The downturn in private equity exits is creating the risk of LPs seeking clawbacks of carried interest payments from GPs as distributions fall short.
GPs have been grappling with the impact of not being able to realize profits on their investments as PE exits hit a decade low in the US last year. Now they could face the additional problem of LPs trying to recoup excess carried interest payments realized from earlier exits.
This risk is particularly relevant in so-called American-style waterfall arrangements, where GPs can take carried interest payments from a fund on a deal-by-deal basis. This contrasts with European-style waterfalls, where GPs cannot receive any carry until LPs have recovered all of their capital contributions to a fund.
In both American and European-style waterfalls there is also the concept of a preferred rate of return, which LPs receive before a GP can access any carried interest. The preferred return will typically be time-weighted, compounding over the life of the fund and becoming a higher threshold for GPs to pass.
“In effect, it’s an exponential calculation, and so every day that a fund delays selling assets and the associated distribution to LPs, the return rate they need to hit before they are entitled to carried interest increases,” said Tim Eberle, head of waterfall services at Citco Fund Services (USA), a global provider of asset servicing to the private markets.
This can create a problem for GPs using American-style waterfalls, who have realized profits earlier in a fund’s lifecycle and taken associated carried interest payments but have since struggled to exit investments or have experienced a fall in the profitability of exits. These funds risk triggering clawback provisions in their limited partner agreements (LPAs), which state that carry payments in excess of a defined percentage of fund profits, typically 20%, should be paid back.
Citco, which says its private markets client book represents more than $800 billion in assets under administration, saw a 35% increase in GP inquiries related to clawback risks in 2023 compared to 2022, as macroeconomic conditions moved this issue from being a theoretical risk to a very real consideration.
Don’t go chasing waterfalls
Despite their names, both waterfall structures are widely used in PE funds globally. “It’s outdated terminology,” said Eberle. “There’s nothing geographical in it. You’re just as likely to have a London fund manager implementing an American-style waterfall as a fund manager in New York employing a European-style waterfall.”
European-style structures tend to be more common by fund count, with the split thought to be around 60% of funds using European-style waterfalls versus around 40% using American-style. However, American-style structures are more prevalent among larger funds, with around 80% PE assets under administration covered by American-style waterfalls versus 20% European-style.
Larger firms tend to favor American-style waterfalls as the carry arrives more quickly, helping funds to recruit and retain talent. For instance, they more easily enable staff to be rewarded for their performance on individual deals, rather than incentives being reliant on an entire fund’s performance.
In the current market, Eberle says clawback risk forms an important part of the decision-making process about whether to exit investments.
“Funds have two competing things that they need to weigh up. One is, if they hold onto the portfolio company for longer, how much more value do they think they will be able to get from it and will that be sufficient to overtake the increase in the preferred rate of return.”
Although the most obvious risk is the financial downside, equally significant is the long-term damage disputes about carried interest can do to LP-GP relationships. “It can be extremely messy,” said Eberle. “In practice these will be tricky negotiations and there can be lawsuits involved”.
Clawback risk mitigations
Although GPs are unlikely to be able to change clawback provisions present in existing LPAs, there are measures that they can put in place to mitigate this risk arising in the future.
Citco suggests three main options:
- Non-time-weighted Preferred Return calculations
If the preferred return is structured as a multiplier on contributed capital this would render it a static target, calculated on a per-investment basis.
- European-style expense recoupment provisions
Structuring the waterfall so that LPs would recoup all of their capital contributed for fund-level expenses before GPs become eligible to receive carried interest would reduce clawback risk.
- Carried Interest escrow requirements
Introducing arrangements where a portion of carried interest would be held in a segregated account for a defined period time, before being paid to GPs. While this provision would not eliminate clawback risk it would ensure capital was available in the event of LPs seeking repayment.
These provisions all enable funds to reduce clawback risks, while being able to continue using American-style waterfalls.
Additionally, Citco also recommends introducing regular scenario modeling focused on assessing the likelihood of future clawback risk when deciding whether to defer or realize carried interest payments.
Featured image by Arthur Morris/Getty
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