Vanguard Mulls New Fund and Annex Fund

Vanguard Ventures is considering raising a new $250 million fund and a $12 million annex fund to do follow-on rounds for an older vehicle, Private Equity Week has learned.

The firm, based in Palo Alto, Calif., plans to officially begin fund-raising for the new fund, to be called Vanguard VIII LP, in the fourth quarter, confirms Anne Rockhold, Vanguard’s chief financial officer. No closing date has been set. The fund will likely be the same size as its predecessor, which closed at $240 million in November 2000.

As for the proposed annex fund, it would make follow-on investments in Vanguard VI LP, a $103 million fund raised in 1998. The management fee for the annex fund has been waived, and it sports a reduced carry. It will only be offered to previous investors, but the firm does not yet know which of its limited partners will choose to re-up and at what levels, Rockhold says.

Fund VI has made 42 investments in 16 companies, according to Venture Economics (publisher of Private Equity Week). The largest number of deals (five) were made in medical/health-related companies, followed by Internet companies (three). It’s two largest investments are in Luminous Networks Inc., a switch maker; and ZipRealty Inc., an Internet service for home buyers and sellers. One of the companies in the portfolio, ShopTok Inc., which made customer service software for online merchants, has gone out of business.

Bill Monagle, a Vanguard LP and managing director at investment advisor CRA RogersCasey, declined to comment directly on Vanguard’s annex fund. But, he says that other funds with the same vintage year of Vanguard VI have raised annex funds. While he characterized the frequency of annex funds as “limited,” he says Vanguard VI’s investment pace has been consistent with other funds of that vintage.

Accel Partners, Enterprise Partners, Jerusalem Venture Partners and New Enterprise Associates all raised annex funds, which seems to be a beast indigenous to this generation of market turmoil.

“Annex funds in general are fine,” Monagle says. “We understand the circumstances where the money was put to work quickly in that vintage year, and the liquidation events have been drawn out.”

However, Annex funds run into murky waters when LPs in the original fund choose not to participate or to participate at different levels. By definition, firms raise annex funds for two purposes: to support portfolio companies with the additional cash required by the extended liquidity drought and to ensure participation in additional rounds, which in this environment are often highly dilutive.

It follows that annex funds typically washout the early investments made by a fund. If not handled correctly, that action could be a sore point for any LPs in the fund that made the original investments and who do not participate in the annex fund. It’s similar to the old challenge of crossover investing, where a fund from one vintage year invests in the investments of another fund from another vintage year.

“In general, what you look at is: Is the annex fund doing something other funds wouldn’t do,” Rockhold says.

This very conflict has already seen time in the courts in a case between the state of Connecticut and buyout shop Forstmann Little. Forstmann Little made a series of investments into beleaguered telecom McLeodUSA. Connecticut participated in funds that made the initial investments, but Connecticut’s stake was allegedly washed out by later investments by Forstmann Little funds in which the state did not participate.

Crossover investments threaten to cloud a GP’s normally good judgment due to his prior involvement with a company. One 20-year veteran VC, recently says that while he’s done crossover investments, “It’s never been a good thing.” It’s not clear what explicit criteria, if any, the Vanguard annex fund will have.

The emergence of annex funds is somewhat ironic, given that many large firms have cut the size of their funds. The market’s slow pace has caused a pacing problem where some funds have too much capital due to a slowed pace of investing, but others have too little due to a slowed pace of liquidity. The only clear difference between those situations and their exceptions is fortunate timing.

Contact Charles Fellers