What is the Market on Terms? A New Look at an Age-Old Question

Robin A. Painter of Testa, Hurwitz & Thibeault

What is the "market" on terms? This is the perennial question raised by venture and private equity fund managers considering their next fund. Now, more than ever, the answer is "it depends." A diverse range of factors continues to drive the dynamics involved in crafting a limited partnership agreement intended to govern a relationship continuing for ten years or longer. These include past performance, team composition and stability, investment strategy, historic terms and limited partner base and composition. Nevertheless, the results of the recent economic cycle have placed a renewed emphasis on, and in some cases, have led to a reexamination of, certain key economic terms of limited partnership agreements.

Fund Size

Both fund managers and investors are taking a careful look at the aggregate amount of capital being raised for new funds. There is no longer a general view that "bigger is better;" rather there is careful analysis as to whether the targeted committed capital is the appropriate amount to be managed by the particular fund group. This analysis includes a close look at the number of investment professionals and their capabilities, as well as a realistic view of available opportunities within the fund's investment focus over the next few years.

Carried Interest

Properly constructed, carried interest provides a powerful opportunity to align incentives between the parties. Of late, there has been considerable interest in ensuring that the carried interest calculation maximizes these incentives. For example, some venture firms with premium carry arrangements (i.e., carried interest in excess of 20%) have proposed differential arrangements whereby the premium carry is contingent upon, or phased in subsequent to, completion of IRR-based or cash-on-cash hurdles. Calculation of the carried interest, and whether fund expenses reduce profits upon which the carried interest is derived, have also been the subject of discussion in a number of recent fund formation transactions.

Distribution Mechanics/Clawback

Closely linked with the carried interest calculation is the timing of payment of the carried interest and the management of clawback risk. Finding the right balance between motivating the fund's management team while minimizing clawback risk has been the subject of healthy debate in both the venture and buyout arenas. Many different approaches have been used to address this balance. Some venture firms have agreed recently to defer payment of carried interest until the fund's contributed capital, or in some cases committed capital, is returned to investors. This movement has certainly been triggered by investor pressure to avoid a repetition of highly publicized clawback exposure that appeared over the past several years in funds with "current pay" or "net asset value" distribution schemes. In the U.S. buyout market, where carried interest has historically been paid out on a current pay basis, there has been an increase in the use of interim clawbacks and escrows.

In addition, in both the venture and buyout arenas, investors are taking a close look at how the clawback obligation is actually calculated, with a particular emphasis on exclusions for tax liabilities of the fund's managers. This discussion about calculation of the clawback often leads to a focus on the ultimate liability for the clawback obligation and a negotiation over the scope of the individual liability of the managers.

Management Fees

Always an area of heavy scrutiny, calculation of the management fee continues to attract significant discussion. Because of the significant dollar amounts involved, much of the debate has focused on the larger buyout firms. There has been increasing pressure to delay accrual of fees until prior funds have ramped down their fees, and to commence the ramp-down of fees upon the formation of successor funds. Fee "leakage" through the fund managers' retention of external fees has also been a subject of considerable debate in the buyout fund arena.

Even with the onset of smaller fund sizes, management fees also are a hot button in the venture market. Here, the focus has centered most often on the so-called "out year reductions" -i.e., the lowering of the fees once the fund's active investment period has ended. While investors have maintained that "out year" fees should be based upon only capital that has been invested to date, managers have pointed to the significant time (and continued funding) that has been required to bring portfolio companies to liquidity in the current economic environment.

So what is the correct approach? What is clear is that there is no "one size fits all" answer. The best set of terms for one fund group may create less than optimal incentives for another. In this state of flux the best approach is the thoughtful one--one which requires all parties to work together to create a set of incentives that will match the full life cycle of the relationship going forward.

About The Author

Robin A. Painter is a partner of Testa, Hurwitz & Thibeault, LLP with over 19 years of experience in the private equity field. Ms. Painter is co-chair of the firm's Private Equity Group and also serves as a member of the Firm's Management Committee. Ms. Painter concentrates in the areas of corporate and securities law with a particular emphasis on private equity transactions, both domestic and foreign. Ms. Painter advises private equity fund managers, institutional investors and investment advisers on a broad range of issues, including capital formations, secondary transactions, portfolio investments, internal governance and distributions and divestments. Ms. Painter. can be reached at

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