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Proudly off-market

Private Equity Manager profiles five limited partnerships that strayed from the terms and conditions norm. Two got away with it, one didn't, and two are about to find out.

The give-and-take between the LP and the GP side of partnership negotiations has sometimes been characterized as being akin to a pendulum. Sometimes the pendulum points toward the limited partners (capital is scarce, returns are down, and GPs are begging) and sometimes the pendulum swings toward the GPs (capital is plentiful, returns are up, and LPs are begging).

One would have to have spent several years on the moon not to know that today's pendulum has swung heavily toward the GPs after a brief trend toward the LPs during the early 2000s. But this power paradigm does not apply to every GP. Only the very best private equity firms have been able to secure extra-favorable terms for themselves, while the rest of the market scrounges for what leftover capital has not already been commandeered by Blackstone, et al. And certainly, a private equity firm that is nervous about hitting a target fund size is in no position to ask for terms and conditions that are anything but ?market? or, even worse (from the GP's point of view), ?LP friendly.?

Regardless of which direction the pendulum points, certain terms seem to have become set in stone, because they are seen as being so central to the alignment of interests between GPs and LPs that anything less kills the deal. For example, deal fees are almost always significantly shared with the LPs today, to prevent a perverse incentive on the part of the GP to reap riches in which the LPs have no share. But as we present in the following article, there remain many terms which some GPs have not been afraid to alter, arguing that the alignment of interest remains intact while granting the GP more flexibility or, in the case of, for example, a 30 percent carry, creating an even stronger incentive for the GP to pursue investment success. We'll let you decide if you buy these arguments – at least one group of LPs did not, and the fund in question experienced a failure to launch.

The Riverside Company: live long and prosper
What will you be doing in 2024? If you don't have a quick answer to that question, you may not be thinking as longterm as Stewart Kohl, a co-chief executive officer of The Riverside Company. The Cleveland- and New York-based buyout firm has just announced the close of a new fund that, with two LP-approved extensions, may have a life span of as long as 18 years.

Given the pace of much of today's private equity deal activity, 18 years is enough time to raise six funds. But Riverside has launched a new investment focus that it feels will work best with a longer-than average holding period.

Last month the firm announced the close of Riverside Micro-Cap Fund I, which drew $250 million (€197 million) in LP commitments, including large investors such as State of Michigan Retirement Systems, AlpInvest Partners and Makena Capital Holdings.

Riverside has throughout its development as a firm targeted small buyouts, with a high end of roughly $100 million in enterprise value. The firm's previous main fund closed on $750 million in 2003. But the Micro-Cap fund will pursue an even smaller class of business – those with EBITDA of $3 million or less. Since last summer, the firm has acquired eight such businesses, and will soon announce a ninth.

According to Kohl, Riverside's value-add proposition is to provide the small companies with the kinds of resources and guidance typically afforded to much bigger businesses. ?We think we can turn these into businesses with $10 million in EBITDA,? says Kohl.

Doing so, however, may take double the amount of time of the typical private equity holding period, says Kohl. During a five- to seven-year hold, a company with $3 million in EBITDA might grow to $4 million or $5 million in EBITDA, thanks in part to Riverside's ?toolkit? of operating partners, CFO services and state-of-the-art systems.

On a relative basis, going from $3 million to $5 million in EBITDA over a typical holding period provides an attractive IRR, notes Kohl. But on an absolute basis, that's not a lot of dollars gained, especially in the eyes of large institutional investors. After conducting extensive research, Riverside came to the conclusion that it may need to hold its micro-cap portfolio companies for as much as four more years to reach $10 million in EBITDA, at which point the companies become highly attractive potential investments for a very large population of middle-market private equity firms.

?If you get to $4 million or $5 million in EBITDA, you got a quality company with quality management systems and a winning business strategy,? says Kohl. ?But at that point we would like to exercise those assets over a longer period.?

Whereas most private equity limited partnerships are structured with a 10-year life span, Riverside convinced its LPs that a 12-year life was more appropriate for its investment strategy. In addition, the partnership allows for a 3-year extension with 50 percent approval from the LPs, and an additional 3-year life span from 80 percent of the LPs.

Kohl admits that the terms of the micro-cap partnership probably ?exaggerate? how much time will be needed to nurture the portfolio companies to their target EBITDA levels, but Riverside wanted to err on the conservative side, and its LPs agreed.

Kohl and Riverside's other co-founder, Béla Szigethy, are both 51 now. ?We're in good health and loving what we do,? says Kohl. The two plan to be fully engaged in running their firm when the life of this micro-cap fund comes to an end. But Kohl adds that he and Szigethy are mentoring a next level of leadership at Riverside, setting the stage for many 12-, 15- and perhaps even 18-year funds to come.

Bain Capital: a mega-carry model
As a major component of fund economics, carried interest is an attention-grabbing term in the private placement memorandum. While venture funds tend to charge between 20 percent and 30 percent carried interest, within the buyout world, keeping 20 percent of the fund's profits is widely considered ?market? practice for most funds.

However, a handful of firms – particularly in the US – are starting to push up against this de facto ceiling. Firms like ABRY Partners, Providence Equity Partners and Berkshire Partners have reportedly secured a respective 30 percent, 25 percent and 25 percent carried interest for their latest funds.

One of the early adopters of outsized carry levels among buyout firms is Bain Capital. Its most recent fund – Bain Capital IX, closed in April 2006 – was the firm's sixth fund to charge 30 percent carry. With many investors in Bain IX's predecessor funds choosing to participate in the new fund, Bain's longtime off-market carried interest levels have apparently not been off-putting to a loyal limited partner base.

Bain's gross IRR through its seventh fund was 40 percent as of the end of last year – 60 percent if you just count the realized investments. The firm's track record and the high investor demand for a stake in Bain's funds provide the firm with leverage to ask for – and obtain – above-market terms. It also doesn't hurt that, via the GP commitment, Bain Capital is the biggest investor in its own funds. However, given that Bain has a global cadre of 200-some investment professionals to compensate – and incentivize, one could argue that the firm's business model justifies a different approach to fund economics than that of a single country-focused buyout shop with 20 or 30 investment professionals.

Apart from its outsized returns and investment team, one of the ways that Bain softens the effects of its above-market carried interest is by presenting LPs with the option of participating in co-investment vehicles. For instance, the $8 billion Bain IX main fund was accompanied by a $2 billion coinvestment vehicle. In June 2004, predecessor fund Bain Capital VIII closed on $3.5 billion plus $750 million for coinvestments. These co-investment vehicles charge management fee only on invested capital – rather than committed capital, as well as charge a 20 percent – rather than 30 percent – carried interest.

There is evidence of a growing movement to increase the carried interest charged by buyout firms – especially among those firms that can ask for the higher rate and still have LPs lining up to get inside. That top- and lower-quartile performers have been going to market with funds with the same fee schedule does seem incredible to proponents of greater differentiation in pricing.

For most buyout firms, the ability to demand above-market standards for carried interest continues to be highly correlated with supply and demand. Should market conditions change, it is unlikely that many of these firms will enjoy the lasting bargaining power of Bain Capital to stay proudly off market.

Upside rewardsMagnolia China charges higher carry as the fund's totalcapital grows

Capital Increments% Carry Carry € million Accumulative € million Accumulative
500 0 0
625 125 10 12.5 12.5 10
750 125 15 18.75 31.25 12.5
875 125 20 25 56.25 15
1000 125 25 31.25 87.5 17.5
1125 125 30 37.5 125 20
1250 125 35 43.75 168.75 22.5
1375 125 40 50 218.75 25
1500 125 45 56.25 275 27.5

Stage 1 Ventures: VC ?on demand?
These days, fund terms and structures for venture funds have become pretty plain vanilla. However, one new kid on the block stands apart from the crowd in how it views the way venture funds should be structured.

Stage 1 Ventures – based in Waltham, Massachusetts and headed by David Baum and Jonathan Gordan – seeks not only to engage in the conventional VC activity of investing in capital-efficient companies, but also to do so in a manner that deploys LP capital efficiently. In fact, the firm's founders claim that they will put ?at least? 93 percent of LPs' money to work.

Doing so involves going to market every two years to raise a ?small bucket? of capital that is used for initial seed investments in the mobile, IPTV, pay-per-performance marketing and ?executable internet? spaces. Using this bucket, Stage 1 writes small checks to these ?early, early? stage entrepreneurs. Then, upon an in-depth assessment, Stage 1 decides whether the initial investment warrants further backing. For those portfolio companies found to meet the standards for followon investments, Stage 1 creates a special purpose investment vehicle (SPIV) around the company and allows the vehicle to grow in size to meet the size of the opportunity, explains Baum.

Consequently, the Stage 1 model presents a fund that looks like a $20 million early stage seed fund while having the ?firing capacity? of a $200 million fund, says Baum. ?Of the successful SPIVs, we can fund those up in the neighborhood of $10 million each,? he explains.

Because the fund charges a ?one-time? management fee that is based on capital invested rather than LPs' committed capital, investors are more receptive to having the capital pool expand and contract, says Baum. He adds that the Stage 1 model better reflects and adapts changes in the markets by ?dynamically matching? a financial vehicle to the set of opportunities it faces. On the profits made, Stage 1 will receive a ?slightly higher carried interest than VC industry standard of 20 percent in return for taking 67 percent less management fees,? says Baum.

According to Baum, the Stage 1 model was inspired by comments from his LPs, who wanted to see a return shift from VC being a fee-driven business back to being a capital gainsdriven business.

?For an industry that thinks it's all about taking risk, the GP never takes any risk for the LPs,? says Baum, formerly a general partner at Prism Venture Partners, of the rationale for Stage 1's fund structure. ?The capital commitment and the annual fees are guaranteed for ten years – unless the key man clause is triggered – regardless of what happens with the manager, the industry, or the market. The LPs don't have many options.?

The problem with raising larger funds is that once those LP commitments have been received, then the GP feels compelled to put all the money to work, adds Baum. But if the opportunity isn't there, then why force it? He asserts: ?It would be better to cut the size of the fund and reduce the fees rather than waste LPs' money.?

ViaNova Capital: the fund of fund that faltered
The travails of ViaNova Capital serve as evidence that devising off-market terms and conditions is no guarantee of success.

ViaNova, with offices in London and Zurich, launched a €500 million private equity fund of funds in 2003, headed by experienced private equity professionals Andrew Evans, Edward Gander, Martin Dreher and Thomas Bischoff.

The fund was to invest in pan-European funds, with 30 percent of the total set aside for ?rising star? managers focusing on specific countries or regions within Europe. Arguably more significant was the total absence of any establishment costs, annual management fees or carried interest. Instead, ViaNova was proposing to take a two percent interest in the fund and receive an initial one-off fee from investors equal to two percent of their commitments.

The fund was certainly innovative, bucking the established trend for funds of funds to charge establishment fees ranging between 0.4 percent and one percent of commitments. At the time of ViaNova's launch, co-founder Evans said such a charge ?reduces the amount of capital available for investment and therefore reduces returns to investors.?

He added that a one-off management fee would be more attractive to investors than annual management costs, pointing out that ?over the life of a typical fund of funds, a total of six to 12 percent of investors' commitments is required to pay annual management fees.?

However, persuading investors of the merits of such arguments proved more difficult than anticipated. Having pencilled in a first close for the first half of 2004, it was clear that the fundraising had lost its momentum by April of this year when Gander quit to rejoin Clifford Chance, the law firm he had left to help launch ViaNova three years previously.

According to a source close to the firm, ViaNova is still up and running and working on a number of private equity-related projects, but the fund of funds is no longer being offered to the market.

Reflecting on the fund's premature demise, one leading European limited partner told PEM: ?I think one of the problems in the private equity industry is that the buyers of product are reticent to look at anything new or innovative. There's a clarion call for changes in fund structures, but an unwillingness to support anyone who responds to that.?

Of course, it could be that investors just didn't share ViaNova's enthusiasm for a new form of fund economics – and it certainly didn't help that the fundraising attempt was made amid growing competition in the funds of funds market. One thing is for sure: the ViaNova fundraising demonstrated that introducing new terms and conditions to the market can be far from a straightforward undertaking.

This article was written by Judy Kuan, David Snow and Andy Thomson.