The dramatic rise in fortune of venture capitalists followed by the equally dramatic swoon has left the industry stressed in ways never before experienced. The fault lines have affected VCs, whose road to riches suddenly found a few crater-sized potholes. And limited partners, too, whose net worth has taken such a big hit that some of them are looking for ways out of their obligations.
“Venture capital started out as a clubby business, where the rules of behavior were probably more important than legal documents,” says Jonathan Axelrad, chairman of the fund services group at Palo Alto, Calif.-based Wilson Sonsini Goodrich & Rosati (WSGR). “Today the industry is so big that many relationships lack the strength of that bygone time when limited partners can call a GP and just discuss a situation that seems unfair. Now we are in an era where many LPs rely on documentation and then attack mistakes.”
Increasingly, what some LPs are attacking are the partnership agreements they signed, trying to find a loophole that will release them from the commitments they promised. Others simply aren’t paying up. “The defaults we have seen thus far are from individual investors who went into funds when their personal portfolios were worth more,” notes Steven Yentzer, head of the private equity fund group at the Seattle office of law firm Perkins Coie LLP. So far these kinds of defaults are not a large percentage of the individual fund’s total capitalization, he adds.
For the most part, general partner groups have aided individual investors when these LPs have been unable to make capital calls, helping them transfer interests. “I think GPs realize they probably need to be as sympathetic to some of their investors, as investors are being to some of the deals done by the GPs,” Yentzer notes.
However, being sympathetic and accommodating does not mean that VCs are taking these defaults lying down. Indeed, the conventional wisdom that VCs would be loathe to take legal action against an LP refusing to meet a capital call no longer applies, says WSGR’s Axelrad. “Funds are doing it. They have no interest in talking about it and the proceedings are typically through some form of arbitration and in secret.” Axelrad is currently involved in several situations with an LP not meeting a capital call.
As the issues come to a head, funds are bracing for potential problems. “We have seen increased activity with our fund clients in advance of capital calls, investigating their ability to take action in regards to forcing their limited partners to meet their obligations,” says R. Scott Beach, chairman of the emerging companies practice group at the Greenwich, Conn., office of law firm Day, Berry & Howard LLP.
Funds usually have several options in dealing with a reluctant LP, Perkins Coie’s Yentzer adds. The first is simply to reduce a defaulting LP’s capital commitment down to a level the LP can meet, although this option is generally viewed very unfavorably by the fund’s other LPs, notes Yentzer. VCs can also try to arrange a transfer to another existing LP or impose more draconian measures, including allocating all of a defaulting LP’s profits to other LPs in the fund, while leaving that LP liable for any losses suffered by the fund, he adds.
Offense remains the best defense. For venture funds this means knowing your LPs’ ability to meet their commitments and making the commitment absolute from the beginning.
When raising a fund, VCs need to follow appropriate procedure, says WSGR’s Axelrad.
That means complying with securities law and not engaging in a general solicitation, he says. Firms also need to keep track of the number of investors they have, so they don’t have to register under the investment advisers act. VCs also need to make sure that LPs have received all relevant information before signing any documents and make certain that the fund’s private placement memorandum realistically informs investors of the possible risks associated with the fund, so an investor cannot later claim he was misled, Axelrad notes.