2005 Report Card for GPs Portfolio Valuation –

We expected to see significant improvement in this category over last year. First there was the issuance of standards by the Private Equity Investment Guidelines Group, and then the promulgation of the “International” guidelines by the European Venture Capital Association, British Venture Capital Association and the Association Francaise des Investisseurs en Capital (AFIC). The European’s International guidelines were quickly endorsed by ILPA. Game, set, and match? Not quite. It turns out there remains a diversity of opinions about how and when to apply valuation standards. In fact, there was widespread disagreement even within Europe about the adoption of the International guidelines.

GPs are perfectly willing to continue with a “mark-to-market” approach, but many LPs, and those countries where VC is a regulated industry, have long advocated a formalization of valuations. Europeans generally advocated rules-and formula-based valuation practices-that left very little discretion to the manager. Surprisingly, the European community of PE organizations this year abandoned its rules-based approach developed over years and moved to the principles-based approach of the United States. That left valuations much more open to the discrimination of individual managers.

The result is more trouble than ever, because discrimination means that both LPs and GPs are now open to a number of methods for valuations. The “multiples approach” seems to make sense because it derives a company’s valuation from the valuation of comparable companies in the private or public markets. But a problem arises when a one-of-a-kind event causes a wide swing in the valuation for a company in the comparables group. That can force a manager to re-value a portfolio company in response to a one-time event, creating portfolio volatility-and a severe headache for LPs, says a life insurance LP.

“In the end, we [LPs] have created a nearly untenable situation for GPs, where they’re drawn by one or another camp of LPs into different valuation practices,” says a fund-of-funds manager. “The result is that GPs really don’t know what to do.”

Portfolio Write-Downs

Once a bone of contention, portfolio write-downs appear to no longer be an issue, with more than half of our survey respondents giving general partners a grade of B. Last year, less than one-quarter of respondents issued that grade.

It’s clear that most general partners have finally cleansed Internet-era investments from their books. LPs have apparently heard all the bad news they’re likely to hear about vintage 1999 to 2001 funds. “We asked our GPs to be aggressive and cut off the dead investments” Internet-era funds, says a fund-of-funds manager. The write-down problem “is pretty much over,” notes the manager of a global pension fund.

It’s worth noting that 48% of respondents gave GPs a grade of C or worse for write-downs. This issue could rear its head again in a few years if the general partners who dive into China or any other hot investment trend end up making a lot of bad investments. Write-downs from the Internet era may be over, but they’re not forgotten.

Succession Issues

For the past two years, succession was one of those topics that almost evenly divided the LP community. But this year the majority of LPs gave out C’s and D’s. Instead of reporting industry wide improvements, LPs are saying that GPs either fall into one of two groups: those who manage the issue well and those who don’t. Clearly succession remains an issue, with some managers intentionally not growing a franchise, and some firms too early on their growth curve for long-term brand identity to be a paramount concern.

LPs appear to be sanguine about succession issues and are feeling more confident because they have become sensitized to it and scrutinize the issue each time they invest or renew their manager relationship. Make no mistake, beneath a generally positive outlook are some pretty hard views on the subject. “We know when a GP is primarily interested in siphoning off the maximum profits from a firm [as he or she is preparing to retire], and to a certain extent that aligns with LPs’ interests,” says an LP from a large insurance company. He notes that LPs recognize that it’s the end of the line for these firms and they’re willing to benefit from the wind down.

Management Fees

On the contentious topic of fees-and in which the average grade remained almost exactly the same as last year-one of the industry’s most successful GPs glibly says: “LPs are happy as long as we’re sending them checks. Then they don’t have anything to say.” Given that the majority of our respondents are so pleased with the returns they’re getting right now, we think we understand why there were far more grades of B this year, compared to last year. But overall, this is the worst grade LPs gave out. “I fear that we have moved to [the acceptance] by our industry of fees as a wealth creation model [rather than a performance model] for many fund managers,” says a limited partner from a global business.

LPs are especially cranky about GPs who are asking for the taxes of the LLC partnership to be deducted as part of their fees. LPs overwhelmingly view this as inappropriate. Another bone of contention is legal fees that are charged back to LPs-as has been done by GPs that hire counsel to negotiate T&A issues with LPs. LPs told us that they’re just plain pissed off about having to retain counsel to keep the GPs’ counsel in line. They’re unhappy that negotiations are slowed even more, and they suspect that GPs do this intentionally to insure that their attorneys get them better deals with LPs. LPs tell us that they resent being forced to back down by a GP’s attorney, rather than having the GP give some ground on an issue. They say they don’t forget such incidents and are unlikely to invest in the offending firm again.

Surprisingly, several LPs said they are succeeding in getting more of their GPs to accept fees at the lower end of the spectrum. The standard fee is in the 1.5% to 2.5% range, but a few LPs say they are negotiating fees in the 1.25% to 1.39% range. That’s the first time we’ve heard anyone talk about fees declining.

LPs are also sensitive about GPs keeping fees that they sometimes get as directors of portfolio companies. Some want to see the practice stopped altogether, with one LP saying it’s a “conflict of interest.” That’s one of the reasons why some LPs would be happy to see some SEC oversight of the industry. Other LPs just want to make sure that the fees a GP collects from sitting on boards are used to offset management fees, and don’t stay in the GP’s pocket. They see board seats-especially given some of the high board seat numbers of the most visible VCs-as yet another way that their managers are seeking to push wealth creation outside of the bounds of where it should be: in the distributed carry.

Carry Structure

On the surface there isn’t a lot to be said about the distributed carry beyond the collection of remarks from our LPs:

“2003 was good, 2004 was better and 2005 looks like more of the same.”

“We’re getting lots of checks in the mail.”

“Phenomenal.”

LPs are almost universally buoyed about the returns that they’re expecting. This year has seen some monster exits that will result in big paydays for LPs. But beyond the happiness with returns, LPs are notably disgruntled about several issues with the distributed carry. An LP for a government pension fund said that the top firms get away with asking for a 25% to 30% carry, but “their returns have to be spectacular to justify” that kind of share. He adds that anything over 20% for a GP cuts the final returns for the LP considerably and will be difficult for the GP to sustain over time.

Capital Deployment

Capital deployment, much like distributed carry, is a category that elicits little response from most LPs. They say that GPs are generally doing well with their investment pace. A life insurance LP tells us that deployments are “definitely better than in the late 90’s-they’re being handled more prudently, more responsibly.” But he adds that it’s an issue he always keeps an eye on. Specifically, he keeps his eyes peeled for managers who are “doing deals on the margin [of good practices], and doing final deals quickly in order to close out a fund in its fifth year, so that they can start raising another fund.”

LPs tell us they’re having their own deployment problem. That is, they’re concerned that they can’t place capital with enough GPs that are going to give them a good return. “More and more LPs-absent the ability to put their money to work with top-quartile funds-are having to move further and further down the food chain,” says one fund-of-funds manager.

Investment Drift

For the third year LPs told us that investment style, or drift, is not a major issue. It’s the one question that returns a stable answer and one of the only categories that generates a few grades of A. In fact, 53% of our respondents gave GPs a B in this category, but the overall grade was hurt by some D’s and F’s (which combined for 39% of the total).

LPs say they have spent so much time in due diligence on their GPs, and so much time getting to know their GPs, that they have assured themselves well in advance that they’re working with firms mature enough to have a well-defined investment niche and strategy. “We don’t have drift because we don’t allow it,” says a government LP.

When we asked LPs if it’s time to eliminate this question from our survey, even the most sanguine LP responded with an immediate no. “We have to remain vigilant on this issue; we always have to watch this,” says a global insurance LP. Another LP was even more emphatic, saying: “It’s important that you leave this question in [because the VCJ survey] is looking for rising concerns or trends that may arise in the industry.” And a fund-of-funds manager notes that investment drift causes severe problems with an LP’s asset mix, creating worse problems than poor returns.

Communication

There has been a significant rise over the past three years in the number of B grades issued for GP communications, but at the same time the number of D grades increased. It appears that there is little middle ground-GPs either communicate well or poorly. There is apparently a remarkably stable group of GPs who hang out in the basement smoking or cutting classes, not getting in their reports to LPs on time or not responding to calls. “Three-quarters of the industry has gotten better, but the other 25% of GPs have regressed and say things such as, We no longer release that information,'” says a global asset manager.

One explanation for the bi-polar nature of this category is the large number of new manager relationships. “When you’re with a manager over time, transparency and information exchange get easier,” explains an LP from the insurance industry. Given that 98% of the LPs in this year’s survey have invested in a new manager over the past year, there is bound to be a group who are bedeviled by a lack of communications.

Summary

As much as we heard about phenomenal returns, we heard just as much about “weeding out” the less able GPs and refusing to re-up or replacing existing-and sometimes longstanding-managers with new players hoping for a crack at LP funds. It reminds us that eight blue-chip LPs all refused to renew their participation in Mayfield’s latest fund because they felt they were treated shabbily. If leading LPs are telling a top-quartile fund to take a hike, it isn’t hard to figure out what they’re saying to GPs who fall below that bar. While that’s bad news for under-performing GPs, it’s great news for emerging managers with a compelling pitch. In fact, most of the LPs in our survey told us that they’re willing to participate in emerging managers. They’d better be at the rate they’re jettisoning their old partners.

Email: Jerry.Borrell@Thomson.com