This is the second of three articles about distributing thinly traded stocks to limited partners. The questions were posed by Standish M. Fleming of Forward Ventures. The participants are Jay Luby, managing director of the Strategic Trading Division of U.S. Trust Co. and David York, a principal and manager of the venture services group at Hambrecht & Quist.
Although the participants’ answers may appear to be pat, both Mr. Luby and Mr. York caution that the many variables of distributions make each unique, and their responses, therefore, will not cover all situations. “There is no simple solution for distributions – every stock on every day has its own liquidity,” Mr. York says.
When should a venture capitalist make distributions of a stock he is holding in his portfolio? Should he distribute as soon as the stock is tradable or hold until the company is “ready” for distribution?
Mr. York: A lot of people used to distribute around the time of the underwriter lock-up dates, but now those dates are so well known you see them talked about on CNBC, and the hedge fund community will short the stock. If the stock is down artificially, meaning nothing fundamental has changed but the market is gearing up for something that might happen once the lock-up is off, I would discourage someone from distributing. If you have to distribute as soon as possible, then I would advise distributing just a portion and wait for the stock price to come back up. Depending on who your limited partners are, they may keep the stock with one manager who would sell a block of stock belonging to several L.P.s. If your shares end up in a highly concentrated group, you need to be conscious of the stock price and how it’s trading. Certainly, you want to distribute when the stock is doing well; you’re better off taking advantage of the stock price momentum rather than trying to top-ticket. If a venture capitalist wants to participate in the upward movement of a stock position, he would benefit from staggering the distribution over a period of time to allow a higher average price. The time period could be as short as two weeks if the demand is sufficient to absorb distribution supply. By taking advantage of these trading events, the venture capitalist should be able to distribute successfully to the limited partners, providing them with ample liquidity and causing minimal impact to the share price.
Mr. Luby: To minimize adverse market impact – one of our highest priorities – it is often best not to distribute right as the lock-up expires unless the float is very high, the fund has a timing constraint which requires an immediate distribution or the fund wants to exit its position either because the stock valuation is deemed excessive or perhaps because the fund is no longer actively involved with the company.
How important is liquidity or the “float” in timing a distribution? How does a venture manager determine sufficient liquidity to accommodate sales by limited partners? What is a reasonable balance between the daily average float and the number of shares that can be effectively distributed?
Mr. Luby: Significant liquidity is a crucial variable in deciding when to distribute stock. There are many tools that can assist venture capitalists in assessing liquidity and timing, including maintaining anonymity. We know that as the percentage of distributed shares relative to the average weekly trading volume increases, the limited partners become that much more vulnerable to having to deal with the consequences of adverse market impact. When funds have larger positions, it is often more effective to distribute in tranches. In addition to reviewing recent trading patterns, we use such systems as Autex and Instinet because they often enable us to learn who is trading or intending to trade without tipping our intentions to those who might work to our client’s disadvantage.
Mr. York: As far as volume is considered, as I said before, the most important question is who ends up with the stock – is it a post-distribution management firm or a limited partner? In general, you shouldn’t try to distribute more than 150% of the four-week average volume. In typical funds with a typical mix of limited partners, I expect at least 30% of the distribution will trade within the first 30 days, the next 30% in 90 days, 30% will be held indefinitely and 10% just drifts off and is never seen again.
How does Rule 144/145 affect the timing of distributions?
Mr. York: Over the last three years, because of the bull market’s acceleration of valuations, many companies have gone public in less than two years since their inception. In an effort to maximize IRR and return profit to investors, many venture capitalists have distributed restricted stock to their partners. The whole question of having restricted stock is not something limited partners want to deal with. Some partnerships don’t allow the distribution of restricted securities. One thing that’s becoming more common are shelf registrations, which take away the volume problems that you would have with 144/145. On the margin, most limited partners would rather not receive restricted stock, but it has become very commonplace to distribute restricted securities. If returns and trading volume are high enough, I couldn’t argue against it.
Mr. Luby: As long as volume restrictions are clearly met allowing for all distributed shares to be traded if desired, then 144/145 shares can be distributed effectively. Often the bigger issue relates to partnership agreements or policies that preclude or limit restricted transactions.
What goals should a venture capitalist seek to achieve in his distributions? Should he seek to maximize his IRR? Should he maximize profits in the stock? Do his interests conflict with his limited partners’?
Mr. Luby: As noted earlier, the venture capitalist should seek to minimize adverse market impact and pursue a program whereby the L.P.s will have a reasonable chance to achieve the distribution price if they wish to sell. In an ideal world, the VC would distribute shares when the stock is trending up with good volume. If the VC is sensitive to the above issues, the VC will not be working in conflict with its L.P.s. In general, we would suggest that the VC should employ a fiduciary approach when distributing or trading. For example, VCs should try to obtain the best price they can for their L.P.s if selling on their behalf at the fund level. We are always amazed when we hear general partners say that they don’t care if they are leaving a quarter or a half point on the table, given that their cost basis is so much lower. VCs should be more sensitive to their fiduciary role.
Mr. York: If a venture capitalist is looking out for his best interest, it will benefit the limited partner. You should try to distribute to strength, you should try to distribute freely traded securities, and you should try to distribute enough securities so the limited partner has something go hold on to. Size is important; I’ve found that the smaller the distribution, the less likely people will want to hold those stocks.
Aside from the impact on general and limited partners, what are the VC’s obligations to other parties, such as the chief executive and management, shareholders of portfolio companies or other venture investors?
Mr. York: It’s really up to the venture capitalist and his relationship with the company, to what extent he’d like to confide in management and how he’d like to conduct his exit. The more people you get involved in the process, the more risk you run of spooking the market. Young management teams aren’t always equipped to run the exit process, and they tend to try to mastermind it more than they need to, and it produces a negative affect. Before you know it, the stock is down 15%. Over time, it’s not a bad idea to let management know your intentions to exit and the form through which you will do it, but I don’t know that you want to get them involved in the process.
Mr. Luby: Presumably, the overall interests are aligned in their desire for higher share prices. The business of the VC is to return value to its L.P.s. If executed responsibly, any short-term share price drop will be offset by the long-term benefit of having more of the outstanding shares in the public float and in stronger hands, thereby providing for enhanced liquidity.
Is it a good idea to give a chief executive 30-day prior notice to distributions, so he can arrange institutional buyers to avoid undue downward pressure? Will it work?
Mr. Luby: We don’t recommend this because intervention by chief executives typically hurts the stock more than it helps. Often a CEO will end up calling a number of dealers, which ends up sending signals to the marketplace that there are several sellers – a sure prescription for triggering adverse market impact.
Mr. York: One thing that we’ve done with the lock-up that will help is to take a company on a roadshow with institutional buyers, so they’re updated on the company’s story and aware of what’s going on with the lock-up. It helps get them focused. It makes sense to arrange institutional buyers, but it doesn’t work to try to get the company to set up trades; that’s better handled by someone who specializes in it.
Who should do the actual distribution? Should a venture capitalist do it himself? Should he rely on a market maker? Should he use a distribution specialist? What are the advantages and disadvantages of each?
Mr. York: Most venture capitalists don’t have the staff, expertise or time to facilitate a stock distribution. There are still some funds that are delivering shares in the form of a physical certificate. Others use a handful of market makers, such as myself; and others use agents that work with wholesalers and other market makers to place the stock. If you assume that between 30% and 50% of limited partners who receive stocks want to sell them, you’re best off working with someone who can help facilitate the sale of those shares. Some people like to use agents because of the confidentiality, but I would argue that you are better off using someone who can help create demand for the stock. All distribution agents have access to various passive trading markets such as the crossing network or Instinet, but in volatile trading markets, generating and finding demand will be critical to the success and liquidity of the distribution.
Mr. Luby: We would suggest that VCs should outsource their distributions to a specialist. Depending upon how the shares are held, manner of sale requirements and the number of L.P.s involved, a distribution can be administratively complex. We would suggest that the fund and L.P.s will be best served when they are able to work with the same distribution agent, regardless of who has underwritten the issue. This provides for continuity of service, enables all partners to get down the learning curve and allows L.P.s to establish meaningful “standing instructions” (e.g., always transfer, always sell at distribution price or better). Because we have eliminated all conflicts of interest (e.g., by law we cannot short stock), funds can feel very comfortable working with us well in advance of an expected distribution so that by the time they are ready to pull the trigger, many of the administrative issues have already been addressed. In addition, as further testimony to the specialized nature of this activity, we have been very gratified that leading underwriters have increasingly outsourced their distribution business to us. As they have evaluated the infrastructure and personnel requirements needed to handle distributions effectively, they have recognized the advantages of working via a uniquely positioned agent instead.
What are the mechanics of a distribution?
Mr. Luby: A successful distribution entails a lot more effort, knowledge and focus on “nuts and bolts” factors (e.g., transfer agents) than most G.P.s are aware. In essence, a distribution entails a legal transfer from the partnership to the L.P.s, effective communication among a number of parties, the correct and timely execution of instructions, definitive closure and appropriate documentation of the process.
Mr. York: The mechanics of a distribution are complicated and can take anywhere from two days to two weeks. The general partner deposits the shares along with the appropriate paperwork to facilitate the distribution. Once it’s declared effective, you talk to your L.P.s about what they would like to do – deliver, sell, or hold their shares – and at the same time you’re delivering the securities to the transfer agent. You have to work with the company’s counsel to allow you to facilitate all of this, and counsel then issues an opinion. If the limited partners have sold in the process, we pay them out in cash.
Are we able to satisfy both limited partners who wish to receive stock and those who wish to receive cash by creating a mixed distribution of some cash, some equity?
Mr. York: Yes, and this is a very good idea, especially for partnerships with a large number of individual investors.
Mr. Luby: As a trust institution, we are uniquely positioned to deal with this problem. Specifically, we have created a special escrow arrangement which, when combined with a standing instruction program, can facilitate the cash or stock preferences of all distributees.
Should or can a venture capitalist time his distributions to coincide with release of news by the company? Should “insider” knowledge affect the timing of a distribution?
Mr. Luby: On the one hand, a positive news release will typically lead to higher share prices and more liquidity. On the other hand, leading law firms have suggested that, when VCs time their distributions to news releases and especially to any “insider” information, they expose the partnership to potential litigation risk.
Mr. York: My feeling is that venture capitalists should distribute into trading strength. If they have inside knowledge, they obviously want to comply with inside trading policies. But distributing into some demand curve is far more efficient and beneficial for the limited partners, and news often helps create that demand.
What kind of information packages and advice should a venture capitalist provide limited partners regarding a company that he is distributing?
Mr. York: If I’m a venture capitalist and I’m doing quarterly fund reports, some information should be going out already. I would include at least the names, phone numbers and contact information for the analysts that follow the company and a list of market makers – that, and research write-ups on the company. If it is convenient to include an annual report on the company or other material that has not been included in the fund’s annual quarterly report, by all means do so.
Mr. Luby: Leading law firms have suggested that the best policy is for a venture fund to provide no investment advice so as to eliminate any potential legal liability.
Does the size and timing of a distribution affect an institutional limited partner’s decision to hold or sell a stock?
Mr. Luby: Yes, in some cases. In general, though, either the institution has a mandate to sell immediately or it will manage the position according to the distribution price, anticipated upside, etc. Sometimes, in very small distributions for example, L.P.s who usually employ a post-distribution manager will sell their shares instead.
Mr. York: Again, this is the question of knowing who the L.P.s are and who ends up holding the shares. We have done distributions that have included a very large percentage of the companies’ outstanding shares (north of 25%) and felt very comfortable with the outcome because we knew who was going to hold the post-distribution shares. In one case, we arranged for the post-distribution manager to meet with the management of the company before distribution. This meeting allowed the manager to become familiar with the company – and ultimately hold the shares after distribution.
Can a venture capitalist use derivatives such as collars to reduce the risk of losses to the fund or the partners on publicly traded stocks?
Mr. York: Yes, there’s no real restriction unless it’s written into the partnership agreement. One thing to remember when considering derivatives is you’re still affecting a sale. Using derivatives does guarantee your downside, but also acts to limit your upside, and can become quite costly if the stock trades above the call strike. The use of derivatives depends on how the VC wants to exit. If it’s through a sale, derivatives are okay; if he wants to distribute in kind, a derivative can be a real hindrance.
Mr. Luby: Yes, we have successfully employed zero premium collars (costless collars) in a number of situations. For example, having managed the Ciena stock distributions for five of the six primary venture investors, we helped put together a number of zero premium collars for a number of general partners. As the price dropped from 92 to 8, you can imagine that those who collared their positions with us were very pleased with their decision. We are unique in that, on behalf of our private equity clients, we have introduced competition into the pricing equation. The primary derivative counterparties like the fact that we serve as a distribution arm into the private equity world, but they understand that the quid pro quo is that they have to sharpen their pencils when pricing a collar because, as a fiduciary, we are going to be obtaining competitive bids. This is a major benefit to our clients due to the inefficiencies in the derivatives marketplace. As an example, we have often seen differences of over 500 basis points to the call structure between the most aggressive and least aggressive dealers at a given point in time. Because even the most successful general partners have only a few positions each year that might be appropriate candidates for collaring, we are much better positioned in our role as agent to negotiate dealer assumptions concerning volatility, etc., because we are structuring these types of transactions all the time.
What kind of performance can a venture capitalist realistically expect in the market when he makes a distribution of a thinly traded stock? Is it inevitable that the stock will drop between 10% and 20% in the next week? What are reasonable expectations of general partners, limited partners and portfolio companies for the distribution process?
Mr. Luby: It is dangerous to make many generalizations in response to this question because so much depends upon the deal, the time constraints, types of orders given, etc. In our experience, however, and particularly given our emphasis on minimizing adverse market impact, we have been able to manage distributions in such a way so that a large percentage of L.P.s have a chance of obtaining the distribution price or better over a limited period of time.
Mr. York: I would suggest these percentages are realistic. We try to counteract the stock drop by working our sell orders over a period of time to provide a better average price. By being patient, we allow our trading desk to create demand for the stock. Most of the stock decline usually happens in the first couple of hours of trading, after which there usually is less impact on the trading price.