in the cards, by agreeing to expend its own resources, time and money in
reviewing the investments which the seed planters tee up. The hope is for a symbiotic relationship
between Fund and the planters, one or more, which will be mutually rewarding.
Indeed, the trick is for the BB Fund to enlarge its access to proprietary deal stream (downplaying
auctions and over-the-transom submissions) by growing a network of intake mechanisms with
various sources of interesting and potentially profitable ideas. Some universities, graduate schools,
teaching hospitals and other research generating institutions have established links, many informal,
with venture funds. This process, of course will be encouraged by the sponsors of the BB Fund …
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with, however, recognition that many such alliances between town and gown which have been
initiated in the past have proven to be dry holes. A lot of education and debris clearing, including
changing various aspects of academic culture, needs to be accomplished before the pipeline from the
bench to the bedside is unclogged … an objective of the Center for American Progress task force
referred to in the previous pages of this memorandum. This is not a new idea, of course. Many
VCs wander the halls of MIT, Stanford, Sandia, etc., looking for category breaking IP. Assuming,
however, the CAP Task Force helps in the establishment of procedures … perhaps guidelines … for
universities et al. to adopt, in order to unclog the pipeline, the BB Fund will buy into the guidelines
in anticipation of access to deal stream fitting the coordinates which the Fund has delivered to the
research generating institution. The hope and expectation is that pipeline will become significantly
less clogged if and as the research generating institutions and the participating VCs are at last on the
same page with the details outlined and agreed. Stay tuned for a draft of a guideline from Bartlett
the Bolshevik.
ADOPT THE PRINCIPLES’ RECOMMENDATIONS
As I read them, I see no reason (with perhaps a fully explained and negotiated exception or two,
based on special circumstances), not to adopt the Principles as stated. Herewith a few remarks and
comments on selected highlights from the Principles.
Under the heading of Alignment of Interest, the remarks on the waterfall structure indicate a
preference, as I read them, in favor of the cumulative return model for calculating the carried
interest rather than the deal-by-deal model which is favored by GPs members who would like to get
some money in their pockets at the earliest possible date.
There is a focus on the clawback, which suggests joint and several clawback responsibilities, a
difficult problem for some GPs where the members have not worked together over a considerable
period of time. Accordingly, the Principles suggest “effective escrows and other general partner
mechanisms to insure clawback repayment.” For those of us who are veterans of issues involved
when a principal bails out in mid-stream and chasing him or her to honor clawback responsibilities is
an exercise in futility, escrows with, as the Principles suggest, a significant reserve (30% of the
carried distributions or more), are the way of the future.
A potentially controversial recommendation is that “the general partner should have a substantial
equity interest in the fund.” Presumably this means that the ‘skin in the game’ requirement for the
GP is higher than 1%. Moreover, the Principles suggest that “a high percentage of the amount
should be in cash as opposed to being contributed through the waiver of management fees.” One
issue in that regard, an intramural question for the principals of the general partner, has to do with
their ability to call on the management company, assuming there is any money in the till at the
management company level, to advance each principal’s share of the GP’s contribution. Why not?
Ownership of the Management Company may not track ownership of the GP. Also, the idea of a
given principal being able to satisfy all or of a portion of his or her required contribution with a note
of some kind is not covered; but in some instances it is simply hard (if not impossible) for young up
and comers to find, in today’s environment, the cash to fund their share of forward commitments in
the 3% range.
The Principles also, in the conflict area, urge that the sponsors “avoid provisions that allow general
partner [sic] to reduce all fiduciary duties to the fullest extent allowed by law.” This is a reaction, of
course, to the philosophy behind the Delaware Liability Company and Delaware Limited
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Partnership Act, which contemplate fiduciary duty as a contract provision which may be adopted or
not by the contracting parties. I will be interested to see a definitive case in Delaware which explains
the residual duty which cannot be contracted away … “good faith and fair dealing.” In a panel some
years ago in which then Chancellor Chandler participated, I asked him for an outline of the
difference between “fiduciary duty” and “good faith and fair dealing.” He just laughed and went on
to the next subject.
In the governance area, a not surprising Principle states that no fault divorce should be triggered at
least in terms of suspending or terminating the investment period, by a simple majority of the LPs
and a two-thirds majority will suffice to remove the general partner. Not far off the current
standard.
The language about the “independent auditor” is interesting in that the Principles suggest that “
management fee and carried calculations should be reviewed and certified by the auditor and [the
external] auditor should review the partnership expenses charged to the partnership and certify that
any charges were consistent with the partnership agreement.” It is not clear to me that the auditors
will feel that they are in a position to carry out these functions; I put this in the “stay tuned”
category. The issue, to my mind, is what frictional expense the requirements (particularly when you
start paying independent auditors for reviews) will impose on both the operational and
organizational phases of a fund’s existence … and who will bear those expenses, the GP or the LPs?
Maybe a big problem for small funds. And certainly, added audit expense should be quantified in
advance and shared with the LPs. It’s their money.
New Ideas
Assuming legislation before the House Small Business Committee is adopted, SBICs and, it appears,
other funds, can apply for one-for-one leverage from the SBA as they purchase stock in Series A, B,
C, etc. The SBA “grants” will be a clone of the Series A, B, C, etc., preferred, only differing by the
SBA having no voting rights. The suggested appropriations top out at $1 billion in 2012. Since VC
funds can establish side-by-side SBICs, or own SBICs as subsidiaries, why shouldn’t the VC
community forthwith get in line? Maybe a combination of conventional SBIC debt, plus the
leverage of non-voting grants will turbo-charge the sector.
CONCLUSION
In short, the BB Fund: builds on my experience; borrows from the pledge or synthetic fund concept
so as to create a hybrid; pro-actively meets and accommodates often-expressed limited partner
issues; opens the door for a wider range of investors; reduces conflicts; minimizes frictional expense
negatively impacting LP returns; promotes cooperation; and improves (hopefully) performance.
The core idea, of course, is to make funds more attractive than they have been in the past, thereby
unlocking LP wallets. A fresh look at fund structure, after 46 years, is (I think) long overdue. I like
to think, as a rookie working with Breed Abbott, we did a good job in 1963 on the first Greylock
partnership. But, no one is that good; we never intended that the structure we authored in 1963
should be immortal. As our President says, the time has come for “change.”
Joseph W. Bartlett
jbartlett@sandw.com
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APPENDIX A
am involved in a task force organized by the Center for American Progress (“CAP”),13 the aim
being a comprehensive report to the Congress and the next Administration on policy issues which
involve the future of the tech economy in the United States and what I call the EVITA14 sector.
The Task Force is under the leadership of Ed Paisley, formerly a senior editor at The Deal and now
directing the Science Progress initiative at CAP. I invite you, first, to review the home page of CAP
(http://www.americanprogress.org/) and then visit the indicated links to the task force and its
undertakings (www.scienceprogress.org). The segment from the paper described in the text reads
as follows:
I
Testing The Market. The idea is to take off (pardon the pun) from the “Long Runway” approach
which Professor Zach Shulman and I suggested in our paper in 2003 and, in the process, to attract
more analytical attention to IPO registrants, analytical attention which can be matured, like a fine
wine, during the pre-IPO period I have labeled the Long Runway.15
Getting to the specifics, I am recommending legislative and regulatory authorization of a
“Waiting Room” or “Trial Period,” by which I mean a blessing by the SEC and the State
Securities regulators of a process which contemplates a private company (presumably venturebacked) considering an IPO creating, well prior to the event and while still private, a venue for
mature investor diligence which mimics the way the best VCs drill down on candidates for the
portfolio.
During the Trial Period, the issuer considering a flotation will have the opportunity to post, on a
password protected site, financial and business information, for the benefit of prescreened
superaccredited investors, which it deems to be material and explain in its own words the
business of the company, its current financial situation, its past history. The system can borrow,
conceptually, from existing regulatory provisions, including Rule 254, which is the “test the
waters” rule under Regulation A and the recent shortening, to 90 days of the private offering/IPO
integration period..
After three to six months or so, the Company can elect to withdraw the information and go about
its business, depending on what it perceives as market conditions or, alternatively, start
entertaining queries from qualified underwriters. It can list its shares on one or more of a growing
number of secondary trading platforms (see below) and check the pricing if and as shares trade.
Assume underwriters express interest, compelled by soundings they have taken in the community
of likely institutional buyers, and can arrive at a “guesstimate” of a likely market valuation, the
board can then make an informed decision to undertake the IPO process (hopefully streamlined).
Information available in the Waiting Room will find its way into the registration statement, of
course … as qualified if subsequent events has made changes appropriate. Provisions recently
published in proposed form by the SEC on the content of corporate websites would be
incorporated as well, including reasonable protection against liability based on allegations of a
class of putative plaintiffs architected by wily plaintiffs’ counsel.16
We need, in short, to remove the hysteria, resembling nothing so much as the opening weekend of
a Hollywood movie, from the current process and give IPO candidates, and the investment
community, a chance to attend what amount to out of town tryouts, read the reviews and then
decide whether the show is ready for Broadway. The current system contemplates a decision
(often uninformed and premature) to go public, followed by a “quiet period” clamp down by the
SEC during which no information is available and millions in legal and accounting expense
incurred, followed by an order to “print the reds,” and then a pell mell rush to assemble a “book”
of tentative orders and sell all the offered stock in one business day. There must be a better way to
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administer public floatations. My program, as luck would have it, intersects and overlaps in many
ways with Pillar 2 of the NVCA proposals, which contemplate private market platform[s]
connecting qualified companies, prescreened and carefully vetted, that intend to go public within
6 to 18 months and pre-screened “cross-over” investors, meaning “long term institutional and
strategic investors,” which will provide the bridge to IPO financing and hold for the long term.
The innovation, which Inside Venture (featured in the NVCA report) promotes what it calls the
Hybrid Private Public Offering; the bridge investors are the IPO bell cows, agreeing to take down
40% (+/-) of the IPO flotation … and continue to hold for the long term.17
And, there are other ideas being floated along these lines, all with the end game of getting the IPO
window reopened for venture-backed mid cap companies. Thus, KKR has cut a deal to take some
of the chills and thrills out of the game by arranging with Fidelity for a structure can pacify the
IPOs of some number of the 50 companies stranded in the portfolios of KKR funds. The idea is
apparently, that KKR’s captive broker/dealer will underwrite the IPOs (saving fees big time) and
the IPO shares will, apparently, be offered, exclusively to Fidelity’s retail and mutual fund
clients, with both KKR’s and Fidelity’s name on the line, both sell and buy side, the process
should be orderly and the floatations conservatively priced. Further, David Weild is focused on
creating financial incentives which, in his view, will bring back the Golden Era market makers
(Alex Brown, Robby Stevens, H&Q, and Montgomery), or (more precisely) their successors, e.g.,
Needham & Company, once they are again able to profit from a spread between the bid and the
asked, so that stock issued in an IPO can be “sold” rather than simply “bought.” He and Ed Kim
have constructed a notion of a “New Market,” to bring public mid-cap companies,18 Those
overlooked by the current market because they are too small, Weild and KKR noting that a
number of mega-billion dollar companies today started as small cap IPOs.
At this point, it is not necessary to pick the details of any one of the specific proposals being
floated to get the window reopened. When you look at the array, you detect a consensus forming
behind the idea of loosening the SEC’s requirements for a quiet period prior to an IPO. Indeed,
the Waiting Room, as I call it, is the reverse of a quiet period: Potential investors, assisted by
information in the Company’s digital diligence file plus, if applicable, data drawn from limited
trading on secondary platforms such as SharesPost and SecondMarket (aided, in each of these
cases, by valuation tools supplied by VC Experts the firm I chair), can get their feet wet in the
Company’s stock and track its progress over a relaxed period of time … before the play opens on
Broadway or the film opens in 150 theatres around the United States. If the run up to the IPO is
more peaceful than is currently the case, and the decision to invest, therefore, more carefully and
thoughtfully considered, the notion is that excess volatility in the post-effective period will be
limited and trading action will not be dominated by hedge funds flipping the security once it first
bursts on the scene. Rather the process, coupled with changes in tax and regulatory policy, will
favor the flotations of venture-backed gazelles, underwritten by adequately compensated bankers
of the old school, covered by reliable and talented analysts paid to do a good job (see the next
section) … and, as customers, sophisticated, patient investors who are willing to back a company
with a long term plan to turn the gazelle into another Microsoft.
In short, it doesn’t take rocket science to figure out that some variation of the Long Runway is the
way to go. The smartest investors in gazelles in this country are the elite VCs, investing privately.
Before they cut the check, they spend months in due diligence, kicking the tires, consulting
experts, then they hold for the long term as the company puts their capital to work. Why should
the buyers (and the bankers and sellers) in an IPO do anything differently?
APPENDIX B
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
“Front-running” or “scalping”

Misrepresenting pricing methodology or failing to follow disclosed valuation methods

Deliberate mispricing of portfolio holdings or manipulating market prices to inflate violations

Failing to disclose in communications to clients that a large portion of a fund’s superior performance
was due to investments in initial public offerings

Misrepresenting internal controls

Miscoding, forgoing or failing to submit order tickets

Overstating performance results

Purchasing securities in contravention of prospectus disclosure

Favoring certain clients or proprietary accounts in allocating initial public offerings or other trades
without adequately disclosing such practice

Taking advantage of investment opportunities belonging to a client or fund

Undisclosed commission-splitting

Failing to disclose the receipt of commissions or service fees from client investments

Failing to disclose soft dollar or other brokerage practices

Failing to disclose personal financial interest in securities transactions for clients or related conflicts of
interest

Failing to disclose that the Adviser would profit by trading as a principal with clients

Willfully submitting inaccurate reports to a board of directors of a mutual fund

Not disclosing remuneration to be received in connection with the assignment of an advisory contract

Misusing and diverting funds under management

Failure to disclose “double fees” received from clients’ assets invested in a fund advised by the
Adviser

“inter-positioning” a broker between a fund and dealers making a primary market in securities,
thereby causing the fund to incur unnecessary expenses

Failing to disclose to clients that they paid materially different commissions due to directed brokerage
arrangements

Failing to disclose to clients that the prices obtained for them were not the most favorable under the
circumstances

Failing to seek best execution on client transactions

Failure to disclose that client commissions were used to compensate brokers for client referrals

Failing to disclose arrangements with “market timers” or “late traders”

Undisclosed short-term trading by portfolio managers in funds they manage
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Those changes include: (a) rules governing the initial public offering process, nicknamed by Zach Shulman and I the
Long Runway approach (Bartlett & Shulman, “IPO Reform: Some Immodest Proposals;” The Journal of Private Equity,
Summer 2003, http://www.joebartlettvc.com/sites/default/files/Bartlett_Shulman.pdf) (b) a recommended structured
for equity-flavored executive compensation, to include a better deal for both the executives and the shareholders, see
Bartlett & Lundburg, “A New Executive Compensation Model,” NYLJ, May 16, 2007
(http://www.joebartlettvc.com/sites/default/files/Bartlett%20&%20Lundburg,%20A%20New%20Executive%20Com
pensat.pdf); (c) a fairer and more equitable approach to tort reform, freeing up companies considering an IPO from the
spectre of extortionate class action litigation, while leveling the playing field between aggrieved shareholders and
corporate managers; (d) various critical improvements in the structuring and drafting transactional documents, including
compact forms (http://www.joebartlettvc.com/compact_forms); (e) the increased use of questionnaires, checklists and
spreadsheets (http://www.joebartlettvc.com/sites/default/files/VCR21_Sonnenschein.pdf); (f) the restoration of
analytical coverage for venture-backed IPOs [a work-in-progress]; and (g) the resolution of the FAS 157 controversy
“FAS 157 - Fair Value Measurements Adopted by the FASB;” (http://www.joebartlettvc.com/sites/default/files/N0126932.pdf).
1
2
Hudec, CFA, “Negotiating Private Equity Fund Terms in 2010 – Will the ILPA Principles make a difference?” Nov. 2009, Farris,
Vaughan, Wills & Murphy LLP, Client Alert.
BenDaniel, Reyes & D’Angelo, “Concentration in the Venture Capital Industry,” The Journal Of Private Equity
Summer 2000.
4
“What the ‘New Foundation’ Could Mean for Private Funds and their Sponsors, 6/29.2009.
5 The genesis of gargantuan buyout funds was not, in my experience, generated by a lust for unearned profits; rather, I
believe the original motivation was a desire, first expressed to me by Steve Gilbert, to be separated from the crowd.
Since attractive buyout deals are often auctioned, the winner faces the “winners curse” … it overpaid. If there are only a
few funds large enough to handle a multibillion dollar deal, maybe no auction and no winners curse.
6 Buttonwood, Locked Away,” The Economist, 87 (Dec. 191, 2008), citing “Hedge Fund Performance Persistence: A New
Approach,” by Nicole Boyson, Financial Analyst Journal, Vol. 64, No. 6.
3
7
Kedrosky, “Right-Sizing the U.S. Venture Capital Industry,” Ewing Marion Kauffman Foundation, Jun. 10, 2009.
See the discussion in the Full Transparency section, infra.
See http://www.vcexperts.com. http://pedatacenter.com/pedc/ The PE Data Center database is the industry’s first
competitive intelligence database that enables entrepreneurs, fund managers and related industry service providers to
research venture backed deals by numerous variables and instantly evaluate the actual deal terms and valuations for those
companies matching the search criteria.
10 See Buzz of the Week, Bartlett, “FAS 157 – Fair Value Measurements Adopted by the FASB,” Part 1, 3/4/2008; Part 2,
3/6/2008, where I report that:
• Question: You mention the LPs in the article you cite. Cannot the LP simply take the general partner's word
for it as to the valuation of the portfolio positions?
• Answer: Apparently not. According to the American Institute of Certified Public Accountants ("AICPA")
2006 Release, "Alternative Investments - Audit Considerations," (a practice aid concerning AU 332 for audit
firms), as interpreted by David Larson, a member of the Private Equity Industry Guidelines Group
("PEIGG"),
"'The new audit guidance is putting pressure on overall valuations from the point of view that an LP that
reports financial information in accordance with GAAP has to record its investment at fair value,' says Larson.
'The LP has to take responsibility for its fair value assessment.'" (Emphasis added.)
• Question: You can't be serious. Does it mean the LPs have to make an independent judgment as to the fair
value of each position held in the portfolios of the funds in which they invest?
• Answer: Such appears to the case. Let me quote at some length from the article I mentioned.
"Now LPs, like GPs, too must have a policy and process in place to arrive at fair value. Already, LPs have to
contend with GP reports that come to them in all shapes, forms, sizes and times, often without adequate
information on a fund's underlying portfolio companies and without across-the-board valuation standards. The
documentation, says Larsen, will vary based on the individual LP or GP and in part "The greater pressure on
LPs to justify the valuation they produce is playing out in a few ways. 'The AICPA guidance essentially said that
LPs need to do their own independent assessment of the fair value of the assets," says Tom Keck, chief
investment officer at private equity advisor Stepstone Group. 'It's not a very practical recommendation. There's
still a fair bit of work to determine how much work is reasonable for LPs to determine what is the underlying
fair value of an investment in a fund.'
8
9
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"This creates two problems. One, not all LPs have sufficient manpower to do the assessments necessary to
justify the numbers required by auditors, particularly if it means combing through the financial information for
each and every investment they own in a fund and making the follow-calls to arrive at a number they are
comfortable with - within the reporting time frame. A large LP may hold thousands of underlying investments.
And while investments in the first year can be held at cost according to PEIGG and the International Private
Equity and Venture Capital Guidelines in Europe, and another portion may be publicly traded, an LP could still
be left with several hundreds, if not thousands, of companies that need to be evaluated."
11 http://www.joebartlettvc.com/sites/default/files/VCR21_Sonnenschein.pdf, Bartlett, “The 21st Century Term
Sheet,” VCR, 21 Spring 2008).
12 http://www.joebartlettvc.com/node/11 see “Private Equity Fund Formation.”
13
http://www.americanprogress.org/
14 Entrepreneurial, Venture-backed Information–dependent-Technology-flavored Activity.
Another process along the same lines as the Long Runway, at least with the same general purpose, is nicknamed “Wall
Crossings.” See Cowan “Wall Crossings ‘Provide Fund-Raising Edge”. The Wall Street Journal, Dec. 29, 2008, p. C3. Wall
Crossings entail a preview by institutional investors of the metrics of a forthcoming public offering of securities. The investors
sign a confidentiality agreement and commit to invest in the issuer, provided that they agree not to trade in the issuer’s securities
(and Wall Crossings are, by definition, confined to investments in companies that are already public and are scheduling a
secondary flotation) until the public offering is in fact effective and closed. As The Wall Street Journal piece suggests, quoting
the Global Head of Equity Capital Markets at Deutsche Bank:
15
“The benefits in this slight modification of raising capital enables management to spend less time on long road shows
and provides a more targeted approach to raising capital.”
16
Under the proposed Regs, SEC Release No. 34-58288 (Aug.1, 2008) certain common sense protections are available. I quote
excerpts from a Howard Rice Client Alert;
Historical information is not deemed "reissued" and need not be updated so long as investors understand that the material speaks
as of an earlier date or period. Legending information with the relevant date or period and segregating historical information in a
specific (and marked) website location can help instruct investors that such information may not be current.
A company does not become liable for hyperlinked third party information so long as the company has not explicitly or implicitly
approved or adopted the information. The Release notes that the context in which the information is presented is crucial for
determining whether the company has approved or adopted the third-party information. The SEC suggests that a company
should: explain the reason for the hyperlink; avoid selectively linking to some sources within a category of information (for
example, linking only to positive analysts' reports instead of to all analysts' reports); and use technical methods to indicate that a
hyperlink leads to third party information, such as an "exit notice" or intermediate screen.
17
As summarized by NVCA President, Mark Heesen, in The Venture Capital Journal:
“Pillar 2: Enhanced Liquidity Paths. There is consensus among many within the capital markets ecosystem that the
distribution system that connects sellers and buyers of venture-backed company new issues is broken. Several factors drive
this disconnect in including mismatched expectations in terms of issue size, the lack of sell side analysts, and the propensity
of hedge funds to buy and sell stock quickly. This combination results in an inadequate distribution channel and
considerable post-IPO market volatility.
“To offer small venture-backed companies an enhanced distribution system for the sale of initial stock, the NVCA endorses
concepts such as Inside Venture, a private market platform that connects qualified companies that intend to IPO within 18
months and pre-screened cross-over investors. These buyers commit to buy and hold these stocks for the long term. Other
providers with similar models include Portal Alliance (Nasdaq), SecondMarket and Xchange.”
18
Bloomberg.com, Mullaney, “Venture Firms Back ‘Hybrid’ IPOs to Help Startups Sell Shares” Jun.1, 2009.
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