Most negotiated term: GP desire for clawbacks on carry waivers

One of the most negotiated terms recently involves GPs building in the right to waive performance fees on investments they sell after holds of under three years, sources told Buyouts in recent interviews.

GPs are adding this right to limited partner agreements governing new funds they bring to market. Some have even asked for amendments to existing funds to give themselves the carry waiver ability.

This is all in the name of avoiding the higher tax hit that comes with investments sold after a firm holds it for less than three years. Performance fees on these short-hold investments are charged ordinary income tax rate that can go as high as 37 percent. Carry from investments exited after holds of three years or more are charged at the capital gains rate of 20 percent.

So on short-hold investments, GPs may elect to push off collecting carry to subsequent investments in the fund. In funds with lots of investments left to sell, this strategy carries less risk. But with funds that are nearing their end, pushing off carry to one or two remaining investments can be a risky bet.

Perhaps because of this, some GPs have tried to protect themselves from failing to qualify for performance fees in remaining investments. Some GPs (I’m not sure who, hint hint) have asked for provisions in fund contracts that would allow them to claw back those waived fees at the end of the fund life in case they don’t make up the fees in subsequent exits.

That ask appears to be a bit too much for most LPs, according to sources. “The trick is going to be making sure they don’t have, right at the end of the fund, come back to you and say, ‘well, we want that money’,” according to a separate LP who has taken part in such negotiations.

“In terms of truing up carry, sorry guys, if you’re getting cute to avoid taxes, you eat your cuteness if you don’t make the number you thought you were going to make,” the LP said.

Asking for this sort of true-up provision is not widespread, sources told me. Jeremy Swan, managing principal in the financial sponsors and financial services group at CohnReznick, said he has not heard of GP asking for that type of provision.

“I can certainly see the LP reaction being, that’s taking it a step too far,” Swan said.

Waiving carry on short-hold investments is a reaction to the 2017 tax reform, which included provisions that charge an ordinary income tax rate on carry generated from investments held for under three years.

Under this strategy, limited partners would get 100 percent of the proceeds from deals subject to the higher tax rate, while GPs would collect nothing, sources said. In subsequent deal, the GP would have the right to collect a disproportionate amount of carry to catch up to what it was owed from the waived carry.

“I think deferring carry is one way that GPs manage their tax burden and I don’t blame anyone for not paying more in taxes than the law requires,” said a separate LP.