Feature: LPs’ Voice Grows Louder As Tough Market Persists –

It’s no secret that the relationship between limited partners and general partners has been strained for close to a year now. Faced with negative fund performance, a tough exit market and a slowing economy, GPs’ leverage in this relationship has grown smaller and smaller. If GPs were in the driver’s seat two years ago, today they’re locked in the trunk.

One of the more noticeable effects of this rebalancing of the scales is the increasingly loud voice of the LP community, whose mood has changed from that of a happy, almost silent partner into a vocal interrogator.

“The bloom is off the rose,” says an institutional investor whose funds have underperformed for the last six quarters. “For a certain period of time at annual meetings, LPs were afraid to ask questions, but now the meetings are getting pretty interactive, because the LPs have a lot more to say.”

One common refrain from LPs is questioning how aggressively their GPs are managing their portfolios. While acknowledging that a tough economy means most firms will have portfolio companies that get shut down, LPs are concerned that GPs aren’t moving aggressively enough to deal with these potential problems. “There are some walking dead out there among portfolio companies that, for all intents and purposes, are going to be closing and going away in six to nine months anyway,” says Ronn Cornelius, a director of private equity at Pacific Life Insurance Co. “So we are trying to push our general partner groups to write these things down now.”

In addition, LPs want their GPs to keep them as up-to-date as possible on what’s going on inside a portfolio-perhaps as frequently as monthly, says one endowment fund manager. “We encourage our partners to take write-downs and to communicate with us and tell us what’s really going on,” says Rick Hayes, senior investment officer with the AIM program at California Public Employees’ Retirement System (CalPERS).

Meanwhile, the question of valuations is an especially thorny one for LPs trying to figure out an approximate value of their VC holdings, since the VC industry still lacks a standardized valuation methodology. “We are invested in over 100 firms, and we see several funds holding the same company at different values,” Hayes laments. As chairman of the nine-year old Institutional Limited Partners Association, one of Hayes’ goals is to see LPs and VC firms work together to set industrywide standards on issues like valuations. “To me, it is not rocket science to decide on a company’s valuation,” he says.

For their part, GPs, who say they want to provide as much contact with LPs as LPs want, say the question of determining valuations and how aggressively they should change portfolio company valuations probably doesn’t have an easy answer. “I know one fund that just wrote down its whole portfolio by 30%, but that was not really helpful, I don’t think. Arguably that write-down really doesn’t tell me where I stand as an LP,” says Daniel Burstein, managing partner at Millennium Technology Ventures. Millennium has decided to only mark company’s values at events, while letting investors know that the value at which it carries a company in the meantime may not be entirely accurate given market conditions. “I think it is important to qualitatively tell investors what the challenges are, but I don’t personally feel like getting into a company by company analysis,” he adds.

For its part, Accel Partners has stuck with its traditional approach to valuation, but added in the wrinkle of being willing to change a company’s valuation if its seems out of step with its marketplace, says Alan Austin, chief operating officer at the firm. “But that is a tough, tricky thing to do, because you have to be talking about something more than just the ebb and flow of the marketplace,” he says.

Dollars and Cents

To be sure, not all of the issues facing LPs are qualitative. They’re looking to use their leverage when it comes to dollars and cents, as well, in some cases pushing GPs to agree to reduced management fees and lower carried interest.

Historically, venture funds were $100 million or $200 million vehicles, so a 2% or 2.5% management fee seemed like a reasonable amount of money to manage a fund and run the firm, says Paul Yett, vice president and manager of venture capital at Hamilton Lane. But in today’s venture world, with billion-dollar funds, some firms are able to generate significant operating income regardless of the success of their funds.

“A big fund could get $30 million a year in fees alone. This is not a bad lifestyle, and it is independent of the fund’s return. The fund could perform horribly and these folks still live well,” notes Pacific Life’s Cornelius. “There is a fine line between the best interests of the LP and those of the GP. In the late 90’s those interests probably became a little misaligned when it came to management fees.”

The consequence of this misalignment means a renewed scrutiny of the partnership agreement terms, a number of LPs say. But while the ability of certain firms to charge a premium carried interest has bothered some in the LP community and generated much discussion, Cornelius doesn’t think LPs should get overly worked up over this. “That the GP is taking any part of the carry implies that I am making a return. In this case, they won’t make money if I don’t make money, so I am willing to get a little less of a great performing fund,” he says.

“As an LP, this issue scares us, because you have to ask if a firm’s interests are really aligned with ours,” Yett notes. “You want general partners going for the carry.” But at a firm where the base salaries for partners are $1 million because of fees, a fund’s carried interest might not affect an individual partner’s net worth enough to make that GP as linked to the fund’s actual performance as an LP wants him to be.

While it’s still early to predict a knockdown, drag-out brawl over management fees, Cornelius suggests LPs will aggressively look out for their best interests the next time GPs come calling. “We will say no’ to a fund if we don’t think our interests are aligned with the GP’s interests. Other investors can do this too, but it requires discipline and not simply going along with what the GPs say they need.”

Some LPs readily admit they are partly responsible for the situation in which they find themselves. “I think most LPs would say they were part of the problem in agreeing to more onerous terms and larger fund sizes. We cannot simply blame all the GPs for this,” says Doug Breckel, senior associate treasurer at the University of Washington.

Recognizing their past lack of caution, LPs aren’t about to make the same mistake twice. “We are currently in some funds that we will walk away from if they are not willing to change their fee structure,” notes an institutional investor, “because, as it turns out, these guys aren’t world beaters, which they said they would be.”

The Future of Fees

Although the discontent over fees within some parts of the LP community appears to be real and growing, a number of GPs say they have yet to see any actual pushback from LPs over fees. One GP says he heard of an LP who told a firm in which he invested not to lower its management fee. “The LP said this because they were afraid it would encourage people to invest faster, and the LP did not want to do anything to change the internal dynamics of the fund,” he notes. “I think the system is working quite well as it is.”

Indeed, the whole question of whether management fees are generating too much income for funds is not really that big of an issue, says Accel’s Austin. “This is something you might have to watch over time, but it is not something we see as a major concern on our radar screen,” he adds.

Moreover, top firms will always have some degree of leverage based on their success versus the rest of the pack. “The great firms always have 10% better returns than the next group of firms…so I prefer to pay top fees for top returns,” says Michael Gutnick, senior vice president of finance at Memorial Sloan-Kettering Cancer Center.

Probably the biggest impediment to LPs being successful in their effort to push GPs into changing their fee structure is that CalPERS-the largest LP on the planet-is not committed to the enterprise. “We are not focused on hammering down fees, we just want to focus on the alignment of interests,” says Hayes. “The amount of money firms will be able to raise will likely be decreasing, so we will let the market set the fees.”

For those LPs who are interested in seeing fees rolled back, it would be a good idea to communicate with one another, Hamilton Lane’s Yett says, noting his firm is currently working with another LP to negotiate changes to a venture firm’s carried interest structure. “Can one investor get a firm to change its fee structure?” he asks. “Well, it depends on the value of that LP to the GP, so it would be better for a group to work together.”