CARRY CONTINGENCIES

Something of a stand-off is occurring in private equity that bears some resemblance to the strike currently crippling Hollywood.

The US entertainment industry has been brought to a standstill thanks to an ongoing writers' union strike, the central dispute of which is royalties from the sale of online entertainment content. The writers are demanding a piece of these, while the studios argue it's too early to even know what future online economics are going to look like, let alone haggle over them.

In private equity land, GPs and LPs alike are worried that a new US government will push through a tax hike on carried interest. Of course, no one knows exactly what this will look like, should it come into effect. This uncertainty has not prevented GPs from rushing to include language in new partnership agreements that would allow them to take action should a tax change materialise. LPs, however, are suspicious of any pre-emptive fixes to problems that haven't yet taken definitive form. A consensus on how to address this contingency has not yet emerged.

According to a number of legal experts and limited partners, there has been a substantial uptick in GPs attempting to monkey with carried interest. Many GPs have test-flown a variety of partnership terms that address the issue of a carried interest tax hike, only to have the language shot down by LPs. The first attempt to go down in flames, put forward by some GPs, was the right to raise the rate of carried interest (up from 20 percent) should the tax rate on carry rise. One major LP – a fund of funds – told me he already has an answer for any request for him to true up GP economics: “NFW”.

Short of asking LPs to foot the bill for new taxes on carry, GPs and their counsel have crafted vaguer language that allows them to take some form of action should a tax change occur. This language comes with the proviso that any partnership term change would not adversely impact the LPs. They are describing this language as a “placeholder” that would be referred back to in the event that the tax on carry is raised.

No matter the assurances, many powerful LPs see sinister intentions at work. They question whether any fix can be found for a carry tax hike that would have the effect of boosting GP pay while keeping LP economics the same. They see a zero-sum game where extra taxes need to be paid by one or the other party. Louis Singer, who as a fund formation partner at law firm Morgan Lewis represents a long list of LP clients, says he has asked GP counsel why they see a need for language to address an event that hasn't happened yet. Should a tax change occur, he says, “LPs and GPs can always talk. Do we really need a placeholder?”

A desire to tinker with carry seems to be manifesting itself on several fronts. Fund formation lawyers also report an increase in partnerships on the market that are seeking “premium carry”, by which the economics to the GP increase if performance passes a specified hurdle. The most common hurdle is based on a multiple of equity returned to investors, as the IRR hurdle can create the same administration headaches to which clawback situations give rise.

Arrangements by which GPs get paid more than 20 percent of profits if they surpass certain performance hurdles have long existed in the industry, but the last time they flourished was during the Internet boom of the late 1990s. Today, uncertainty over taxes as well as the increasing power of established top-tier firms may be driving the momentum on premium carry.

The unexpected spectre of GPs having their incentive fees axed by the taxman may be the catalyst that further divides the industry into haves and have-nots. Already the biggest firms are commanding a greater and greater percentage of the capital under management. With demand for their services so high, a new model of carry may emerge among the elite that ultimately offsets higher taxes with higher fees. The LPs need to decide under what circumstances this rate hike is acceptable.