A lackluster exit environment means LPs are more likely to seek clawbacks
Citco says it saw a 35% increase in risk mitigation inquiries and active support in 2023
SEC introduced new reporting rules last year covering clawbacks
January 25, 2024 (Preqin News) – A stunted dealmaking environment is leading to growing GP concern over LP clawbacks, according to fund administrator Citco.
With the high interest rate environment delaying funds from realizing their investments, the time-weighting associated with many funds’ fee arrangements has raised the risk of carried interest clawback, it says.
Citco, whose $1.8tn in assets under administration (AUA) includes $800bn of private market assets, says it saw a 35% increase in overall inquiries and active support on clawback risk in 2023.
‘While clawback has always been a concern for GPs, the delay in liquidations due to recent market conditions has, in many cases, made clawback more of a practical – rather than theoretical – risk,’ Tim Eberle, Head of Waterfall Services, Citco Fund Services (USA), told Preqin News. ‘As such, clawback mitigation strategies have been increasing front of mind for PE CFOs.’
The issue has gained greater prominence following the adoption last year by the Securities and Exchange Commission (SEC) of its Private Fund Advisor rule, which introduced enhanced reporting around clawbacks. Under previous versions of the rules, only Chief Executive Officers and Chief Financial Officers were subject to clawbacks. Now, more categories of executives are eligible.
Distribution waterfalls, the way GPs are remunerated, come in two main forms: ‘European’ or ‘American’. Under a European-style waterfall arrangement, GPs are not eligible for an allocation of the carried interest until LPs have recouped their aggregate capital contributions and the associated return in a fund. For American-style arrangements, distributions are made on a deal-by-deal basis, which means that there is far greater room for clawbacks to occur.
The advantage of the American type is that GPs can receive years of carried interest throughout the lifetime of a fund. While clawback risk is higher with the American-style waterfalls, the arrangement is viewed as helping funds recruit and retain the best talent, in turn boosting performance.
According to Citco there are structural mechanisms that could be incorporated into a fund’s Limited Partnership Agreement to mitigate against clawback risk, including non-time weighted preferred return calculations, European-style expense recoupment provisions, and carried interest escrow requirements.
The firm said that, amid the current market conditions, a growing number of its clients have also recognized the value of supplemental scenario modeling at the time of distribution, which helps to appraise the risk of future clawbacks when having to decide whether to realize or ‘defer’ carried interest originating from a profitable realization.
Despite the potentially more complicated clawback risk associated with American-style waterfalls, Citco suggested that other factors support retaining the arrangement.
‘While a European-style waterfall does certainly reduce the likelihood of a clawback event, it also significantly delays carried interest payments to the GP, which could make it difficult for the GP to hire and retain top investment talent,’ Eberle said. ‘We feel that proper waterfall structuring and scenario analysis can adequately reduce the risk of clawback while still allowing for an American-style waterfall structure.’
The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.