In early May we explored what it means for a fund to fall out of carry. The bottom line: taking back performance fees will play out differently depending on a fund’s waterfall structure; the mechanics of the clawback set out in the fund’s governing documents can minimise risk for both GPs and LPs alike, and positioning funds back into carry requires time.
In subsequent conversations with industry practitioners, we looked further into factors that impact clawback risk and their implications in the long-term.
Fund life, not fund size
Funds at the tail-ends of their lives are likely to be more affected by clawback issues than others, according to Blaze Cass, a senior vice-president at Meketa Investment Group.
A fund halfway through its term might have seven years left or more to turn around any investments that were negatively impacted by a downturn such as the covid-19 crisis, compared with those which have less time, he said.
“Timing can have a big impact,” Cass noted.
Being ‘well capitalised’ matters
Larger funds which have more capital on reserve have an advantage when it comes to meeting clawback obligations, according to Sarah de Ste Croix, a funds lawyer at Stephenson Harwood.
“Larger GPs might be able to meet any carry clawback obligations out of existing reserves whereas smaller managers may have less reserves and therefore may need to look to any personal or institutional guarantees to meet any shortfalls,” de Ste Croix said.
It will depend on what clawback and escrow obligations were put in place at the time of the fundraising, she added.
KKR, for example, noted in its first quarter earnings call this year that the firm had $2.5 billion of cash and short-term investments in addition to its undrawn revolver capacity, which provides liquidity as well as financial flexibility. The buyout giant has roughly $90 million of clawback exposure and had close to $1.3 billion in accrued carry on its balance sheet as of end-March, the firm said in early May.
A multi-platform model is also beneficial, added Todd Silverman, a principal at Meketa.
“It doesn’t necessarily go hand in hand with a larger fund size, but if you are a GP with multiple strategies or product lines, that can be another source of funds and provide a cushion as opposed to a mono-line strategy or firm,” Silverman said.
Potential clawback issues will also depend on the structure of who is obligated for the clawback or whether the management company is guaranteeing the clawback obligation, he added.
“If the clawback obligation rests on the partners individually, there may not be much protection from having a larger or better capitalised management company.”
A different skin-in-the-game
The covid-19 crisis may mean the usual level of GP commitment – often funded by carry from prior funds – may look somewhat different in the next fundraising cycle.
“Where funds are dropping out of carry or where there’s a vintage gap so that there is less money being delivered to more junior investment professionals, it might be that executives will find it harder in the future to fund their co-invest commitment out of their own pocket,” de Ste Croix said.
She added that a more long-term impact of this circumstance may be that LPs become more flexible, particularly with smaller funds, on management fees. Without the long-term incentive of carried interest, GPs may look to LPs for increased management fees so they can use this to retain top investment talent.
Gabriel Boghossian, a partner at Stephenson Harwood, noted spin-offs could also happen as a result of carry being pushed out.
“Carry is an incentivisation but also a loyalty-based metric that’s designed to keep you at the same platform,” said Boghossian.
If executives are not receiving carry, they could be incentivised to start their own firms when the market recovers or will be more open to moving to another firm, he said.