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Addressing clawback concerns

April 2024

4 April 2024 - Provisions that mitigate clawback risk are becoming a more important part of the LP-GP conversation, says Tim Eberle, managing director and head of waterfall services at the Citco group of companies (Citco).

Fund service providers report an uptick in clawback risk enquiries. What is driving that?

In general, clawback refers to a situation in which the GP of a private equity fund has realised carried interest, taken money out of the fund and then suffers a subsequent loss and needs to give that money back to the LP. You generally find clawback associated with American-style waterfalls and it has always been there as a risk, because in those structures GPs can take carried interest payments from a fund on a deal-by-deal basis.

The issue we are seeing now is that macroeconomic conditions are forcing private equity funds to delay exits for longer and extend hold periods, meaning the preferred return component of the waterfall – which is time-weighted and compounds over the life of the fund – is becoming a tighter threshold for GPs to pass. Essentially, every day that a realisation is delayed means the dollars needed to go back to the LP before the GP can take carry increases. So even if the fund sells the deal profitably, if those profits are not in excess of that preferred return hurdle, the GP is not entitled to carried interest.

How can LPs best mitigate clawback risk, and what role can technology play in this?

There are really two solutions to clawback risk, one of which is structural and the other practical, with the latter being where technology can play a role.

The structural ways of mitigating clawback risk involve crafting provisions into waterfall agreements and side letters that force funds to adopt a structure that mitigates that risk. One such provision might be changing the definition of the preferred return, which does not have to be structured as a time-weighted instrument. GPs can move from a time-weighted preferred return to something like a multiplier on contributed capital, saying for instance that before a GP is eligible for carry, it must reach a preferred return that is a 1.5x multiple on capital contributions. That is something that can go into the limited partnership agreement, which doesn’t increase over time and is calculated on a per-investment basis, taking that pressure away.

Another option is an aggregate expense recoupment provision, where the waterfall is structured so that LPs recoup all their capital contributed for fund-level expenses before GPs become eligible to receive carried interest. That accelerates the rate at which dollars get back to the LP before the GP takes carry and thereby reduces clawback risk.

Both of those provisions can be codified contractually, allowing the GP to continue to benefit from an American-style waterfall, which they want, while mitigating the risk of the clawback.

Clawback risk can also be mitigated by applying more detailed scenario analysis to the portfolio, and that is where technology comes into play. We recommend that on a quarterly basis funds go through a detailed stress test programme of scenario modelling, looking at their entire portfolio and what could happen in various worst-case scenarios. That exercise gives a sense of the real scale of clawback risk, but it is difficult to do with Excel because it involves so many variables. For that reason, we suggest applying technological solutions to those calculations, which can then also be used to help front-office decision making when determining the optimum time for investments to be sold.

This guidance on clawback mitigation can be beneficial for LPs, but what is the impact on GPs?

Clawback is not a good situation for either GPs or LPs. LPs want to do anything they can to avoid clawback, if for no other reason than the fact that the vast majority of clawback provisions in LPAs only entitle the LP to clawback the post-tax value of the excess carry the GP has realised, so they never get their full dollars back.

The GP also wants to avoid clawback, because it doesn’t want to start writing cheques but also because, bar something fraudulent happening, clawback is perhaps the most significant risk to any GP-LP relationship. The GP has basically taken more money than it is entitled to and often these disputes end up in litigation.

We don’t necessarily see mitigation as LP-friendly or GP-friendly, but rather it is something that should be addressed together. We don’t think any of these strategies are detrimental to the GP, they just need to be implemented appropriately in order to work for everyone.

What differences are you observing between recent developments in European and American waterfalls?

Five years ago, there were two main waterfall structures: American and European. They were generally implemented in the same way across the board such that any fund with an American-style waterfall would look the same as another fund with an American-style waterfall.

That is not the case today. For a start, there is no longer any geographical distinction between funds that apply American-style waterfalls and funds applying European-style waterfalls – we see both models in all parts of the world. The definition of an American-style and a total return-style waterfall is also becoming increasingly blurry as both GPs and LPs become more sophisticated.

On the LP side, with more capital flowing into these vehicles, they are looking more closely at their fee calculations, and at waterfall calculations specifically, often incorporating some European-like aggregate expense provisions into American-style arrangements, for example. On European-style waterfalls, we are seeing more American-style features, with additions such as multiple preferred return tiers.

We are also seeing a lot of side letters with bespoke waterfall calculations related to those contributions specifically. In short, the whole landscape is becoming more complex and both GPs and LPs are able to get what they want, though that is increasing the complexity of calculations.

How do you see these trends progressing through 2024 and beyond?

What we are seeing more and more as we go forward is clawback mitigation provisions being incorporated at the time of new fund launches. These are becoming a much more important part of the conversation when LPAs are being drafted, when side letters are being written and when funds are being marketed.

Right now, a lot of the funds raised six or seven years ago are approaching maturity and trying to get ahead of a potential clawback event, because this wasn’t such a concern when those funds were formed. In future, the way forward is going to be having these provisions front of mind when funds are being marketed and contracts are being written, to avoid these issues arising down the road.

We don’t see this going away if the economy starts to rebound either, because the cat is out of the bag. Mitigation is the main path forward because clawback is now something that people are concerned about, and institutional LPs in particular are going to continue to prioritise it during allocation decisions.

This article was originally published in Private Funds CFO’s Future of Fund Services issue.

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