Time’s Up! Options for VCs & LPs When Funds Reach the End of Their Term
The tech boom in the late 1990’s led to a rapid increase in venture investment, with over 400 new funds raised in the US between 1998 and 2002. Many of these venture funds are now well past their 10 year terms, have meaningful investments remaining and are trying to determine how to navigate beyond temporary extensions. This issue is not confined to the boom-era funds and is likely to become an ongoing concern for many general partners (“GPs”).
Since 2002, time to liquidity has increased as companies have opted to remain private longer and the average time from initial funding to IPO now stretching to 7 years. The typical 10-year partnership a limited partner (“LP”) maintains with its GP may no longer provide adequate time for a fund to invest and return capital. In the near-term we are unlikely to see this duration change as LPs are resistant to modifying the standard 10-year duration. Historically, funds also had access to several one-year extensions that a GP or the advisory board could approve. Recently, a growing number of LPs are concerned about the potential misalignment of interests at the tail-end of a fund, and are now requiring new funds to have a super-majority vote or full LP consent for extensions.
In the instance that LPs are voicing a need for liquidity, or an extension is not approved, GPs need to weigh a variety of different interests and factors when deciding next steps. While GPs ultimately want to maximize value for their LPs, certain LPs may need liquidity after reaching the term limit on a fund in order to manage their own portfolios. In addition, GPs need to be incentivized to continue to actively manage the remaining assets, especially in light of reduced or no management fees. Fortunately for both GPs and LPs, there are several options available to manage remaining assets in older funds. As a limited partner investing in many funds, having provided GPs with a variety of liquidity solutions, we have seen the following options pursued when facing end-of-life decisions.
Sell LP Stakes through Referrals
If only a few LPs are pushing for liquidity, venture funds can quickly and discretely manage an LP stake sale process through their own referral networks, targeting appropriate buyers. A benefit to this process is that the GP can remain at arms-length throughout the negotiation. We also see funds utilize this one-off sale process to provide liquidity for LPs that may not want to approve an extension. However, it is important for the GP to have a good understanding of the number of LPs that want liquidity to avoid continually being distracted by managing multiple LP sales.
Proxy LP Base
If there are numerous LPs seeking liquidity or if the GP doesn’t have a strong sense of how many LPs want or need liquidity in the near-term, a proxy could be a good solution. The decision to pursue this route will likely be impacted by the GPs’ current situation. If the GP already has subsequent funds, opting for a proxy could be simpler than managing a full recap. In a proxy, there is just one price for a fund interest, so there may be a situation where certain LPs that are seeking liquidity won’t participate as they are not sellers at the determined price. In all cases GPs should remain at arm’s length and be careful not to knowingly or tacitly approve a price as it could be a conflict of interest depending on any future fees associated with the transaction.
Full Fund Recap
The benefits of a full fund recapitalization is that it provides a new time period on the fund and resets the management fee and carry structure which realigns GPs and new LP interests and minimizes the distraction to portfolio companies. The recap could provide liquidity for all or some of the LPs by offering a choice of replacing existing LPs with new LPs, or allowing existing LPs to roll into the new structure or keep current economics. As GPs weigh this option, managing the consent of LPs, and potentially creating two different classes of LPs can prove difficult. While we have seen more recaps in the past three years, GPs typically do not pursue this option due to the time, complexity and perception of conflicts of interest involved. However, if many of a fund’s value drivers are unlikely to achieve near-term liquidity and would benefit from the time reset, this may be a good option.
Distribute Private Stock or Sell Assets Directly
It is a difficult decision for a GP to wind down their fund, and it is rare that LPs would push for immediate liquidity. Seldom do funds decide to distribute private stock directly to LPs, since LPs would prefer cash and portfolio companies do not want to complicate their cap tables. However, in certain situations, a direct sale of the remaining assets may make the most sense. It allows GPs to move on and pursue new opportunities, and if the fund is able to sell the remaining positions for fair value, this could create a win-win situation. The ROFR and co-sale navigation may be tricky to manage, and it is important for GPs to keep in mind fiduciary duty obligations to LPs to avoid liability.
Recent Industry Ventures Example
We recently pursued an opportunity in a 1999 vintage fund, which was part of a fund family with multiple predecessor and successive funds. After two consecutive two year extensions, the GP estimated that they needed another two to four years for a natural liquidation of the valuable remaining assets. They also estimated that nearly half of their LPs wanted near-term liquidity.
The GP did not want to sell the assets directly given the feasibility of sizable outcomes among the remaining portfolio companies and the desire to continue to manage the assets. With the high number of LPs seeking near-term liquidity, it would have been difficult to manage one-off sales of LP stakes through referrals. In this case, the best option was to execute a full fund recap, allowing any existing LPs to participate if they wanted to stay and agreed to the new terms.
The buyers and GP agreed to a 3 year term, reduced management fees to cover the fund’s accounting and audit expenses, and a new carry hurdle that paid different levels of carry after various success multiples were reached. The GP had ongoing conversations with their LP base so there were no surprises when LPs received the official proxy recap letter, and both the GP and LPs were appreciative of the choice.