Changing, carefully

This pressure exists no matter what kind of fund is being established, but the process has gotten particularly more complex recently as firms adapt to market trends on both sides of the Atlantic. While some European GPs are abandoning their typical per-fund waterfall to dabble in deal-by-deal carry, US GPs are moving in the opposite direction, incorporating more elements of the European waterfall into their carry provisions in order to satisfy LPs.

And even if a fund decides not to modify its carry model between funds, there is still plenty of work to do in order to ensure the waterfall functions correctly, including a fair amount of crystal ball gazing.

As these changes to waterfall arrangements are implemented, lawyers are being asked to tinker with one of the most complicated sections of the partnership agreement. With so much opportunity for things to go wrong, pfm asked a few fund formation lawyers to give us the inside scoop on how carried interest provisions are evolving, and how to reflect these changes in the partnership agreement while making sure the waterfall flows uninterrupted. As is the case with most terms in a limited partnership agreement (LPA), the devil is in the details.

Adapt to the times

Firms heading to market with new funds in 2016 are being confronted with a challenge they likely did not have to deal with when they launched their previous vehicles. In the US, the norm has been shifting, incrementally, from deal-by-deal carry to the traditional European per-fund style waterfall. At a minimum, many funds have begun using a modified deal-by-deal structure, where carried interest is distributed to the GPs only after all capital contributions used for all fund expenses have also been returned the LPs first, notes Dechert partner Carl de Brito.

“It has the effect of delaying when the sponsors get carry but not quite as far out as a total return of all capital would require,” he says. “Sponsors are finding a compromise there with investors.”

For similar reasons, Debevoise & Plimpton partner Jonathan Adler notes that the use of interim clawbacks is also on the rise. Rather than wait until the end of a fund’s life 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 – a “meaningful change in favor of LPs,” Adler says.

With funds that invest in strategies like real estate or mezzanine loans (that produce significant amounts of current income) more GPs are also looking into using separate waterfalls to assume a return of principal, which would permit them to realize carried interest as current income is paid.

“You can think about different waterfalls for different types of income (for example, current income versus disposition proceeds), and use two totally different sets of rules for each. You have the ability to bifurcate things like that,” Adler says.

But while US managers are edging slightly towards a European model, some European GPs are now seeking to adopt a US model in part, offering investors a choice between deal-by-deal carry and per fund carry within funds, consequently resulting in a proportion of carried interest being paid on a deal-by-deal basis, which Simpson Thacher partner Jason Glover calls a “significant move in the marketplace.

This is a departure from the position of European sponsored funds launched five or so years ago, when, irrespective of the historic carry model that they had adopted, a traditional investor-friendly per fund carry structure was required by investors, Glover notes. GPs have found since then that the per fund carry structure can create a misalignment of interest with investors, with executives having to wait at least seven to eight years before being in receipt of carry payments, thereby diminishing the value of the carry from a net present value perspective, particularly in the eyes of younger executives; instead such executives are incentivized to generate more immediate personal wealth through salary and bonuses.

Test your documents

With these trends in mind, managers have to be particularly prudent about deciding whether or not to change their carry structure come their next fundraise. No matter their choice, however, once the carry provision is drafted, a sharp eye and serious scrutiny is needed to ensure that the language actually prescribes what the GP intends it to.

“There are many aspects of the LPA that are conceptual, but the waterfall is quantitative. You cannot draft a good waterfall without testing it,” notes Adler.

And lawyers, he adds, should not be the only ones to transfer the on-paper waterfall into real life examples. The deal team and back office accountants should get involved in drafting models and running examples – including the exits of both good and bad deals – through the waterfall, based on an actual built out hypothetical cash flow.

Checking for weaknesses will not only ensure that the waterfall is working, but also verify that it’s making sense for everyone involved. One problem there, notes Adler, is that the language of a waterfall is not necessarily universal. Different parties have different definitions of key terminology like preferred return, IRR or compounded interest. GPs, lawyers and fund accountants all need to get together to be sure that everyone agrees on what these terms mean, because “precision is key,” Adler says.

Think ahead

But no matter how diligent you are in getting the economics and the language of a carry provision exactly right, no one can make an LPA foolproof to one inevitable and universal consequence – the passage of time. A fund formation team can try its best, but it is nearly impossible to predict the market, tax and regulatory changes five to ten years might hold.

For example, in the current political climate where the taxation of carried interest is under global scrutiny, it’s possible that tax regimes will have changed by the time carry crystalizes, leaving partners with tax treatment that’s completely different from what they anticipated.

“Carry recipients can no longer rely on the tax treatment in place at the time that carry is granted; instead one is having to be mindful of the tax regime and its likely evolution and, in particular, seeking to make sure that the carry structure works correctly in six to eight years’ time,” says Glover. “That’s something that can go wrong and frankly does go wrong.”

Despite all the effort that goes in to ensuring carry terms are drafted correctly, most GPs do not give arguably the most important piece of their LPA a second glance until the time comes to start paying out.

By that time, even if a GP has stuck with the same law firm that drafted its LPA, the particular lawyers who wrote the carry terms may no longer be working with them and the team interpreting the waterfall may not understand why something was written a particular way.

Taking a look at your waterfall as a refresher, even when you don’t have to, is never a bad idea. If the terms don’t match up to what you remembered or expected, calling in an outside law firm to take a look is also an option.

“We have been called in to review documents that a firm thinks do not adequately reflect what their intent originally was,” notes Glover. “Interpretative issues will come up when carry has crystalized and people will start to say, ‘How is this meant to work?’”