It's the GP Not the LP (Part 2)

Joseph W. Bartlett, Founder of VC

Continuing the prior discussion, another inherent feature of the relationship of the GP members amongst themselves is the threat posed, if things get out of hand, of exposing the entire membership of the GP to litigation from the limited partners. Again, with the arising angst resulting from the public and private market meltdown, a number of limited partners are looking for excuses to get out of their bargain.

What better way to trigger an exodus of the LPs than an unseemly and public (at least amongst the LPs) donnybrook between and amongst the GP members? In fact, some of the disappointed LPs are threatening to sue the sponsors of the partnership, which would include the GP members, for recission. Not only are they purporting to cancel their commitments based on one theory or another, but they are asking for their money back with interest .. the best defense is a good offense. What better rationale for taking the offense against the GP members than citing the nasty things they are saying about each other in the course of an intramural dispute. Accordingly, it is critically important that sensitive and very specific dispute resolution machinery be incorporated in the GP agreement which, to the extent possible, resolves disputes quickly and amicably.

Another often-uncovered issue has to do with board seats and warrant positions in portfolio companies. Assume, again that the majority (or perhaps a supermajority) of the GP members wants to cash out one of their number whose performance has been significantly disappointing. Disappointing or no, the odds are that an individual sits on several boards of portfolio companies. Obviously, if the individual is to be shown the door, the remaining partners want to get those board seats back.

Usually the agreement entered into when the board seat was negotiated will give the power to the GP, and not to the individual appointee, to determine who sits on the board. However, what can happen (as has happened in my experience), the individual caucuses with his or her fellow directors and induces them to tell the GP that the company does not want to make a change. Moreover, the warrant position, which sometimes can be generous (although usually directors warrants are not issued to a VC-appointed director), should be, in the eyes of a board so solicited, retained by the director concerned and perhaps even enhanced. Maybe the management of the company is particularly pleased to continue that individual's seat, styling him or her as the only truly "independent" director under the new rules on independence, and suggesting as well he or she be set up to chair the all-important compensation committee . an inside job in other words, keeping the VCs at bay. Can the expelled GP member be compelled to give up all the board seats and not permitted to negotiate for a continuation at the request of the other members of the board?

What are some of the additional issues? Herewith a list (with a tip of the hat to Jonathan Axelrad at Wilson Sonsini, one of the co-deans of the business);

Vesting of a Member's interest and withdrawal.

Note that this is not merely a simple number of years (or months or quarters) calculation. On withdrawal, does the vested interest in carried interest profits reduce prospectively? How about unrealized appreciation . some sort of book up at the GP level even if the fund does not book up? Does the withdrawing member forfeit future profits but remain exposed to future losses? If not, is that an incentive to quit while one is ahead. Is his or her ultimate result capped . i.e. no better than the result had he or she stayed to the end? Any obligation to forfeit prior allocations . or, even prior to return distributions? Is the withdrawing member liable for the entire clawback? Is the interest limited to the harvested results from, and only from, existing portfolio positions, including (or excluding) follow ons?

How is the inexorable generational shift to be handled?

Turning to the management company, a recent Wall Street Journal survey (WSJ "Kohlberg Kravis Is in Talks to Sell Stake," Oct. 4) indicates some powerful limited partners (CalPers, Washington, Oregon) are paying big bucks for a piece of the manager's action. The KKR transaction (if it occurs) implies a franchise value in the $5 billion area. When a manager dies or retires, does he or she (or their estate) take a slice of that implied value? If so, where does the cash come from? Is it politic to admit to the LPs as a whole that the management fee throws off excess cash? In the new environment for fund raising, will the trend to budgeted management fees clamp down on surplus value?