Fund-Raisers Face Demanding LPs –

With fund-raising at its lowest point in nine years, it has become increasingly clear that limited partners are in a position of strength. General partnerships are being asked to cut their management fees, delay or reduce distributions to themselves and shrink their funds.

This year is on pace to be even worse than last year. The total amount raised in the first quarter was the lowest quarterly total in nine years (see story, page 12). Several funds that have closed recently have come in below their targets, including the fourth fund raised by U.S. Bancorp Piper Jaffray Ventures and a brand new fund raised by Thomas, McNerney & Partners.

“The fund-raising environment is very tough,” says Buzz Benson, managing director of Piper Jaffray Ventures, which has offices in Minneapolis and San Francisco. “The existing players in the marketplace that have committed to private equity are reassessing as to how much. A lot of them are above their stated policy because of shortfalls in their denominator.”

The tough environment means Jaffray Healthcare Fund IV will not meet its target of $150 million. “I think you can see with the amount of capital raised over the last three years, there’s been a pretty dramatic falloff in funds being raised,” Benson says. Fund IV had a first close of about $40 million in 2002 with limited partners from funds II and III investing. The firm’s limited partners include Dresner Kleiner Benson, GE Capital Equity Capital Group, NSP Pension Plan and the Minnesota State Board of Investment.

Thomas, McNerney & Partners, which just raised its first fund, had to be content with $216 million, about $34 million less than its target (see Fund Profile, page 15). This despite the fact that its three managing partners have had 24 of their portfolio companies go public and another 17 get sold. “It was pretty hard to raise the fund, but we got a good reception based on our track record,” says James Thomas, co-founder and managing partner of the firm, formerly known as Lumina Ventures.

Limited partners are most predictably drawn to returns and to venture capitalists whose funds that have “right-sized” or curbed their ambition of raising every fund larger than its predecessor raises. Take Sequoia Capital XI’s close on $395 million. The Silicon Valley firm’s 11th fund was 43% smaller than its previous one, a $695 million vehicle raised in 2000. With historically strong returns, Sequoia had to turn away a lot of investors who wanted into the new fund. Its partners have declined to discuss the fund.

Aurora Casts Glow

One of the few who was happy to spread the good news was the Aurora Funds, which announced in April that it had actually exceeded its original fund-raising goal for its fourth fund. The Research Triangle Park, N.C.-based firm said it closed Aurora Ventures IV with $85 million, $10 million above its original goal.

Aurora didn’t have to change its management fees or its carry, which holds steady at a standard 20%. According to GP and LP alike, Aurora has been doing business as usual. It has kept tabs on what its LPs are thinking though, which beat back the urge to make its fund bigger. “We’ve been listening to our LPs all along,” says Jeff Clark, managing general partner. “They were advocating that we stay modest in size and stay focused on seed- and early-stage investment. We sized the fund to be somewhat modest in size and strategy. We want that to be our modus operandi going forward.”

Clark says limited partners are put off by large funds. “One of the things we’ve heard is that there’s concern in investing in big funds,” he says. “The days of exits exceeding $250 million are going to be limited, so it’s going to be very different for larger funds to make strong returns in a world where the size of the exits is more modest.”

Consistency is also being rewarded by LPs in ARCH Venture Partners, which recently held a first close on its sixth seed-stage fund, with $75 million in dry commitments from four returning investors. ARCH Venture Fund VI will follow the same strategy as its $380 million predecessor, which closed in early 2000. This means a focus on interdisciplinary companies spun out of academic, corporate and government labs. The goal is to close on between $250 million and $350 million by year-end.

“The first close came earlier than expected, so we were a bit surprised by it,” says Bob Nelson, a Seattle-based managing director with ARCH. “We’ll probably hold another one in the next couple of months. Nelson adds that ARCH “had nearly a 100% hit rate” with limited partners examining the firm’s latest fund.

While interested in rewarding those venture firms that have remained consistent in their focus, limited partners are voicing concerns that some VCs have not been responsive to the changing times. “We, like everybody else, are disappointed that we haven’t seen management fees come down,” says an executive at an institutional investor with stakes in several top-tier venture funds. “That’s a really critical discussion. You can either lower the fee from 2.5% to 2%, or 2% to 1.5%.”

The reduction can be done in a number of ways. “Another way is after five years of the fund, the management fee will be reduced by 25% per year for the next four years,” the executive says. “A third way: If a 10-year fund lasts longer than 10 years, no more management fees are paid, period. That gives the management team additional incentive to find a way to harvest a return on these investments as quickly as possible.”

Fees are a big topic on the minds of LPs, says Bob Anders, managing director of capital markets at RBC Centura Capital Partners, the private equity investing arm of Royal Bank Financial Group. “We are having serious conversations with teams to let them know that we feel strongly about the control of management fees,” Anders says. “I think the limited partners are willing to give up a little bit on the performance compensation if the management teams are willing to give up a little bit on the finite fee. At the end of the day, what everybody’s willing to do is pay for performance.”

Michael Littenberg, an attorney with Schulte Rogh & Zabel, says his GP clients are feeling pressure to reduce fees. “When you set up a second fund or a follow-on fund, the LPs now in many cases are asking that the management fees be spread out over the two funds,” he says.

“My sense is that if you’re going to succeed at fund-raising today you clearly have to a have a differentiated strategy,” says Ashton Newhall a general partner with fund-of-funds manager Montagu Newhall. Newhall says that while management fees are important, what is more important is the strategy of the investor and the experience of its management team. LPs are concerned that venture capital firms may be suffering from a lack of experience as older general partners retire and funds are run by younger and less experienced GPs.

Robin Painter, an attorney who heads Tesla Hurwitz & Thibeault’s private equity practice, cautions that the terms that general partners end up with largely depend on what kinds of limited partners they have.

“I had two funds that went out about the same time and had very similar track records and similar management teams, but they ended up with dramatically different terms because they had very different LP bases,” Painter says. Whereas one LP was “tweaking” management fees and pushing back on the distribution of the carry, the other was asking the VCs to become more transparent with investors.

RBC’s Anders finds that venture capitalists are progressively trying to adapt to the changing demands of limited partners. “The vast majority are very responsive to this,” he says. “I think they understand that the typical private equity investor is taking a very critical look at their overall portfolio and the percentage of assets that the LP is dedicating to alternative assets. It’s a difficult time in the investing arena and I think everyone needs to understand that.”