Clawback Concern Spurs Spectrum Fee Cut

For more on the following story, including a discussion of a fee cut at Crescendo Ventures, check out the subscriber section of this site or Monday’s print edition of PE Week.

Spectrum Equity Investors wants to take its lickings now rather than wait seven years to be punished. In a letter obtained by Private Equity Week, the firm asks limited partners to approve a reduction in the management fees charged on Spectrum’s 1999 Fund III by a total of $27.5 million. The move would effectively offset a future clawback that the firm would otherwise be assessed on its $682.2 million fund.

A spokesman for Spectrum predicted that more firms would follow Spectrum’s lead because of the mediocre performance of 1999 funds. By cutting their fees now, the firms can effectively pay the clawback in advance. “This is the story in the private equity world right now,” says the spokesman, who asked not to be named.

News of the Spectrum fee cut was first noted in Monday’s Boston Globe.

In addition to 15 firms that have cut their fees as part of sizable fund reductions, at least four firms have made or plan to make pure fee reductions. ComVentures was the first to do so, telling its LPs in February that it would reduce the fee on its 2-year-old $550 million Fund V by 0.5%. Three more firms, including Spectrum, followed suit this month: VantagePoint Venture Partners informed its investors that it will defer fees on half of its $1.6 billion Fund IV, which was raised in early 2000, for the next 18 months. Meanwhile, Mobius Venture Capital (formerly Softbank Venture Capital) reportedly told LPs that it would cut the 2% fee on its $6333 million Fund V, which closed in 1999.

Spectrum, based in Menlo Park, Calif., 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. But 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. “A survey of 110 funds by Cambridge Associates says it’s in the top decile in performance, but 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].

More Work Ahead

Fund III has made at least 26 investments totaling $281 million, according to Venture Economics (VE), a market researcher and publisher of PE Week. At least four of those deals have gone belly up, including Adero Inc., Digital Access Inc., Ennovate Networks Inc., and, 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.

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 the $150 million investment it made in a yellow pages directory, the spokesman says.

The letter sent to LPs, which is signed by Spectrum’s six general partners, includes an amendment to the limited partnership agreement that requires approval of 66.66% of LPs. “We’re extremely close to approval but not quite there yet,” the spokesman says.

The letter was sent on July 12 to all of Spectrum’s limited partners, including Fund III investors like BankAmerica, The Crossroads Group, FLAG Venture Partners, Pathway Capital Management, Qwest Asset Management Co. and Willshire Associates.

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%.

Offsetting the Clawback

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 to be $15.5 million as of June 30, the letter states. Clawbacks are written into virtually every limited partnership agreement to make sure that a GP doesn’t make money at an LP’s expense. Here’s how it works:

Say you’re a GP and raised a $100 million fund and made 10 investments at $10 million apiece. Assume two of the investments did well, earning $50 million each, while the other eight were held at cost. That would mean the portfolio is worth about $180 million. If you subtract the $100 million that was invested by LPs, that leaves you with a gain of $80 million, 20% (or $16 million) of which you may take when you distribute 80% of the profits on the two deals to LPs. Now assume that the value of the remaining portfolio falls by half to $40 million, a realistic scenario these days. Instead of being ahead by $16 million, you’re now “over distributed” by $8 million.

Traditionally, GPs wait to see how a portfolio does over its lifetime, betting that it will eventually produce a gain and, thus, eliminate having to pay a clawback. Today, GPs are less certain that their 1999 funds will produce positive returns, so they’re trying to cover themselves before being hit with a major clawback at the end of a fund’s life.

;Imagine you have a fund of $1 billion and you have returned nothing or 10 cents to date, and what’s left in your portfolio is a lot of questionable stuff,” the spokesman says. “How do you say to yourself, ‘I’m going to continue to take the fee and I’m going to deal with it seven years from now [at the end of the fund’s life].

Yet another factor to consider: What’s a fair fee once most of a fund has been invested? Say you’ve invested 60% of a $100 million fund, but you’re still charging your LPs 2.5% of the fund’s overall size of $100 million. “That’s $2.5 million, and if you divide that by $40 million [the amount of the fund that remains to be invested], that’s a fee of 6.25%,” the spokesman says. “That makes no sense.

LPs don’t mind paying that larger fee if a fund is returning five times their money, but when the fund is in the red, they are less willing to ignore it.

Contact Lawrence Aragon