The Institutional Limited Partners Association, which has grown to more than 240 members at a time of growing limited partner power, this month called for additional protections for LPs faced with a situation where a general partner takes profits early in the life of a fund that eventually have to be returned to investors.
Why this occasionally happens stems from the fact that most buyouts firms today can begin sharing in profits well before they return all committed or contributed capital back to investors. A typical formulation would be for the sponsor to have to return the cost basis of all realized investments, plus unrealized write-downs and write-offs, plus related fees and expenses, as well as a priority return. This is commonly called a deal-by-deal distribution waterfall.
Most partnership agreements include a GP Clawback clause, which creates an obligation on the part of the GP to return any profits taken pre-maturely to ensure that the investors don’t get short-changed on their 80 percent profit-share (typically). In the first edition of its “ILPA Private Equity Principles,” published in 2009, ILPA included three recommendations for how its members should structure the GP clawback:
1) Any clawback liabilities should be disclosed to investors at the end of every reporting period, along with a plan to make investors whole;
2) The clawback should include any taxes paid by the GP and paid within two years of the clawback being discovered;
3) The clawback liability should be joint and several, so that each member of the GP is liable for the full amount of the clawback obligation.
The second edition of the principles, released this month, includes a more extensive set of GP clawback recommendations, including a net asset value coverage test that would be used to help ensure that the value of the a portfolio has appreciated enough to justify a distribution of carried interest to the GP. Other additions:
1) If GPs go a deal-by-deal waterfall, ILPA recommends including a requirement for interim clawbacks to be paid at pre-defined intervals should the clawback get triggered;
2) In cases where the clawback liability is not joint and several, ILPA recommends that the GP nevertheless make some kind of “creditworthy guarantee” by, say, a parent company, or an individual member of the GP. “An escrow account (generally of at least 30 percent) may also provide an effective mechanism for clawback guarantee,” wrote ILPA.
3) In a concession to the GP, ILPA reversed its stance on whether the GP clawback should be gross of tax distributions, noting that “after extensive discussions with GPS, we believe that it would be impractical to ask them to bear the cost.” However, ILPA also suggested that LPs guard against situations in which GPs “reduce the tax burden through carrying losses forward, offsetting a gain against a loss, or living in a favorable tax jurisdiction.” ILPA added: “GPs clearly should not make a profit from the LPs’ willingness to bear their tax payments in clawback situations.”
The revised set of pinciples also call for a more standard approach to capital calls and distribution notices. ILPA has developed generic reporting templates to as a starting point from which other templates can be evolved. The idea is to create a standardized format for the documents to prevent confusion between GPs and LPs and reduce expenses, said Tim Recker, ILPA’s chairman. “The information you need to deal with a capital call notice is…complicated,” he said during a Jan. 11 conference call with reporters. “We’re saying, let’s put a standard out there so GPs can follow that.”