by Timothy Spangler
The time value of money is central to all #investing, but has a particular importance in the area of private equity.
Interesting, the practice in the United Kingdom and Europe with regards to the payment of carried interest in private equity funds has differed historically from the practice in the United States. In the case of the former, a “fund-as-a-whole” approach was followed, whereby all of the capital contributions of investors is returned before the fund manager begins to participate in any of the carried interest. In the latter case, a “deal-by-deal” approach has been standard for some time, under which a fund manager participates in the carried interest upon each realized investment to the extent that capital is returned in excess of the capital originally drawndown from investors to acquire the investment, thereby accelerating the receipt of carried interest by individual participants. As a result, the approach in the United States is much more “pro-GP”, while the approach taken on the other side of the Atlantic and elsewhere is considerably more “pro-LP.”
To remedy potential unfairness in the operation of the deal-by-deal approach in practice, each subsequent realizations of a portfolio company will be aggregated with earlier realizations. Simply put, carry is recalculated and paid on all deals that have realized to date. This enables a significant loss to be set off against either previous or successive gains.
As a result of these recalculations, a fund manager who earned and received carry payments in regards to investments 1 and 2, may find that the loss suffered when #selling investment 3 is so large that when carry is recalculated across all three, it turns out that none is due and payable. So what happens to the money already paid out to the fund manager?
Where earlier carried interest payments to the fund manager in hindsight appear to be overpayments, a “clawback” obligation is imposed on the fund manager. This clawback requires the repayment of any excess carried interest payout from the fund. Often, investors want to rely more on just the credit worthiness of the individual principals at the fund manager. As a result, the clawback may be supported by either an escrow of some amount of the carried interest with a third party bank, which will not be released to principals of the fund manager, guarantees from the individual principals to repay any amounts of carried interest distributed to them, or a holdback within the fund’s bank account.
However, very soon after carry payments are received by the individual principals, they each (on the advice of their accountants) will promptly pay a significant part of the money into the government as #taxes. To do otherwise would run the risk of invoking the rage of the IRS or the HMRC!
The receipt of carried interest by the fund manager and its individual principals will often be a taxable event for them. Therefore, the possibility exists that clawback obligations may imply an obligation to repay #gross amounts of money upon which tax has been paid. However, it is customary to make clear that only after-tax amounts received by the fund manager and the individual principals must be repaid.
A widely observed trend in recent years has been to focus more and more time and attention on the practical mechanics of clawback provisions, specifically the inclusion of annual “true ups” and more #escrows. Prior to 2008, these provisions were frequently included simply as a formality, with little anticipation that they would ever need to be invoked.
With more volatile markets since the start of the global financial crisis, clawback enforcement has now become an unfortunate feature of many funds’ lifecycle. The reason is quite simple. Often, it is the most successful companies that are exited earliest and with the highest multiples. The portfolio companies left to the final years of a fund’s life may significantly drag down overall performance, should they be written off or exited at a fraction of their acquisition costs.
For example, in 2010, Blackstone was required to refund approximately $3 million of its carried interest, received from the Blackstone Real Estate Partners International LP. Initial deals had done well, but the remaining deals in the fund performed less well, taking the overall fund performance down below the level at which carry was payable.
Where invoking a clawback obligation begins to appear likely, a fund manager may consider waiving some portion of future management fees as a means to lower the amounts of clawback. Separate steps may also be taken by the fund manager in connection with distributed carry to individual principals, by investing provisions in their documentation to require a “true-up” in anticipation of the clawback being invoked.
In the late 1990s, certain UK and European private equity houses began to launch funds following the “deal-by-deal” method, despite some vocal complaints by annoyed prospective investors used to the “fund-as-a-whole” approach. The impact, however, on market terms was limited. More importantly, when the market began moving against fund managers after the start of the global financial crisis is 2008, a number of recent funds have been raised in the United States under the “fund-as-a-whole” approach. This has been driven by the prolonged and mounting insistence of reluctant investors who had bad experiences with clawbacks in practice.
Investors successfully pushing for the “deal-by-deal” approach argue that it incentivizes fund managers to be focused on the preference of the entire fund, as well as accommodating a desire among individual principals to avoid to exercise of clawback rights against them, as has occurred frequently in recent years. However, postponing the timing of carried interest payments towards a fund-as-a-whole model have made fund managers less likely to agree to parallel cuts in the annual management fee. This income in a fund’s early years becomes the only source of employee and principal compensation, which has traditionally been one of private equity’s strongest recruiting tools to acquire new talent.
The flipside of the fund manager’s obligation to return money to the fund when carried interest payments are recalculated is an obligation on the part of the fund investors to return money to the fund if there are subsequently incurred costs our liabilities at the fund level which are the obligation of the investors to pay. The obligation of investors to return distributed money back to the fund has become increasingly accepted in the US, although practice is more diverse in the UK and Europe. The basis for this obligation is that the possibility exists for liabilities to arise (such as, for example, indemnities) to the fund which, in the absence of sufficient assets could fall to the general partner where the fund is structured as a partnership. Many general partners view the investor giveback obligations as the necessary quid pro quo for their own obligations under the clawback provisions. The focus of negotiations frequently centres upon time limits; and caps on the amount to be returned.
The investor giveback effectively protects the carried interest entitlement of the fund manager from loss incurred by the private equity fund, after significant distributions had been made out of the fund to the investors. Without such mechanisms, the fund manager, as general partner, would be wholly liable for such losses, with the investors enjoying limited recourse because of their position as limited partners. Such losses could arise in a number of circumstances, including breach of warranty by the fund in the sale of an investment, or an environmental liability stemming from an investment, and could otherwise have a highly punitive effect on the fund manager.
No matter how well crafted a set of waterfall provisions are in a private equity limited partnership agreement is, there is always the possibility that too much money may be released to some of the partners too early. As a result, the basic economic agreement between the general partners and the limited partners will be undermined. Each of the clawback and the giveback provisions attempt to put the fund manager and the investors back in the same position as if the amount of the losses had never been distributed. The investor giveback provisions remain highly contested and resisted by certain limited partners, often only being agreed subject to predetermined percentage and “sunset” limitations.
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