Private equity investments are by their nature generally illiquid. Thus, private equity funds are often managed on a deal by deal basis.
In other words, upon disposition of a single investment, absent recycling, the limited partners will typically be distributed their capital contributions and a preferred return (if applicable) both solely with respect to that investment, and the remaining proceeds from that investment will be shared by the investors and management.
In effect, the management group will share in the proceeds of an investment (receive its “carry”) before the limited partners have been returned their capital that went toward other investments in the fund.
The problem arises when certain investments subsequently sour. After all the investments are disposed of and the fund liquidates the investors may not receive their capital contributions or preferred return on an aggregate basis.
The clawback, though, obligates the management team to return all or a portion of their share of the profits previously received from prior deals if subsequent investments are not profitable.
There are other solutions to this problem. Some funds may mandate the return of the investors’ aggregate capital contributions before the management team may share in any profit. Other agreements mimic hedge funds and include a “fair value test” that restricts distributions of profit to the management team unless the net asset value of the fund at the time of the distribution exceeds 100 percent.
Despite these compromises, most private equity funds include a clawback provision. Typically, the clawback is triggered upon the liquidation or termination of the fund and is measured by two alternative thresholds; one from the investors’ perspective and the other from the management team’s perspective. The first threshold is whether or not the investors have received their capital contributions and preferred returns. The second threshold is based on whether or not management has received more than its share of carry determined on aggregate basis including all the fund’s investments.
Regardless of the threshold, the clawback amount is almost always limited to the “after tax” carry amount, i.e., the share of profit or proceeds received by the management team less the tax on such share. However, this limitation is phrased (often incorrectly) in a variety of different forms and there is often confusion among income allocations, cash distributions and the very definition of “carry.”
Simple to Dicey: The Clawback at Work
Example 1: A fund has three investments in X, Y and Z. The investors contribute $300 million to the fund, which is invested in equal portions across the portfolio. Assume there is no preferred return and management is entitled to a 20% carry. In the second year, X is sold for $200 million. The investors receive $180 million ($80 million of which is profit) and management receives $20 million as carry. A year later, though, Y and Z become worthless. From the investors’ perspective, management has received $20 million of profit before the investors received their original $300 million of capital. Alternatively, from the GP’s perspective, management has received more than 20% of the overall profit, thus, under the clawback obligation, it must return to the fund the $20 million less the tax.
Example 2: Same as example 1, except that management does not receive the $20 million on the sale of X because they expect Y and Z to become worthless. Even absent a distribution, management may be allocated $20 million of the gain on X and in most cases will be entitled to a distribution to cover taxes. Depending upon how the after tax limitation is phrased, a clawback may be due. If the after-tax limit is based on cash received and is reduced by actual tax distributions, then no clawback will be due. However, if the after tax limit is based on profit allocated or on cash received, but reduced by actual or assumed tax on such distributions (rather than allocations), then it may be argued that a clawback obligation may be due.
The management right to receive a carry is generally considered a profits interest issued for services. The notion is that the grant of the carry is compensatory but the carry value is worth nothing based upon a liquidation value analysis. After the grant, the right to carry is considered a capital investment that flows through profit to management based on the underlying income of the fund.
Assuming a clawback payment is triggered, it is a payment due with respect to a capital investment and should generate a capital loss. The capital loss may be of limited value if the management team has no capital gains to offset in future years. Moreover, some clawbacks require the management team to increase the clawback amount by after-tax benefits arising from the clawback payment. This can be particularly egregious in the second example used, where the only distribution is for taxes.
An interesting alternative to claiming a current capital loss for a clawback payment is the claim of right deduction under IRC Section 1341. That claim would permit a taxpayer making a clawback payment to reduce the tax in the current year by the amount of tax attributable to the inclusion of the original profit in the earlier year. In addition, the reduction in tax is actually refundable if it cannot be utilized in the year of repayment.
However, Section 1341 applies only if a taxpayer included an item in gross income because it appeared that the taxpayer had an unrestricted right to the particular item. A deduction (greater than $3,000) is allowed in a later year because it was established in the year that the taxpayer had no such unrestricted right.
The difficulty in applying IRC Section 1341 to the clawback has always been the concept of the appearance of “an unrestricted right” to the income. The IRS has interpreted this requirement to mean that the facts that undermine the right to the income must be in existence in the initial inclusion year.
However, a recent case involving Pennzoil-Quaker State appears to support a broader reading of Code Section 1341 and suggests that it applies even when the taxpayer had an actual, rather than apparent, right to the income in the initial year.
The clawback is “hardwired” into the fund documents. Thus, the formula and contingent obligation to repay the carry is in existence before any carry is paid. However, the trigger for the carry obligation is based on aggregate fund results and those numbers are not available when the initial carry is paid.
Moreover, not all clawbacks are created equal. Perhaps, an annual clawback would be more successful under a claim of right analysis because the obligation to repay is not deferred. In any event, recent favorable authority suggests that the clawback may be a proper subject of a claim of right deduction.
A Final Note
The subject of the clawback is limited to the management team’s share of profit paid to investors. However, the clawback protection does not extend to other royalties such as management fees, deal/financing outlays, monitoring and oversight fees, or termination costs.
It has recently been reported that these fees have become a source of profits for buyout shops and have “irked” some investors. Nevertheless, investors have not yet demanded the return of such fees under the clawback.
Perhaps private equity investors have not been so demanding because they realize that the clawback provides them with greater protection than they receive from hedge funds. Hedge funds typically include a “high water mark” or “loss recovery account” to limit carry if losses precede profits but do not have clawback obligations to protect investors when profits precede losses. With the appearance of additional clawbacks in connection with management fee waivers, it is not inconceivable that investors may soon be demanding clawbacks of excess management fees, as well.
Isaac Grossman is a lawyer and partner at Morrison Cohen.