The Next Big Trend: Cutting Mgmt. Fees –

The number of private equity firms planning to cut fees or work out new fee arrangements with limited partners has grown to five, with four firms making the move in July. It’s a clear indication that there are more to come.

The three latest firms to join the group are Crescendo Ventures, Mobius Venture Capital and Spectrum Equity Investors. Venture Capital Journal (VCJ) reported in its August issue about VantagePoint Venture Partners’ plans to defer fees for 18 months on its $1.6 billion Fund IV.

Each firm has different plans in mind. Crescendo hopes to pool the fees on one of its funds to make one or two new investments; Mobius says it wants to trim its fees to treat LPs fairly in light of declining valuations and Spectrum is looking to offset a potential clawback on its 1999 fund.

ComVentures was the first firm to cut fees this year. It told LPs in February that it would reduce the fee on its 2-year-old $550 million Fund V by 0.5 percentage points. Fifteen other firms have cut their fees as part of fund reductions that will result in a total refund to LPs of $4.2 billion.

Salvage Operation

In all cases, the firms lowering fees are “definitely trying to salvage the relationship with the LPs,” says Jesse Reyes, vice president of Venture Economics, a market researcher and publisher of VCJ. The firms with 1999 and 2000 funds are basically telling the LPs, “We may not make much money for you, but at least we can stop taking more money from you,” Reyes says.

He adds that “if the LPs had their druthers, they would have had the best guys just forego fees and have the under-performing funds just return some of their money. As it is, what appears to be happening is the opposite. This tells me that the ostensible altruistic rationale that they are giving their investors is not totally true-but probably self-motivated.”

The move by Spectrum is the most likely to be copied by other firms, since 1999 funds have posted mediocre returns and aren’t expected to improve because most of their investments were made at the height of the Internet boom. By cutting their fees now on those funds, firms can effectively pay the clawback in advance. Spectrum is asking its limited partners to approve a reduction in the management fees they pay on its $682.2 million Fund III by a total of $27.5 million, according to a letter sent to LPs that was obtained by VCJ. The reduction would effectively eliminate the need for Spectrum to pay a potential clawback (see below, “What’s a Clawback?”) when the 1999 fund draws to a close. “This is the story in the private equity world right now,” says a Spectrum spokesman who asked not to be named.

The LPs in spectrum’s Fund III include BankAmerica, The Crossroads Group, FLAG Venture Partners, Pathway Capital Management, Qwest Asset Management Co. and Wilshire Associates.

In addition to the fee cut for Fund III, Spectrum plans to reduce the fees it charges on its $252.5 million Fund II, which was raised in 1997. That reduction, also in anticipation of a clawback, will be in the range of 15% to 20%, the spokesman says.

He emphasized that the firm isn’t seeking a reduction of the fees it charges on its $2 billion Fund IV, which was raised in 2000, nor does it plan to reduce the size of that fund. Spectrum is a private equity investor, so it has more options to put its money to work than traditional VCs, like leveraged buyout deals.

Deliberations

The Menlo Park, Calif.-based firm has been mulling a fee cut for about two months. Its GPs scuttled the idea after they were told about a month ago that it would result in a tax liability.

The plan was later given the thumbs up by Dean Garnier, a tax partner at Boston law firm Testa, Hurwitz & Thibeault. He poured over the limited partnership agreement and determined that the GPs could make the cut without paying capital gains, the spokesman says.

The decision to make the cut was pretty simple, because “the 1999 fund isn’t a good fund,” the spokesman says. “It has only returned 63 cents on the dollar, and I don’t feel good about that.”

He adds that Fund III “will probably make a little bit of money for partners … but I’m not comfortable and Spectrum’s not comfortable taking enormous fee income [for a fund that won’t return at least 5 times LP’s money].”

Fund III has made at least 26 investments totaling $281 million, according to VE. At least four of those deals have gone belly up, including Adero Inc., Digital Access Inc., Ennovate Networks Inc., and Spinway.com, VE data shows. Two other companies in the portfolio went public and another was acquired in 1999. That leaves at least 19 companies on the books.

The proposed amendment to the LP agreement requires the approval of 66.66% of LPs. The amendment would reduce the remaining fees on Fund III by 45.5%, starting with Q3’s fee, resulting in “an average annual fee of 0.8% on committed capital over the remaining term of the fund and an average annual fee of 1.26% on committed capital over the life of the fund,” the letter states. The fee is presently set at 2.5%.

The reduction would cut future fees by $27.5 million, offsetting an anticipated clawback once the fund’s life expires in December 2008. Spectrum pegged its theoretical clawback payment for its 1999 fund at $15.5 million as of June 30, the letter states.

One More Deal

The cuts by Crescendo and Mobius are not in response to potential clawbacks, spokespeople for both firms say.

Crescendo hopes to have a “restructuring of fees” in place by Labor Day, says David Spreng, the firm’s managing general partner. The restructuring has nothing to do with a clawback, since the firm doesn’t take disbursements in advance. “As we’re seeing now, that can be a bit of a dangerous practice,” he says.

Crescendo wants to take the 2.25% fee it collects on its $650 million Fund IV and put the money toward one or two new investments. It would get the fee back at the end of the fund’s life if the LPs make money.

The move may be a good calculated risk, because the firm may have higher odds of “hitting that lottery ticket by investing now in companies with lower valuations,” Reyes says.

The move by Crescendo isn’t an indication that the firm lacks capital, Spreng says. In fact, the firm backed off a fund-raising plan last year and instead cleaned up the 2-year-old Fund IV portfolio to free up cash. “We prematurely terminated the life of 12 service providers,” ranging from CLECs to ISPs to ASPs, Spreng says. The deals made sense two years ago but not in today’s tough market. “It was far better to write off $100 million [for the 12 companies] than put in $200 million more and not have them succeed,” Spreng says. The move leaves Crescendo with about $300 million, which it figures will last about 18 months and fund 10 to 15 new deals.

Fund IV has not had any liquidity events, according to VE’s records.

Mobius (formerly known as Softbank Venture Capital) plans to cut the 2% fee on its $633.3 million Fund V, which closed in 1999, by an undisclosed amount.

“It was not in anticipation of a clawback,” says Heidi Roizen, a managing director at Mobius. “It was in our minds just good and appropriate business management and relationship management with our LPs.” The cut reflects the “reduced value” of the 1999 fund, but “we’ve not abandoned that fund and are managing the companies to their best outcomes,” Roizen says.

Fund V has invested in at least 50 companies, of which seven have gone out of business, six have been acquired and one has gone public, according to VE. The failed investments were primarily dot-coms, like Ecoverage.com, an online insurance company, and Zoza.com, a clothing e-tailer.

Additional reporting by Dan Primack.

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