FUND TERMS Waterfall wars

Last month the Institutional Limited Partners Association (ILPA) – a trade group for LPs – released a set of “Private Equity Principles” designed to promulgate terms that LPs prefer. CalPERS was the first organisation to endorse the principles, which ILPA says are meant to frame a conversation about terms, not dictate them.

The ILPA principle that likely raised the most eyebrows is one advocating what is often called the “European-style” waterfall formula, whereby the general partner only begins collecting carried interest after the return of all contributed capital plus the preferred return. This term is standard in Europe but somehow US GPs have over the years largely won the right to begin collecting carry before it is clear that the fund as a whole will generate any carry.

The downturn has raised the spectre of hundreds of millions in clawback obligations, which arise in deal-by-deal funds where, lo and behold, the GPs have overpaid themselves early in the fund's life. This issue has been highly frustrating for LPs, according to an ILPA member, and the prominence given to the all-contributions-back-first model in the ILPA principles is one result.

Also diluting sympathy for GPs who prefer deal-by-deal carry is the fact that, during the boom, some fund managers paid themselves carry on the flimsiest inklings of deal success. In some cases, GPs withdrew cash carry based on partial, unrealised exits, such as IPOs. In other cases, carry was paid based on dividend recapitalisations well before the equity in the deal had been fully repaid, leaving a company's balance sheet in worse shape but its financial sponsors in possession of hard cash.

Actual end-of-fund clawbacks are so onerous to execute that LPs are scrambling to do anything that makes them an endangered species.