Are the terms of US and European private equity funds converging?

Terms of private equity funds organised in Europe are moving ever closer to those governing US-based vehicles, find Michael P. Harrell and Marwan Al-Turki of Debevoise & Plimpton.

In the Spring 2002 issue of the Debevoise & Plimpton Private Equity Report, we examined the differences between US and European private equity funds, and found that a number of the previously existing differences had narrowed in the period from 1997 through 2001.  In this article, we look again at trends in structuring European private equity funds and ask the question:  “Are the terms of US and European private equity funds converging?”  In trying to answer this question, we reviewed the information added to our proprietary funds database since 2001. 

To refine our analysis further, we took a more detailed look at 40 major European private equity funds raised in the last two years.  Finally, we canvassed the lawyers in our London, Paris and Frankfurt offices who work regularly in this area. We found that the trends identified in our Spring 2002 issue have continued and that, in several respects, the terms of private equity funds sponsored by European firms continue to move even closer to those of US funds.  We predict that this trend will continue.

The areas of “convergence” that we identified and predict will become more apparent include: 

(1)  a possible movement in Europe toward the “all deals realised to date” model for carried interest distributions described below;

(2)  an increased focus in Europe on general partner (GP) clawbacks and increased use of carried interest escrows and, to a lesser extent, personal guarantees of the GP clawback obligation by principals of private equity firms;

(3)  a movement in the UK away from the multiple partnership structures previously required by the now defunct limit on the number of partners in a UK investment partnership;

(4)  an increased use in Europe of so-called “limited partner (LP) clawbacks” and “no fault divorce” provisions.  We also continue to see areas where US and European funds differ, and are expected to continue to differ, although this “non-convergence” is often a matter of form over substance.

Timing of Carried Interest Distributions.  Historically, most European private equity funds provided for the return to the LPs of all capital contributed by them to the fund before carried interest was distributed to the GP or other carried interest recipient [see note 1 below].  In this article, we refer to this as the “return all contributions first” model.

In the United States, by comparison, since the 1980s most private equity funds have used a different model.  The US model, like the “return all contributions first” model, nets gains and losses across the portfolio but, unlike the “return all contributions first” model, allows the GP to receive carried interest on what we shall call an “all deals realised to date” basis.  In this distribution model, each time a portfolio company is disposed of at a gain, the GP is allowed to take its carried interest on that deal, so long as investors have received a return of (1) all capital invested in that portfolio company and in all portfolio companies previously disposed of, (2) related fees and expenses and (3) amounts by which companies that remain in the portfolio have been written down or written off [see note 2]

The “all deals realised to date” model has the advantage of potentially allowing the GP to receive carried interest much earlier than would be the case with the “return all contributions first” model, but significantly increases the risk of the GP receiving an “overdistribution” of its carried interest entitlement, requiring a “clawback” from the GP of the overdistribution.  (For more detail on these two models and GP clawbacks, see the article on clawbacks that appeared in the Fall 2000 issue of the Debevoise & Plimpton Private Equity Report.) 

Whatever one’s preferred model, it is the case that, until recently, most private equity funds organised by European sponsors have followed the “return all contributions first” model.  This may be due in part to the historically greater proportion of institutionally sponsored funds in Europe (which is rapidly changing as such institutions spin off their private equity businesses), as compared to the United States with its large number of boutique private equity firms.  It seems likely that institutional fund sponsors with multiple lines of business are less focused on early receipt of carried interest (they may be less dependent on the cash flow and thus happy to defer receipt of income and tax thereon) than is the case with private equity boutiques owned by individual principals.  In addition, an institutional fund sponsor may also be more averse to exposing the institution to clawback risk.  For both reputational reasons and because it is a “deep pocket”, an institutional fund sponsor may realise that it will be required to make the fund whole if a clawback is triggered, even if some of the carried interest was paid to individuals who worked for the institution but then left and defaulted on their fair share of the clawback obligation.

The data in our database shows an increase in the number of European funds following the US “all deals realised to date” model in the last twelve months.  However, the US model is by no means “market” in Europe, and the best known and most successful UK funds continue to follow the European model of returning all contributions first.  A number of European LPs have told us that they are resisting any trend in Europe toward adoption of the US distribution model.  We are aware, for instance, of a recent high profile European fund that went to market with a US-style “all deals realised to date” distribution scheme, but was forced during the course of negotiations with LPs to change to the “return all contributions first” model.

Interestingly, in recent months some US LPs have been discussing the desirability of returning to the “return all contributions first” model for US funds (or for annual “true-ups” of the clawback, which has a similar economic effect).  This is perhaps not surprising, given the number of US GPs that are currently facing large clawback obligations in funds using the “all deals realised to date” model.  However, thus far we have not seen this approach seriously negotiated in the United States.

We think that it is likely that, for better or worse, the movement in Europe toward the US “all deals realised to date” model for distributions will continue.  European LPs may succeed in slowing this down in the short term, but in the long term we think the trend will accelerate for a number of reasons.  First, European GPs, in particular the middle market buyout funds that are currently in vogue, are asking for it more frequently.  Second, despite clawback concerns, this model has achieved broad acceptance in the United States and has obvious appeal to European private equity firms not affiliated with large institutions (the number of which, as noted above, is rapidly increasing in Europe in proportion to the number of institutional houses).  Third, US LPs, who are increasingly active investors in European funds, are familiar and generally comfortable with this approach. 

As for the United States, we do not expect to see the “return all contributions first” model take hold there in any meaningful way, despite concerns expressed by some US LPs about the greater clawback risk posed by the “all deals realised to date” model.

Security for GP Clawbacks.  Clawbacks from the GP of overdistributions of carried interest are almost universal in the United States and in Europe.  However, one area where we do see a difference is in the security for these clawbacks.  Since most GPs are special purpose vehicles that immediately distribute carried interest out to the private equity firm and/or its principals, the GP’s clawback obligation to the fund has little substance:  the GP generally has no assets.  Thus, in the United States LPs have required that most clawback obligations be guaranteed by the individuals or institutions that own the GP. 

Indeed, these guarantees are almost universal and clearly “market” in the United States, although there are often intense discussions between GPs and LPs as to whether the guarantees should be joint and several, or merely several, obligations of the guarantors.  Holdbacks or escrows of carried interest to secure the clawback obligation are relatively unusual in the United States, by comparison.  Only 18 per cent of the buyout funds and 5 per cent of the venture capital funds in our database that were organised after 1990 have such provisions (not surprisingly, escrows and holdbacks are more frequent in first-time funds, and less so for funds sponsored by more established firms).

In Europe, the situation seems to be reversed.  We see holdbacks/escrows securing the clawback obligation with increasing frequency in Europe; indeed, they are much more common in Europe than in the United States.  Until recently, however, we rarely saw personal guarantees by principals.  This may be changing.  In the past six months or so we have seen a small increase in the numbers of personal guarantees in European funds.  It is possible that personal guarantees will become more prevalent in Europe, particularly as US institutions increase their participation in the market; however, there remains a deeply ingrained resistance to personal guarantees by European principals, who may well prefer continuing to offer large carried interest holdbacks rather than guarantees.

LP Clawbacks.  As discussed in our Spring 2002 issue, from 1990 through 1996, none of the European funds in our database had LP clawback provisions.  (Such provisions require partners to return distributions to cover “end of the fund” liabilities, including fund indemnification obligations.)  This compared to 19 per cent of US buyout funds in our database that had LP clawbacks during this period.  Since 1997, the percentages increased to 15 per cent for European funds and 37 per cent for US funds.  In the past year, we have seen this trend accelerate in Europe.  Of the 40 European funds reviewed for this article, 18 per cent had LP clawbacks.  LP clawbacks now appear frequently in at least the first drafts of partnership agreements of European funds that we review, whereas even two years ago we rarely saw such provisions in European funds.
We expect that LP clawbacks will become more common in both US and European funds, and that they will rapidly become as prevalent in European as in US funds.

No Fault Divorce Provisions.  As with LP clawbacks, we are seeing more European funds include so-called “no fault divorce” provisions, i.e., provisions that allow a supermajority of LPs to vote either to suspend the investment period or to remove the GP, in either case without cause.  In our Spring 2002 look at this issue, we saw that in the period from 1990 to 1996 (when the Mercer Report, which strongly advocated such provisions, was issued), “no fault divorce” provisions were included in 32 per cent of US buyout funds and 25 per cent of European funds.  In the period from 1997 to 2001, the percentages had increased to 51 per cent for US funds and 26 per cent for European funds.
Since 2001, we have seen a significant increase in the frequency of these provisions in European funds, due perhaps to increased penetration of the European private equity market by US institutional investors.  Whatever the reasons, we believe that these provisions have now become “market” in Europe.  Of the 40 recent European funds reviewed for this article, 68 per cent (27) had a “no fault divorce” provision in one form or another.  We expect this trend to continue, with these provisions possibly becoming as common in European funds as in US funds.

It should be noted, however, that there is one twist that differentiates European “no fault divorce” provisions from their US counterparts.  European no fault removal (but not no fault suspension) provisions usually have “tails”; that is, they generally provide that the fund manager will be entitled to receive management fees for anywhere from 6 months to two years after its removal.  US provisions do not contain this “tail”; in the United States such a “tail” is seen as overly aggressive by most LPs and, in any event, most likely would be deemed a penalty that is not permissible under the Investment Advisers Act of 1940.

Single Partnership.  In the Winter 2002 and Winter 2003 issues of the Debevoise & Plimpton Private Equity Report, we reported on the elimination in the UK of the requirement that UK investment partnerships have no more than 20 partners.  The old requirement had resulted in many UK funds being organise as a series of parallel partnerships, each with no more than 20 partners.  The resulting proliferation of vehicles, especially as UK funds grew much larger in the late 1990s, has had a number of negative consequences:  (1) it increased organisational costs; (2) it complicated closings (because, for example, if the fund made an investment in a portfolio company before its final closing, and then the relative sizes of the parallel partnerships shifted as additional investors were admitted, it became necessary to transfer cash and securities among partnerships to keep their respective holdings proportionate to their relative sizes); (3) it increased administrative burdens, and costs, on fund managers over the entire 10 year (or longer) term of the fund; (4) it required that separate audits be done for each partnership; and (5) it complicated voting on, for instance, amendments.  Some LPs have expressed concern that these multiple partnerships also decrease transparency: one LP may never see the partnership in which another similarly situated LP invests.

The use of parallel partnerships encouraged UK sponsors to place different categories of investors into different partnerships.  The most typical example of this is US investors, whom UK fund sponsors have often placed into a parallel partnership, which was sometimes a Delaware (as opposed to an English) partnership.  US pension plans and other investors subject to ERISA sometimes also have had their own partnership.

In the United States, by comparison, there has been no such restriction on the number of partners in an investment partnership, and for over two decades our firm has helped organise funds for US fund sponsors using a single partnership, with special provisions “built in” to address concerns of particular classes of investors, such as ERISA investors and banks.  That being said, we do often help US fund clients organise parallel and feeder vehicles to deal with tax and regulatory concerns of particular classes of investors (including certain European investors), but investors often decide, upon closer examination, that these additional vehicles are not needed.  As a result, most US private equity funds consist of one partnership or, at most, two or three parallel and feeder vehicles that address the needs of all classes of investors, eliminating unnecessary cost and administrative burdens.

Some fund groups and lawyers in the UK have continued to organise funds with multiple partnerships for reasons other than tax concerns.  They may wish, for instance, to keep all US investors, or all ERISA investors, in a separate partnership to insulate non-US investors from perceived adverse US taxation, ERISA or litigation risk.  While we understand these concerns, we believe that some of them are overstated and can be addressed with, for instance, excuse and mandatory transfer provisions (as is common in the United States).

It should be noted that, because the tax regimes across Europe are not harmonised, we do expect to continue to see and work on more parallel and feeder vehicles in Europe than is the case in the United States, in order to optimise returns for different classes of European investors.  An example is the Netherlands parallel CV/BV structure, often used because corporate fund structures, which are rarely used in the United States, are tax efficient for certain European corporate investors, resulting in the creation of a BV for them and a CV or a partnership vehicle for other categories of investors. 

Nevertheless, with the elimination of the artificial UK 20 partner limit, and as funds and their counsel adjust to the new regime, we believe that the simpler and less burdensome US model, of only one partnership or perhaps two or three parallel and feeder vehicles, will become the norm in the UK

Other Areas of Convergence.  We see additional areas where the terms of US and European private equity funds are becoming more alike.  First, while levels of investor due diligence and insistence on transparency, as well as the sophistication of investors in negotiating fund terms, are uneven on both sides of the Atlantic, European investors are perhaps still behind their American counterparts in these areas.  We expect, though, that the amount of due diligence by European investors, and their aggressiveness and sophistication in negotiating terms and insisting on greater disclosure by GPs, will increase as their exposure to private equity as an asset class increases.

In addition, we expect investors in funds organised in both the United States and Europe to negotiate more intensely over the sharing of transaction fees charged by fund sponsors.  This has been an issue of concern to LPs for many years now, and has not gone away.  Our sense is that, in the past, this issue was less heavily negotiated in Europe than in the United States.  We believe, though, that recently European investors have become as heavily focused on this issue as their US counterparts.  We predict that this issue will continue to be a major focus for investors on both sides of the Atlantic.

In general, as the European market matures, and with regulatory changes and increasing transparency, we believe that European funds will move more toward the US models and adopt the US-style terms discussed above.  Our view comes from the perspective that we have of the European industry through our team of fund lawyers in London, Paris and Frankfurt, who work closely with our US fund lawyers and continuously exchange market intelligence across the Atlantic divide.

Areas Where Differences Remain.  Despite the areas of convergence discussed above, in a number of respects US and European private equity funds will continue to differ, although these differences are often more a matter of form than substance.  First, European funds will continue to be structured somewhat differently from US funds, largely for tax reasons.  At the investor level, this is driven by the fact that European tax and regulatory regimes vary greatly, so that one fund structure will not necessarily work for all of the main European investors in this asset class.  At the GP level, carried interest optimisation poses challenges where principals are tax residents of more than one country, for much the same reasons.  This leads to a variety of solutions to this problem, which are generally different than those used in the United States.  At the manager level, VAT concerns (where VAT is charged on management fees, resulting in an irrecoverable cost to the fund) are also relevant; for instance, in order to get over this problem, UK funds structure the management fee as a guaranteed profit share of the GP (which in turn pays some or all of that amount on to the fund manager).  As for carried interest, UK funds generally follow the BVCA/UK Inland Revenue model and pay carried interest to a special purpose LP rather than to the GP.  These last two issues are outlined in the article comparing the structures of US and European funds appearing in the Winter 2003 issue of the Debevoise & Plimpton Private Equity Report.

Second, some techniques that are commonly used in the United States to achieve tax savings for GPs—such as payment of organisational expenses and placement fees by the fund, coupled with offsets to the management fee for organisational expenses in excess of the cap and offsets for all placement fees—have not been used in Europe, generally because the same tax concerns do not exist in Europe.

Third, other innovative techniques that we have developed for private equity sponsors—such as funding of the GP’s capital commitment through a management fee deferral mechanism, and integrated estate planning for the principals of private equity firms—are only now beginning to be seen in Europe.  We are discussing these techniques and approaches, which we have used in the United States for well over a decade now, with our European clients, but thus far they have not been widely adopted in Europe.

Finally, we note that an understanding of the laws of the jurisdictions where private funds are organised or operate is important.  Some terms of US private equity funds and European private equity funds appear to be the same or are expressed in the same way (such as the standard of care and the mechanics of default provisions).  However, such provisions in fact may operate differently because of differences in the interpretation or enforceability of such provisions in different jurisdictions.  For example, although many fund  agreements purport to indemnify the GP against acts other than “gross” negligence, the laws of Delaware, France, Germany, Jersey, England and The Netherlands may give this term different meanings—or no meaning at all.  Similarly, although many fund agreements provide for forfeiture by an LP of some or all of its interest in the fund if the LP defaults on a capital call, such provisions may not be enforceable in some of these jurisdictions, such as England, in contrast to Delaware, where forfeiture provisions are explicitly authorised by the Delaware limited partnership law.  Thus, differences will continue to exist among jurisdictions, absent changes in the law, even where the fund terms do not appear to be different.
Conclusion.  The European and the US markets for private equity funds continue to evolve.  While we cannot predict the future, we are seeing the adoption in Europe of a number of US-style terms and provisions with which we are intimately familiar, and we expect these trends to continue.

Michael P Harrell and Marwan Al-Turki are partners at Debevoise & Plimpton, based in New York and London respectively.

[1] Two comments are worth noting:  First, in the case of funds sponsored by UK private equity firms, carried interest is typically paid not to the GP, but to a special purpose LP owned by the private equity firm and/or its principals.  However, for the sake of simplicity, in this article we will use the term “GP” to refer to the entity receiving the carried interest from the fund, whether or not it is in fact the general partner of the fund.  Second, we note that as recently as the late 1990s boom era, a number of European funds, like many US funds organised before 1985, did not net gains and losses across the portfolio.  However, this alternative model is not discussed in the article because the number of these funds in Europe today is very small.

[2] We note that many US venture capital funds use a somewhat different formulation, which appears to be the “return all contributions first” model, but is not.  The partnership agreements of these venture funds state that all contributions must be returned first, but then permit early payouts of carried interest if certain fair value tests are met.  In effect these funds operate much like buyout funds, on an “all deals realised to date” basis.