Terms Tango –

Venture capital partnership terms have remained relatively stable since the market picked up earlier this decade, but recent years have brought some mild changes.

Management fees on the whole have declined slightly from their traditional 2.5%, and while 80%/20% remains the common carried interest split, top-flight G.P.s are taking 25% and even 30% cuts without causing too much of an uproar.

Lofty returns have drawn increased institutional interest in venture capital, and the competition to get into highly regarded funds has left limited partners with little negotiating ability – hence, control of terms remains with G.P.s. Many G.P.s, however, are careful not to abuse their power, recalling a less prosperous past for venture capital and the potential for a future downturn.

Nevertheless, eyebrows no longer raise when top-tier funds set 75%/25% carry splits. Accel Partners adopted such a provision with Accel V in 1996 (VCJ, May 1996, page 14) and Institutional Venture Partners made the shift about the same time with IVP VII (VCJ, June 1996, page 20). By then, Kleiner Perkins Caufield & Byers had implemented a 70%/30% split (VCJ, May 1996, page 15), and Media Technology Ventures raised its inaugural fund in 1997 with a 75%/25% carry – and a 3% management fee (VCJ, February 1997, page 18).

Limited partners do not welcome the steeper carries but have very little negotiating room as more investors clamor for spots with the best firms and as over-subscription is all but a given for the top-performing funds. Venture capitalists raised more than $24 billion last year, a $10 billion increase from 1996’s total, according to Venture Economics Information Services, a data company owned by the same parent company as Venture Capital Journal. Firms such as Alta Communications Inc. and Weston Presidio Capital (VCJ, September 1998, pages 18, 26) and Patricof & Co. Ventures Inc. (VCJ, July 1998, page 26) have seen more L.P. interest than their funds can accommodate at their target sizes, forcing the firms to pare down backers’ investments or increase fund sizes.

Despite a distaste for higher carries, some L.P.s such as Wilshire Associates acknowledge that the 75%/25% carried interest divisions may be merited if returns are strong. Erica Bushner, a vice president with the Pittsburgh and Santa Monica, Calif.-based consulting firm, points to New Enterprise Associates (NEA) and Menlo Ventures as venture firms “worth every penny” of their 75%/25% carry split. “They’re top-tier firms, and they are well motivated,” she says.

NEA employed those terms when it raised its first fund in 1978, says General Partner Chuck Newhall, but the firm’s management fees tend to be lower than average. Instead of setting a standard 2% fee, NEA submits an operating budget to L.P.s for approval and takes that total as its management fee. The arrangement yields expenses of about 1.2% to 1.3%, Mr. Newhall adds, pushing the rate of return higher than it would be under an 80%/20% split and a 1.8% or 2% set management fee.

NEA has raised eight funds; the last, New Enterprise Associates VIII, closed on $550 million last September (VCJ, November 1998, page 22).

NEA Chief Financial Officer Lou Van Dyck came up with an annualized net IRR of 42%, based on a weighted average for Funds I through VII, as of April. NEA VIII and NEA VII, a $311 million fund that wrapped in November 1996, are too young to provide very meaningful returns, but NEA VI, which closed on $230 million in December 1993, is posting a 43% return, Mr. Van Dyck says.

Menlo initiated a 75%/25% carry split with its last fund, Menlo VII, which wrapped in late 1996. Menlo VIII, targeting $400 million, will be launched in the second quarter (VCJ, April, page 23).

Management Fees Dip Slightly

Mike Holt, a principal at William M. Mercer Inc. who oversees the consulting firm’s annual compensation survey for private equity firms, has witnessed a slight decline in management fees, which have dipped as funds have gotten larger and heftier fees have become harder to justify. The 1998 compensation survey polled 60 private equity firms, a majority of which were VC.

Whereas 2.5% was the standard management fee six to 10 years ago, 2% is the current norm, Mr. Holt says. But the fee varies in accordance with fund size and by the year the vehicle was raised. Larger and more mature funds generally have smaller fees.

For funds of less than $150 million, the average management fee for the first year was 2.4%, which declined to 2.3% by the fifth year, the study found.

For midsize funds – those with $100 million to $400 million – the first year’s fee averaged 2.3%, falling to 2.1% by year seven, 1.9% by year eight and 1.8% by year nine. For funds of $350 million or more, the first year’s average fee was 1.9%. The average increased to 2% in year two and to 2.2% in year three, where it remained until year seven, after which it dropped to 1.8%. By the tenth year, the fee was reduced to 1.7%.

Mr. Holt credits the overall decline in management fees to the increased savvy of today’s investors, most of which are institutions. However, he does not foresee any major changes in the fees or carry splits in the next few years.

Take It Or Leave It

Meanwhile, Jonathan Axelrad, a partner at Silicon Valley law firm Wilson Sonsini Goodrich & Rosati, has started to review partnership documents that award carry on a sliding scale; that is, the G.P.’s carry increases after the fund achieves a certain IRR. However, the opposite does not apply, and the carry does not dip if the fund yields poor returns.

For example, Mr. Axelrad has seen a document that calls for a 30% carry for the G.P. once the fund’s IRR reaches 25%, he says, declining to identify the venture firm. VC groups with top-quartile returns come to market with firmly set terms that are “pretty much what you’ll have to swallow,” observes Glen Schwartz, senior investment officer at the San Francisco City & County Employees’ Retirement System. “And you’d better like the taste of it. If not, they’ll find somebody else that will.” L.P.s sometimes can get non-financial terms adjusted, Mr. Schwartz adds.

The limited and general partner power relationship is a bit different when the L.P. has a very large amount of capital to invest or has a staff experienced and savvy enough to anticipate the timing of raising a new fund. Bigger investors can write bigger checks, and alert L.P.s can band together months in advance of a fund being raised to demand better terms, notes David Katz, founder and chief executive of Katz Analytics, formerly known as Katco, which helps investors track their private equity portfolios. Mr. Katz declines to name investors engaged in such cooperative negotiating.

Bigger L.P.s Wield More Power

The same booming venture market that allows VCs to demand bigger pieces of the compensation pie also has, ironically, benefited L.P.s by encouraging VCs to start their own venture firms, says Hal Brown, vice president of private capital for ULLICO, the union pension group.

First-time funds, even when headed by experienced VCs, do not enjoy the ease of fund raising that established firms with long track records experience. Therefore, limited partners can take their time when deciding whether to back such newcomers and also can negotiate more favorable terms, Mr. Brown says.

Not surprisingly, financial terms remain foremost on the minds of both general partners and investors. But some G.P.s have gone out of their way to make sure their L.P.s are kept in the loop on all aspects of the decision-making process, scoring a lot of points with certain limited partners.

“I think, at least in a number of the funds we’ve looked at, there has been a slight shift to include the (limited) partners more,” says Janet Kruzel, alternative investment officer for the Kansas Public Employees Retirement System, pointing to Behrman Capital as an example. The later-stage VC and buyout firm goes out of its way to keep L.P.s abreast of investment decisions, sharing more than the standard information, she says. For example, Behrman often tells its L.P.s the firm’s motivation for backing certain companies, even when not required.

Additionally, Behrman’s managers came to visit Ms. Kruzel and her staff in Kansas after the pension had committed to Behrman Capital II L.P., a gesture that impressed her considerably.

Brentwood Venture Capital’s Jeff Brody and Battery Ventures’ Rick Frisbie both are aware of the upper hand G.P.s have in the current venture capital environment. But they also know that the market can – and one day will – change, and they want L.P.s to remember being treated fairly when power eventually shifts hands.

The $300 million Brentwood IX, which closed in October (VCJ, December 1998, page 21) features a 25% carry allocation to the G.P., as did its predecessor fund, Brentwood VIII. The firm decided several years ago to boost its take from 20% because its funds produced top returns, and 25% carries were becoming more common among top firms. The conclusion reached by limited and general partners was: “That’s the current market rate, and we deserve it,” Mr. Brody recalls.

Brentwood also factored in that it had increased its professional staff over the years to its current six general partners, three venture partners, two special limited partners and two retired former partners, who are still fairly active, and the firm wanted more carry to spread around.

Battery considered some of the same issues, but the group decided against increasing its carry, figuring that a 20% carry was “fair.”

“We feel like we’re well compensated now, and as long as we produce good returns, we make a lot of money off the 20% carry,” Mr. Frisbie reasons. “It’s hard to make the argument that we need more. We clearly felt we could get more, but we don’t really need it.” Nevertheless, Mr. Frisbie thinks that had the firm boosted its carry to 25%, most L.P.s still would have returned for the new fund. As it turned out, all 30 backers of the previous vehicle invested in the latest fund, the $400 million Battery Ventures V. Returning investors included the University of Washington and the Washington State Investment Board (VCJ, April, page 26).

“The venture capitalists do have the upper hand, but it may not always be this way,” Mr. Frisbie observes.