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In pursuit of premium carry

When structuring premium carry on a contingency basis, GPs should consider the best- and worst-case scenarios.

Some firms have successful fundraisings despite having off-market carry terms. Bain Capital can ask for a flat 30 percent carry fee structure without blinking an eye. A fund formation lawyer says he remembers reviewing a client's term sheet that included a 25 percent carry, and warning that most limited partners would balk. Instead, the client went on to beat the fundraising target.

?In general, there are relatively few groups that can command carry, contingent or otherwise, that exceeds 20 percent,? explains Terence Crikelair of Connecticut placement agency Champlain Advisors. However, he adds, ?Pemium fees are becoming more acceptable to investors in high performing groups.?

Crikelair notes that the GPs with premium carry are typically marquee names that are heavily oversubscribed. In many cases, the premium carry only kicks in after performance has cleared a certain hurdle

?Contingency based carry is used most often when the LP and GP differ significantly over the opportunity a fund offers and have roughly equal bargaining power.?

Basing carry terms on a contingency basis means that should the GP reach certain milestones, such as producing a specified internal rate of return, the GP's share of carried interest increases, sometimes reaching as high as 25 or 30 percent. The complexity of such an arrangement emerges when the performance of a fund fluctuates over its lifespan. IRR might reach dizzying heights in the wake of significant exit early on, only to decline by the end of the fund. Would GPs have to return those early profits? The fact is that the performance of a fund is always in flux and such arrangements court clawback situations if the GP fails to sustain a high performance for the entire life of the fund.

For now, such arrangements are relatively rare. ?Contingency based carry is used most often when the LP and GP differ significantly over the opportunity a fund offers and have roughly equal bargaining power,? explains Eric Wright, a lawyer with Ropes & Gray's Palo Alto office.

The debate is not necessarily over whether, the ?opportunity exists, but the scale of that opportunity,? adds Wright. ?And frankly, there hasn't been much difference these days.?

As private equity faces a credit crunch and a broader economic slowdown, LPs may be looking for better terms, or at least a stricter alignment of interest with GPs. ?Many investors prefer performance-based profits to higher management fees,? says Robert Fore of the law firm Goodwin Proctor.

Wright recommends a structure that ?allocates carry at the lower percentage until the LPs have received distributions that exceed the target rate of return. Once the target is met, profits are re-allocated to the GP until it ?catches up? to the higher rate. Ditto for carry distributions – at the lower percentage until the target is met, and then a catch-up to the higher percentage. This reflects the economic deal while acknowledging investor concerns about over-distributing carry to the GP.?

Fore explains that besides IRR, a popular benchmark used in these structures is payback based on a multiple of committed capital. ?Many LPs obviously prefer this, but it can take so long to reach that milestone of committed capital, that there may not be enough profits by the end of the fund to pay that 30 percent contingent carry,? says Fore. ?Naturally, the alternative is to use IRR, but what if the higher carried interest is triggered by the third exit, only to have the team struggle to exit the remainder of the portfolio? At this point, the marketplace hasn't established a rule of thumb.?

Premium carry indeed has been applied in unusual ways. Roger Singer, a fund formation attorney at Clifford Chance's New York office has seen situations where the GP simply applied the higher carry fee structure to certain types of deals, using the rationale that those transactions take more effort to execute, and thus warrant better compensation.

For now, some GPs and LPs are willing to accept such risks. ?Some GPs and LPs decide to simply start using the higher fee structure from the get go and see where the fund stands over time,? says Fore. However, these are fee structures are being negotiated now and only time will tell when or if investors decide to explore clawback options. Premium carry may well fall by the wayside as an anomaly of the recent boom era.