Citco Q&A: Mitigating waterfall clawback risk

GPs are facing a greater risk of clawbacks amid delayed investment realizations, greater LP scrutiny and increased disclosure requirements under the SEC’s private funds rules.

Fund administrator Citco said that it saw a 35 percent increase in overall enquiries and active support on clawback risk in 2023. The practice of actively mitigating clawback risk in private markets waterfall distributions is relatively nascent, but it is becoming more important due to the SEC’s recent private fund rules that require enhanced reporting to LPs on clawbacks, according to the firm.

Faced with this growing risk, Citco outlines the most effective means of mitigating clawback risk in its guide The Drawbacks of Clawbacks – A waterfall guide to mitigating private markets clawback risk, including how to incorporate non-time-weighted preferred return calculations, European-style expense recoupment provisions, or carried interest escrow requirements into a fund’s limited partnership agreement.

GPs can also mitigate clawback risk by including supplemental scenario modelling at the time of a distribution. Three scenario models recommended by Citco include contemporaneous unrealized waterfall calculations, zero proceeds waterfall calculations, and loss-to-clawback analytics.

Private Funds CFO recently spoke with Tim Eberle, managing director of Citco Fund Services (USA), about why GPs are facing greater clawback risk, Citco’s recommendations for mitigating such risk, and the impact different mitigation techniques will have on the back office. 

Why are GPs so concerned about waterfall clawback risk now?

The reason you’re hearing about waterfall clawbacks more now is a combination of factors. Firstly, it’s because of the current market. Funds have to wait longer to sell their investments and there’s also been increased focus around disclosure from GPs to LPs.

Secondly, LPs are becoming more and more sophisticated. So in turn, as LPs have been moving from more open-end hedge structures into closed-end waterfall structures, it has brought an increased scrutiny around the way that fees are calculated and the risk of clawback.

So, with the increasing amount of money flowing into the private market space and the increased scrutiny of this area, LPs are becoming focused on fees and expenses, and so clawbacks are becoming of greater importance to LPs.

Are GPs currently taking steps to mitigate these risks?

Funds are absolutely trying to mitigate clawback risk right now – and there are a couple of ways that they can do this.

One way is in the structure of their carried interest calculations, which are outlined in the LPA or in side letter provisions associated with an LP’s commitment to a fund. There are ways that you can mitigate clawback risk through scenario modeling associated with distributions.

When GPs prepare to make a distribution, they can run very detailed scenarios of how likely they would be to find their funds in a clawback situation if the manager were to hold onto an investment longer [for example].

We’re seeing more funds looking for much more sophisticated, much more accurate ways of doing that calculation, because the risk of clawback is higher than it was a few years ago. The problem is these calculations are difficult to perform with any kind of accuracy unless you have some kind of technology around it, and that’s why funds are starting to rely on service providers – such as tech providers and administrators – to assist with that aspect of their in-house practice and their front office decision-making.

Can you summarize the recommendations you make from your recent guide on mitigating clawback risk?

We recommend that at the time of a fund launch, clawback mitigation should be front of mind when fund administrators, lawyers and investors are working together to craft the carry interest calculation section of the LPA – that’s very important.

Generally speaking, we see that when funds and lawyers are starting to structure these waterfalls and the priority distribution provisions of the LPA, they are primarily concerned with performance, and less so with things like downside risk and clawback mitigation.

Another recommendation is that before the fund makes a capital distribution, they go through a series of stress tests and scenario analytics – not only to determine how they can get the most value out of their investments but how to best mitigate the risk of clawback associated with such distributions.

You mentioned incorporating certain steps to mitigate clawback risk into a fund’s LPA, which is helpful to GPs launching a new fund, but what can existing managers do to mitigate these risks?

We recommend that existing managers – as a component of their quarter end process, regardless of whether or not they are having a distribution – do a detailed analysis of the unrealized performance of their underlying portfolio companies.

You don’t need to wait until the time of a distribution to run all of these stress tests. As soon as valuations come in and you have a sense of how your unrealized portfolio is performing, we advise clients to run a series of stress tests, or what we call “contemporaneous waterfalls” or “zero proceed waterfalls”, so that if you have taken a carry then you have a sense as to how much of that carry would be subject to clawback, based on how your deals are performing today. In addition to the “normal” closing of the books and records that happen on a quarterly basis or once valuations are in, [they should] do a very detailed clawback analysis.

Your guide also discusses supplemental scenario modeling; can you highlight some of the most useful scenario models for GPs?

The two primary calculations that we recommend clients run prior to making any decision about whether or not to take or defer carry with upcoming distributions are the “zero proceeds analysis” and the “contemporaneous waterfall calculation.”

The model we call the “zero proceeds analysis” runs the unrealized value of your investments through a waterfall calculation as if those investments were liquidated at zero. It’s a very aggressive approach to a waterfall calculation – in short, it allows GPs to determine how much their clawback would be if everything went to zero today.

If the fund has been deferring carry early on in the life of the fund, whether GPs are waiting to see what their realized portfolio is doing, eventually you will get to a place where you’ve completely eliminated the risk of any kind of clawback, based on the way the waterfall mechanics work and the inception to date nature of them. But, if you’ve deferred all of this carry too far, for you to get all the carry that you’re entitled to you need to be specific about how you incorporate that calculation into your process, which is why we strongly recommend doing the zero proceeds calculation on a quarterly basis.

Another recommendation is to supplement the zero proceeds analysis with what we call the “contemporaneous waterfall calculation,” which is where you determine the waterfall calculation based on current values. You’re basically trying to figure out how much carry you would be entitled to if you were to liquidate your portfolio today.

Can you talk about some of the technology available to help GPs with these models?

Over the last couple of years, most funds were still trying to build these calculations out into in Excel, but the amount of inputs that you need in order to do these calculations accurately and the amount of technical expertise that you would need to build one of those models makes Excel not the best place to do such calculations.

Now we are starting to see an emerging landscape of technical architecture that can facilitate these analyses.

Citco Waterfall is one mechanism to do the carried interest calculations and we’ve enhanced that technology to be flexible enough to run various stress test scenarios.

How do these different clawback mitigation steps impact CFOs and other back-office professionals?

These calculations are a burden on the back office unless you outsource the function, because your back office is primarily concerned with books and records, and running these scenarios can be time-consuming and difficult because you’re dealing with hypotheticals and dealing with building out complex models that require a lot of input.

There is a lot of additional operational risk that comes with running these models, and that’s where a third-party administrator who has technological solutions to remedy this can come in and automate those calculations to lessen the burden on your back office.

While your guide outlines steps for reducing clawback risk, are there current practices or terms that could increase risk for GPs?

I would say the lack of any deferred carry provision in a LP agreement that doesn’t give the GP the ability to defer carried interest they otherwise would be entitled to is the biggest contributor to the clawback risk. In turn, we recommend that funds always include a deferred carry provision in their LPAs in order to make sure they do have the ability to, theoretically, limit the risk of clawback.

Another major contributor is current income. Funds that take in current income – such as bond coupons – and take a carry on that current income too early probably presents the biggest risk of clawback, largely because current income isn’t considered a realization event.

These clawback risk mitigation steps seem very helpful to GPs, but are there any drawbacks for LPs if GPs are taking the steps you’ve outlined?

I would say there aren’t any significant drawbacks to the LP – this is because all of these provisions ensure that the LPs get a little bit more of their capital back earlier than they would be entitled to otherwise. In fact, I would say it’s actually very beneficial to the LP.