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Clawback arrangements - the investor strikes back

Lack of exit opportunities, portfolio company failures and the possibility that the economic recovery may be more prolonged than previously expected have given rise to a general expectation that private equity fund managers will need to come to terms with so-called ‘clawbacks'. An often confusing feature of the industry, Elizabeth Small of Edwards & Angell gives an overview of what clawbacks are and how they might affect the private equity landscape.

Lack of exit opportunities, portfolio company failures and the possibility that the economic recovery may be more prolonged than previously expected have given rise to a general expectation that private equity fund managers will need to come to terms with so-called ‘clawbacks'.  Clawback provisions in fund partnership agreements require the general partner to return, typically at the end of the fund's life, distributions with respect to its carried interest to the extent that such distributions exceed a fixed percentage over the life of the fund.  This protects the agreed-upon economic split between the general partner and the limited partner investors in a fund.  How clawback liabilities will be satisfied and methods to secure the repayment of clawback obligations in the future are likely to be subject of renewed discussion among fund managers and their investors.

Different methodologies for making fund distributions can lead to varying needs and uses of a clawback mechanism.  At one end of the spectrum, a return to an earlier era of the ‘all capital first' distribution methodology (in which investors are entitled to the return of all contributed capital before any carried interest distributions are made to the general partner) would greatly reduce the possibility that the general partner will receive more than its agreed-upon percentage of cumulative net profits over the life of the fund.  A mid-fund switch to this distribution methodology would lower the eventual clawback repayment obligation if such obligation appeared likely.

In contrast, the deal-by-deal distribution methodology, in which carried interest distributions are made following the return of capital contributions attributable to realised investments (as well as investments that have been written off or written down and fund expenses and management fees allocated to such deals) allows the general partner to receive carried interest distributions sooner.  This distribution format provides the general partner with an incentive to realise successful deals early and to delay the recognition of unsuccessful deals and write-downs of unprofitable investments.  Absent a clawback mechanism, a fund that recognised early successes, later reversed by investment failures, may provide a distribution scheme that over-compensates a general partner at the expense of the fund's investors.

Take the example of a typical fund in which over the life of the fund the partners are entitled to receive the return of their invested capital and 80 per cent of the cumulative net profits and the general partner is entitled to receive a carried interest equal to 20 per cent of the cumulative net profits.  Assume that the fund makes two investments, each for $100.  Assume that the first investment was sold for $300.  The partners as a group will receive $100 (return of capital contributed with respect to that deal) plus $160 representing 80 per cent of the profit and the general partner will receive $40.  Now assume that the second investment is written off completely.  The cumulative net profits over the life of the fund ($300 realised less $200 invested) are $100 and the general partner has received 40 per cent of the cumulative net profits, ie, $40.  The general partner was only entitled to $20 (20 per cent of $100) and therefore carried interest has been over-distributed to the tune of $20.  Thus, the general partner would be forced to repay the $20 to the fund's partners.

Clawback provisions in fund agreements may not fully protect investors.  Since a clawback provision is a promise to repay excess distributions, such promise is only as good as the creditworthiness of the promisor.  In some fund agreements, a clawback may bind only the general partner.  Since, however, the general partner is normally a limited liability vehicle with no assets other than its interest in the fund and typically distributes out its carried interest distributions immediately to its owners, it may be difficult for investors to enforce a clawback obligation absent the cooperation of the owners of the general partner.

The clawback obligations embedded in the partnership agreements of many funds, however, are secured by personal guarantees by the owners of the general partner.  In these cases, the balance sheets of the individual fund managers stand behind the clawback obligation.  These guarantees are either joint and several or several only to the extent of each such owner's proportionate share of the clawback obligation.  If several, the fund partners will not receive the entire required clawback payment unless each guarantor is able to pay his or her required share.  By contrast, if the guarantee is joint and several, each of the guarantors may be called upon to make good on 100 per cent of the general partner's clawback obligation even though they may have received only a small portion of the over-distribution.  Thus, the fund's limited partners have received greater security for their obligation, and the general partner's owners have put themselves at correspondingly greater risk.

An alternative method to secure the clawback obligation is for a fixed percentage of the general partner's distributions to be escrowed in a segregated account.  General partners tend to dislike this approach as it Delays their receipt of the carried interest distributions and prevents them from investing the escrowed funds.  The burden to the general partner will vary with the time frame for release and threshold valuation that the fund's remaining portfolio must equal or exceed prior to the release of the escrowed funds.

An additional means of protection that limited partners could seek is to trigger clawback obligations more frequently (for example, on an annual basis) rather than just once at the end of the fund's life.  This approach has the benefit of avoiding a major readjustment at the end of the fund and accelerates distributions to investors.  Some fund agreements allow the clawback to be triggered more frequently than once at the end of the fund; however, the trigger is usually at the option of the general partner.  An annual clawback would presumably force the owners of the general partner to set aside funds to satisfy potential obligations, similar to an escrow of the funds.

Another alternative would be to adopt the hybrid approach of utilising a fair value test with respect to carried interest distributions (whereby distributions are made to all partners pro rata based on capital contributions unless the sum of (i) the amount of distributions received by the limited partners plus (ii) the fair market value of the fund's portfolio equals or exceeds an agreed upon percentage of the limited partners' aggregate capital contributions).  Given current market fluctuations, as well as the lack of consistent valuation methodologies across funds, this approach may not result in perfect substitute for a clawback provision.  Presumably, investors will push to set the residual fair market value test at a higher level than they have historically required, possibly in conjunction with the fund's limited partner advisory committee being involved in the fair market value determination.

Some fund managers have already taken steps to settle looming potential clawback obligations through arrangements involving a reduction of future management fees.  A proactive approach addressing potential future clawback obligations through one or more methods is a positive step to maintain good investor relations with a view to future fund-raising.  In any event, irrespective of what the future holds for private equity fund formation, one thing is certain - clawback provisions will no longer be negotiated with a mindset that they will never come into play in the real world.

Copyright © 2002 Edwards & Angell

Elizabeth S Small is a partner in the Providence office of Edwards & Angell.

Edwards & Angell is a full service law firm focusing on financial services, private equity, and technology.  With more than 270 attorneys, the firm has seven US offices in the New England and New York areas, as well as Florida. For more information please visit www.ealaw.com  Ms Small may be contacted at esmall@ealaw.com