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May 4, 2022
From the very inception of the private equity fund model, limited partners (LPs) have been sensitive to sponsors benefitting disproportionately to investors. This wariness resulted in the carried interest clawback. The idea behind a clawback is to ensure that sponsors have not been overpaid beyond the remit of the waterfall. In the event of overpayment, a sponsor is under an obligation to return distributions until the amounts distributed to the investors and the sponsor are in the agreed profit-sharing ratio.
In this piece, we review one of the most contentious fund terms – the carried interest clawback – and outline some considerations that stakeholders should keep in mind when negotiating clawback provisions. This is Part 1 of our two-part series on carried interest and clawback provisions.
In the investment funds world, carried interest is the share in profits that a sponsor is entitled to after the investors have received their capital contributions. Carried interest is generally either computed on a deal-by-deal basis (US-style waterfall) or a wholeof-fund basis (European-style waterfall). Whilst funds with a US-style waterfall run a waterfall for each investment made by the fund, funds with a European-style waterfall use a single waterfall to track all capital flows from and to the investors.
The total amount distributed to the sponsor in stages 3 and 4 is known as the carried interest.
The clawback provision works as a reconciliation mechanism that ensures that a sponsor has not been overpaid. The initial step in this process is to ascertain whether or not there has in fact been an excess distribution of carried interest to the sponsor. This will of course depend on the specific carried interest economics agreed between the LPs and sponsor. The clawback provision will scrutinize carried interest distributions by running two tests: (i) the preferred return test; and (ii) the post-capital profit share test.
Preferred Return Test
This test checks whether the aggregate distributions received by an investor is equal to or greater than the sum of the investor’s capital contributions and the preferred return calculated on such contributions. If the fund documents define the preferred return in terms of an IRR (say 8%), this test will simply check whether an investor has received sufficient distributions to produce an 8% IRR.
Post-capital Profit Share Test
This test checks whether an investor has received sufficient distributions on top of its capital contributions such that its share in the total post-capital distributions is equal to or greater than the profit-sharing percentage agreed between the LPs and the sponsor. For instance, if the carried interest percentage is 20%, the investors’ share in the postcapital distributions should be equal to at least 80%.
If either of these tests is not met, then the sponsor will be required to repay the fund such amounts as may be necessary to ensure that both tests are met. In substance, the clawback provision ensures that: (i) a sponsor is not “in the carry” unless the investors have received a full distribution of their preferred return entitlement; and (ii) a sponsor does not share in the post-capital distributions in excess of its carried interest percentage.
Negotiating clawback provisions can be a challenging process for investors and sponsors alike. Both investors and sponsors should look to ensure accuracy of clawback calculations. In addition, investors are minded to secure some protection against the risk of non-payment by the sponsor. Sponsors, on the other hand, are keen to release their carried interest payouts from the risk of clawback as swiftly as possible.
We have set out below six considerations which we believe should guide clawback negotiations between LPs and sponsors.
A. Clawback liability must be ascertained with respect to each investor
Calculations relating to both carried interest and clawback liability must be separately ascertained for each investor in the fund. Investors are differently situated from a legal, tax and regulatory perspective. During the life of the fund, some investors may have excused themselves from participating in some of the investments of the fund; others may have been excluded from fully participating in investments. Such events may materially impact the exposure that investors have in the fund. As a result, investors may not always stand on the same footing with one another for the purposes of carried interest and / or clawback liability calculations. To avoid inaccuracies, both sets of calculations (i.e. carried interest and clawback liability) must be separately run for each investor.
B. Standalone clawback obligations may not be sufficient
A single, standalone clawback obligation at the end of the term of the fund may not offer sufficient protection to investors. At the end of the fund’s tenure, it may be too late to recover overpaid carried interest distributions particularly where there have been changes in the fund’s investment team. To solve for this problem, a clawback obligation is backed up with one or more of the following:
C. The clawback provision should provide for a true-up mechanism for sponsors
Whilst the purpose of the clawback obligation is to ensure that a sponsor does not receive excess carried interest distributions, it would be inequitable if the clawback resulted in a sponsor receiving less than its entitlement. Such a scenario may arise where the fund documents provide for interim clawbacks. To solve for this problem, the clawback provision should include some form of true-up mechanism that will allow the sponsor to receive its fair entitlement without comprising the entitlement of the investors.
D. Tax leakages must be accounted for when determining clawback liability
Carried interest distributions are likely to be the subject of taxes, duties, withholdings and / or deductions. Leakages suffered on these counts are unlikely to be recovered or easily recoverable. The clawback obligation must not result in the sponsor going out-of-pocket. Therefore, the clawback obligation must be capped at the actual amount of carried interest distributions received by the sponsor after accounting for taxes, duties, withholdings and deductions that are payable on such distributions. Further, when carried interest distributions are returned to the fund pursuant to the clawback obligation, the sponsor should be treated as never having received the grossed-up amount (i.e. the repaid carried interest plus taxes, duties, withholding and/or deductions payable thereon).
E. The waterfall sequence must be maintained when clawed back amounts are distributed to LPs
When carried interest distributions are clawed back by the fund and thereafter distributed to the LPs, such distributions should follow the sequence of the waterfall i.e. the clawed back amounts are first applied towards returning capital contributions (Step 1), followed by distributions towards the preferred return (Step 2) and finally towards residual distributions (Step 4). This preserves the integrity of the preferred return calculation.
F. In a no-fault removal scenario, the original carried interest recipients should be released from future clawback liability
In circumstances where the original sponsor is removed without cause and replaced by a new sponsor pursuant to an investor vote, the original sponsor will generally be entitled to receive carried interest (subject to a haircut) as if all the investments of the fund are realized on the date of removal. Such amounts will be distributed out of the proceeds arising from the actual realization of the investments. The carried interest distributions received by the original sponsor on or prior to the date of removal will typically be subject to a clawback test. However, the original sponsor should have no obligation to participate in clawback events that arise after its replacement. This makes sense intuitively since any fall in the value of the fund following the replacement of the original sponsor would have taken place under new management.
As LPs continue to seek out greater alignment of interests in their private fund investments, the offer of a fair and equitable clawback provision would not only be a major boost for the sponsor from an investor relations perspective but also minimise the scope for disagreement between stakeholders besides reducing potential administrative inefficiencies.
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