In this Ropes & Gray podcast, asset management partners Lindsey Goldstein and Isabel Dische discuss considerations both fund sponsors and investors will want to keep in mind if a fund "falls out of carry" because of COVID-19 related market declines.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I'm Isabel Dische, a partner in our asset management group based in New York and co-head of our institutional investor practice. Joining me today is Lindsey Goldstein, an asset management partner also based in New York. Recent months have seen some significant market declines in connection with the COVID-19 pandemic. As assets decline in value, the likelihood that a fund sponsor will receive carry—or a share of profits—drops as well. Indeed, over recent months, a number of fund sponsors have announced that they will no longer accrue carry with respect to one or more of their funds.
Today, we are going to discuss what it means for a fund to "fall out of carry" and some of the considerations that both fund sponsors and investors will want to keep in mind. Lindsey, would you like to kick-off our discussion?
Lindsey Goldstein: Gladly. In recent months, private equity sponsors have had to revalue their portfolios to reflect the dramatic market declines triggered by COVID-19. These revaluations have shifted funds' expectations as to where they stand in their carry waterfalls, particularly for funds where carry is calculated on a deal-by-deal basis under a so-called "American" waterfall. Under a typical "American" waterfall, a sponsor is entitled to receive a performance allocation on a deal-by-deal basis. This means that sponsors can begin to accrue carry even before the fund has returned all capital contributions to investors as long as it has accrued the preferred return with respect to a particular investment. Because carry is assessed on an investment-by-investment basis, it is possible for a sponsor to receive carry earlier in the life of the fund – for example, if there is an early deal that is a home run. Under a deal-by-deal waterfall, it's possible for the carry a sponsor receives with respect to early distributions to exceed the carry it would be entitled to if you looked at the performance of the fund as a whole over its life. This is called "falling out of carry." Notably, under a typical "European" waterfall, falling out of the carry is far less likely because a sponsor is entitled to receive carry only after capital contributions are returned on a whole-fund basis, meaning the fund must first return capital contributions with respect to both realized and unrealized investments, as well as expenses, and return the preferred return on all of those contributions. With recent downward shifts in portfolio valuations, the likelihood that a sponsor has fallen out of carry has increased, especially for funds that have "American" waterfalls, and several large sponsors have announced meaningful carry clawbacks. What this means for a given fund will depend on the terms of the partnership agreement. Isabel, do you want to walk through some of the considerations fund sponsors and fund investors will want to have in mind?
Isabel Dische: Certainly, Lindsey. As you noted, this is very dependent on the terms of a fund's partnership agreement and many of the provisions we'll touch upon are highly negotiated, so you will want to review a fund's partnership agreement to understand how this may play out for a particular fund. Most LPAs include a clawback of excess carry, whereby a GP must return distributions it has received that it ends up not being entitled to – for example, because it has failed to meet a performance threshold. Note that a GP could find itself subject to a clawback even where it hasn't taken carry distributions, if, for example, it is entitled to less carry than the tax distributions it has received. The mechanics of when a GP clawback is assessed and what can be recalled vary. Some funds only assess whether a clawback is required at liquidation, while others will include interim clawbacks at set dates – for example, at years 5, 7 or 9 of the fund's term. Needless to say, periodic testing is preferred by LPs as it mitigates clawback exposure and avoids a situation where a GP can avoid a clawback by delaying selling straggler investments at the end of the fund's term. Now typically, a GP is only required to return after-tax amounts, as they've had to satisfy their tax liabilities on an annual basis and those amounts will already have been paid to the applicable tax authorities. Parties also need to assess the credit risk with respect to these clawback obligations. For example, some LPAs include escrow mechanisms. Escrows provide stronger credit comfort that the cash will be there in the event of a clawback, but come at the cost of requiring the capital to be tied up, which is unpopular with GPs. For that reason, where escrows are used, they typically include only a portion of the GP's carry – say 30%. Because of this, the escrow may not be sufficient in the event of a larger clawback. The unpopularity of escrows with GPs because of their cash drag has meant that guarantees are a more common mechanism for providing credit comfort with respect to a GP's clawback obligations. Where you have a guarantee, you'll want to understand who is bound by that guarantee and what portion of the carry is subject to the guarantee. For example, the GP itself may not have the financial wherewithal to satisfy a clawback obligation and for that reason the individual carry recipients who receive the carry often are asked to sign the clawback guarantees personally. Because most private equity funds have terms of a decade or more, there is a meaningful chance that the professionals who signed the clawback guarantees at inception either won't be associated with the fund ten years later or won't have the funds to satisfy their obligations.
Lindsey Goldstein: I would also note, clawbacks can serve to disincentive members of the investment team and put pressure on alignment between LPs and GPs. For example, the investment team may feel that, with time, it could turn the portfolio around, even if a fund has fallen out of carry in the near term based on market declines. On the other hand, and depending upon the investment strategy of a fund, LPs may prefer not to roll the dice on the possibility of a market recovery, particularly for funds that are at or near the end of their terms. Where feasible, we are likely to continue to see both LPs and GPs seeking flexibility from the other side in order to weather this storm. Needless to say, there is a lot to consider.
Originally published by Ropes & Gray, July 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.