When a fund’s performance tails off, and carried interest paid early in the fund’s life proves to have been too much, a clawback mechanism often kicks in.
Fairly standard stuff for private equity firms that adopt a deal-by-deal distribution waterfall, where carry can be paid before the fund completes its last investment. But legal sources speaking to PE Manager say these clawbacks have recently been causing some major headaches for GPs.
More specifically, a problem arises when a partner pockets some of the carry and later leaves. In this scenario, the remaining partners are confronted with the challenge of how that missing carry is accounted for should a clawback arise, and at times, eat the costs themselves.
“It’s most likely brought about by poor planning on the part of the GP,” says Louis Singer, funds partner at Morgan Lewis, who adds that this problem is typical of older funds where clawback provisions in the limited partner agreements were less sophisticated and received less time and attention.
There’s also a psychological factor at play. Fund managers don’t spend a significant amount of time negotiating clawback mechanisms because most assume it’s a problem they won’t have to deal with as a well performing manager. Moreover, GPs believe their team will never go through a bitter-break up where getting money from ex-partners is an issue, observe legal sources.
“It can be an awkward conversation and a bit like debating whether or not to have a pre-nup, bringing into question whether you trust each other,” says Nigel Campion-Smith, funds partner at Latham & Watkins. And discussing what happens in the event a departing partner receives carry that is later subject to clawback can be especially difficult for GPs on the fundraising trail “who are busy telling investors what a unified collegiate team they are.”
AGREEING THE MECHANICS
A partnership agreement with poorly worded clawback provisions can always be a problem, but industry lawyers say the risk is especially great today now that investors place greater scrutiny on how clawbacks are executed. The challenge for GPs here is to ensure investors are happy with the clawback language without putting themselves at financial risk in a worst case scenario.
What investors like is for GPs to reserve a percentage of their due carry in an escrow account (which all but guarantees that fund managers have the money on hand to pay for a clawback). Investor trade body the Institutional Limited Partners Association (ILPA) specifically calls for GPs to place at least 30 percent of the carry in these accounts.
What some GPs do is have the escrow account hold their carry distributions until an agreed threshold is met. For instance, the escrow will hold carry distributions until all of the LPs’ committed capital is first returned, with any returns above that amount paid to the fund manager as carry.
But GPs are not necessarily keen on using escrows accounts. GP sources say an escrow account defeats the point of a deal-by-deal carry distribution because it denies them expected carry payments until much later in the fund life, which can take years. And those carry distributions are needed to effectively incentivize a junior team that didn’t receive carry payments from a previous fund, says Sam Kay, funds partner at Travers Smith.
WHO’S RESPONSIBLE?
When GPs refuse to hold their carry in escrow, LPs will at least want a guarantee from their fund advisor that it will meet any clawback requirement. But this raises the question of who exactly is signing the guarantee.
“Some of the larger firms don’t have their individual executives sign the clawback guarantee, “ says one US-based private funds lawyer. “Instead it’s the institution that stands behind the clawback, and thus on the hook. But this isn’t always an option really available for small or mid-market shops.”
ILPA strongly recommends individual GP members have joint and several liability for clawback payments. But agreeing to that is often why fund managers experience clawback problems in the first place, say legal sources, who say joint and several liability can put a deal partner on the hook for carry pocketed by a former partner.
GPs say they feel much more comfortable if a guarantee is signed on a several basis, meaning individuals are only responsible for their pro rata share of carry received. But here too problems still arise when a departing partner owes carry back. One might assume that getting that former partner’s share of the bill is a straight-forward claim, but lawyers say it can become messy when you factor in possible tax deductions, if the money was already spent, passed on to a family member or placed in a family trust or tax planning vehicle.
“Pursuing former partners is often a purely commercial decision,” says Campion-Smith. “If the sum isn’t huge, the GP will have to ask itself whether it is going to invest in recovering the sums through the courts.”
The time and cost involved in going to court is not the only thing that can dissuade a GP from pursuing money owed by a former partner. There’s an image consideration here too. And taking a former colleague to court can “engender a lot of bad blood,” says one UK-based placement agent.
Because of that some GPs have struck deals with departing partners in order to meet the carry shortfall. Others have negotiated with a former partner to see how much money they in fact could pay back, with the firm covering the remainder, says Kay.
LPs also want to have the right to force the individual clawback guarantees themselves, says the US funds lawyer, as in the past it was often only the GP that could enforce the clawback guarantees against the individual executives. “Now it is the investor who wants the right to go after individuals if they have left the firm.”
INVESTOR COMFORTS
Speaking of investor demands, LPs are also giving more thought to clawback-related tax considerations, note legal sources. Standard market practice today is for a GP to pay back undue carry on an after-tax basis. “But more LPs are asking GPs to commit to seeking repayment of tax,” says Campion-Smith.
Another area that LPs are applying pressure is interim clawbacks, says Charles Froland, chief executive and chief investment officer of Performance Equity Management.
Rather than wait until the end of the funds’ lives to settle up, LPs are asking GPs to allow for an interim clawback or even series of clawbacks before the fund’s term has expired.
“The idea that, through the carry distribution, a GP can get ahead of the LPs and then the LPs might end up paying for the taxes on those distributions and have to wait out the fund’s life to get back the carry – which could be 10, 12, or 14 years down the road – just seems unfair.”
Morgan Lewis’ Singer thinks interim clawbacks are best practice for GPs to adopt. “Escrows are inefficient from an economic standpoint. But with interim clawbacks you [the GP] can’t get too far ahead of yourself.”
And while many of the clawback disputes GPs are dealing with are a corollary of older and less sophisticated agreements, legal sources say the modern ones have yet to iron out all of the wrinkles. Accordingly, clawback terms need greater attention or more GPs may end up facing disputes with LPs or former partners.
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