First, it is important to point out that the LPA terms covering distributions from the fund should not be confused with the terms covering allocations. Nevertheless, these two terms, together with the escrow and GP clawback terms should always be read together. Distribution provisions in LPAs deal with cash flows from the fund (often referred to as the waterfall), as opposed to the allocations of profit and loss for tax purposes. The purpose of the distribution waterfall is to set out the order and priority of the cash distributions of capital and income to the partners. Accordingly, the distribution waterfall contains the key commercial agreement on the profit split between the manager and the limited partners .
In some US LPAs, however, the allocation provisions govern not only how profit and loss is shared among the partners for tax purposes, but also the economic arrangement between the manager and the LPs. In these allocation-driven agreements, the distribution provisions simply govern the timing of cashflows, but not the ultimate economic arrangement. This chapter, however, assumes that the LPA economics are governed by the distribution waterfall and not the allocation provisions.
LPA distribution terms may also cover:
- Timing of distributions, with capital proceeds being distributed as soon as practicable, and income proceeds generally aggregated for distribution periodically on the basis that in private equity funds income proceeds are likely to be small and, therefore, do not justify distribution as soon as they are received by the fund.
- Re-investment and recycling criteria and restrictions.
- Limitations on distributions, including escrow arrangements in relation to distributions in respect of the carried interest (see below).
- Limitations and procedures in relation to distributions in specie.
The traditional starting point for negotiation of the order and priority of payments has remained largely unchanged over the years. As discussed elsewhere in this book, there exists a transatlantic dichotomy between funds that must return all drawn down capital to LPs plus a preferred return before proceeding to carried interest distributions — the so-called fund-as-a-whole model, which is dominant in Europe — and those funds that must return only drawn down capital on investments that have been exited plus a preferred return — the so-called deal-by-deal model more commonly found in the US.
While the economic environment following the global financial crisis resulted in pressure from investors to remove the more manager-friendly deal-by-deal model in Europe, a since stronger fundraising market has enabled some top-tier managers and in demand first-time fund managers to negotiate that at least a portion of distributions are subject to a deal-by-deal model. In the US, experienced buyout fund managers that have had historical deal-by-deal waterfall have generally been able to continue with such an approach in more recent funds. However, LPs typically require new managers to implement a fund-as-a-whole waterfall.
A 20 percent carried interest rate remains the market standard for buyout funds. However, this rate is not the default position for all funds and will often vary based on the particular strategy of the fund. For example, debt funds, funds of funds and secondaries funds may have a lower carried interest rate, and some top-tier venture capital funds or lower mid-market buyout funds have a rate above 20 percent (otherwise known as a ‘premium’ carry). There is also a small but increasing minority of managers that have a performance-based carried interest, which increases based on the performance of the fund. This means that a specified return threshold (for example, 2x or 3x of capital commitments) will entitle the manager to a higher carried interest percentage. Premium carried interest is typically reserved for top-tier venture capital funds and, in Europe, for some top-performing growth capital and lower mid-market managers with bespoke and focused investment strategies.
A key issue for LPs when negotiating distribution provisions is to ensure that interests are fully aligned with the manager throughout the term of the fund. LPs will want appropriate protection from any overpayment of carried interest to the manager, since the manager will often receive carried interest distributions before the final liquidation of the fund and, therefore, before the aggregate net gains of the fund can be calculated.
Managers generally recognize the need for some investor protection in this regard. However, a total subordination of the manager’s right to proceeds until there is no risk of an overpayment of carried interest is generally not the norm in the US, Europe or in any other market. The reason for this is that any extreme delay in the payment of carried interest could create a practical issue for the manager in ensuring that compensation for its team is sufficiently competitive to retain high-performing staff. In a competitive market for young private equity professionals, delaying carried interest distributions until the end of a fund’s life could be an obstacle to attracting top talent. Escrow and clawback provisions (discussed further below) are generally used to facilitate a compromise position, which gives the manager access to carried interest proceeds earlier in the term of the fund while offering investors protection against an overpayment of carried interest when the final balance of proceeds is assessed.
Howard Beber is a partner in the Corporate Department and co-head of the private funds group at Proskauer, in the Boston office. Scott Jones is a partner in the tax department and a member of the private funds group at Proskauer, in the Boston office. Andew Shore is a partner in the private funds group at Proskauer, in the London office.
This is an excerpt from The LPA Anatomised (2018), published by Private Equity International, and available for purchase here.