This article originally appeared July 8, 2002 on PrivateEquityCentral.net
GPs have lately been magnanimously letting investors have some of their money back in the form of fund reductions. Going forward, some unlucky private equity firms may be required to give back even more, thanks to the "clawback" provision, a seldom-enacted partnership term that can hit GPs in their own pocketbooks.
A clawback goes into effect when it is found that a GP group has paid itself too much carry. Market observers say the rapid bubble-to-bust cycle of 1999 and 2000 period created a prime environment for these overpayments to take place - early profit distributions followed by pandemic valuation meltdowns. Some private equity firms are already taking preemptive action so as to avoid having to write large checks at the end of their respective funds' lives. If certain rumors are to be believed, other GP groups are facing far more devastating consequences.
The clawback provision is sometimes called a "look-back," because it requires a partnership to undergo a final accounting of all of its capital distributions when the fund is wrapped. This task is designed to ensure that the GP receives no more than its fair share of the profits (20% is the industry standard).
Clawback provisions were not a designed check against GP fraud, but rather to address the complicated nature of distributing profits in a private equity partnership. The ultimate return of a fund cannot be determined until the end of its life, some 10 to 15 years after the first investment is made. Along the way, liquidity events occur and capital distributions are made based on a predetermined "distribution waterfall," whereby LPs typically receive a certain amount of the profit before the GPs can take their cut. In addition, after every liquidity event, the fund administrator must make basic assumptions about the ultimate profitability of a fund when dividing up the profits from each exit. Until recently, those assumptions have not included the sentiment, "It's all downhill from here."
These days, a number of funds from late-1990s vintages are grappling with the prospect of producing returns that will look like an inverted J-curve. To make matters worse, the terms of their partnership agreements were not designed to effectively manage the distributions resulting from this aberrational performance.
The clawback issue facing these firms can be illustrated by the following scenario - a venture capital firm raises a fund in the late 1990s and its first investments are quickly exited at dizzying valuations. Profits are distributed to all, and the GPs enjoy big paydays. Then the market collapses, along with the rest of fund's unexited portfolio companies. Despite the early successes, it now looks like the fund might not be able return the "hurdle rate" - the minimum IRR that LPs must receive before the GPs get any carry (frequently 8%). If the fund does not ultimately return profits north of this preferred return, the money the GPs have already paid themselves must be (gulp) returned to the LPs.
The scenario detailed above has until recently existed more in theory than in practice. Now, many market participants are preparing themselves to deal with the real-life issues surrounding clawbacks as the need to enact this term appears on the horizon.
Louis Singer, a partner at law firm Orrick Herrington & Sutcliffe who specializes private partnerships, says concern is rising among investors that some GPs may have taken too much carry in the early stages of their respective funds' lives. In less uncertain times, private equity GPs were better able to manage their distributions so that the carry paid ended up right on the mark when the fund wrapped. Now, with valuations having fallen further than anyone expected, Singer says, "I'm not sure that you can manage to that result."
A consultant who advises on private partnerships says many of the vintage 1998 and 1999 venture capital funds, the ones most vulnerable to early success and subsequent failure, do not have terms sufficient to mitigate potential clawback problems.
Quite in line with LPs, general partners would rather take care of clawbacks sooner than later. Not least among the reasons for this is the issue of taxes. When GPs pay themselves carry, they must also pay taxes. If, years later, they must refund part or all of that carry, it is for the full, pre-tax amount. (To address this potential headache, many clawback clauses, in fact, specify that the return be the GP's after-tax gain).
Rather than waiting for clawbacks to be exercised, a number of venture capital firms have already begun to work out revised distribution schemes with their investors. A portfolio manager at a major institutional limited partner says one of his venture capital funds sent a letter to investors admitting a possible overallocation of carry, and proposing a "fix" going forward. The fund, which is "about four years old," the LP says, will not pay itself any carry until an amount equal to total drawn-down capital is distributed to investors.
Other GPs may not have as pleasant an option. A certain story is making the rounds in the venture capital world with the velocity, and vagueness, of an urban legend. It describes a nightmare clawback scenario at a venture capital firm of undetermined identity. The story goes like this - the fund had an early, huge exit. The proceeds of the exit were distributed "in kind" - in other words, as stock, as opposed to cash. Venture capital firms usually record the value of an in-kind distribution based on the value of the stock at the time of the distribution. According to the rumor, the value of the stock distribution subsequently descends into worthlessness, as do most of the remaining portfolio companies. The initial exit may have had a huge IRR, but the fund's IRR will turn out to be flat or negative. Now the GPs owe the LPs a huge clawback, but there's a problem - they simply don't have the money. The GPs were not able to realize the full value of the carry they distributed to themselves. They also do not have the necessary personal wealth to make good on the clawback. One version of this story has the general partners being forced to declare personal bankruptcy.
Which leads us to a second implication of the clawback provision - the issue of credit. Under the provision, the GP agrees to write a check to the LPs if an over-distribution of carry is discovered. But is this guarantee backed up by living, breathing people or by a shell entity? The clawback provision may be hard to enforce unless it is tied to the personal wealth of the various partners. In addition, the LPs' ability to recover capital may be influenced by whether the various GPs are bound by a "several" obligation or a "joint-and-several" obligation. On a several basis, the partners of a private equity firm are responsible only for their respective proportional ownerships of the GP On a joint-and-several basis, a single partner must make good on that portion of a liability that the other partners, for whatever reason, are unable to pay. On a joint-and-several basis, if there are four partners, and two go bankrupt and one flees to Panama City, the fourth must pay the entire clawback.
Because many clawbacks are backed by the partners themselves, the issue can be a personal one within private equity firms. "Within the GP group, there is likely to be a strong difference of opinion on how to deal with clawbacks depending upon each individual's financial situation, " says a veteran private equity consultant. "Some partners. . . have considerable fortunes - others do not. For those less well off, a delay [in paying a clawback] may be preferable [because they hope] a few late bloomers in the portfolio may save them."
The many ways that clawback provisions can theoretically wreck venture capital firms are fascinating, if depressing, to think about. But as of yet, there has been little in the way of real legal action related generated by this term. No one interviewed for this article said they had ever dealt with the issue. Orrick's Singer says he spoke at a bar association conference three years ago, where he asked a room full of lawyers if anyone had ever seen a clawback provision exercised. "Not a single person raised their hand," he says.
The clawback rumors could turn out to be more severe than the reality. But one thing is certain - a large number of market insiders are gaining a quick education on a partnership term that once seemed rather innocuous.