The private equity fundraising environment has been exceptionally strong over the last few years, with ever-larger funds being raised, including a large number of spin-offs and other first-time funds, as the industry has gone through a period of significant growth and consolidation.
Such growth has occurred globally across the US, Europe, Asia and, most recently, the Middle East, and it is likely that it has contributed to a degree of convergence of fund terms across jurisdictions.
The better model?
Historically most European private equity funds provided for the return to the limited partners (LPs) of all contributions made by them to the fund before carried interest was distributed. This is referred to as the ‘return all contributions first’ model.
In the US, 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 European model it allows the general partner (GP) to receive carried interest on what is called 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: 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 such overdistribution.
Whatever one’s preferred model, most private equity funds organised by European sponsors generally follow the ‘return all contributions first’ model. There has recently been an increase in the number of European funds following the US ‘all deals realised to date’ model, including one high-profile buyout fund.
However, the US model is still not market practice in Europe and most European funds continue to follow the European model of returning all contributions first.
It is likely that European GPs will increasingly seek to adopt the US model. European LPs may succeed in slowing this down in the short term, but in the long term it is likely the trend will continue for a number of reasons. First, European GPs are asking for it more frequently and are more likely to get it in a strong market. Second, despite clawback concerns, this model has achieved broad acceptance in the US and has obvious appeal to European private equity firms. Third, US LPs are familiar and generally more comfortable with this approach.
As for the US, the ‘return all contributions first’ model is not expected to take hold there in any meaningful way, despite concerns expressed from time to time by some US LPs about the greater clawback risk posed by the ‘all deals realised to date’ model.
Security for clawbacks
Clawbacks of overdistributions of carried interest are almost universal in both the US and Europe. However, one area where there is a difference is in the security for these clawbacks. Since most entities receiving carry are special purpose vehicles that immediately distribute carried interest out to the private equity firm and/or its principals, the clawback obligation to the fund has little substance: the carry vehicle generally has no assets.
Thus, in the US LPs have required that most clawback obligations be guaranteed by the individuals or institutions that own the carry vehicle. Indeed, these guarantees are almost universal and clearly market practice in the US, 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. By comparison, holdbacks or escrows of carried interest to secure the clawback obligation are relatively unusual in the US.
In Europe the situation seems to be reversed. Holdbacks or escrows securing the clawback obligation are often used in Europe – indeed, they are much more common in Europe than in the US. Until recently, however, personal guarantees by principals rarely occurred. This may be changing. Recently there has been a small increase in the numbers of personal guarantees in European funds.
It is possible that personal guarantees may become more prevalent in Europe. However, there remains a deeply ingrained resistance to personal guarantees by European principals, which may well prefer continuing to offer large carried interest holdbacks rather than guarantees.
Until relatively recently, unlike their US counterparts, few, if any, European funds had partner clawback provisions. Such provisions require partners to return distributions to cover ‘end of the fund’ liabilities, including fund indemnification obligations. Such provisions have recently become much more prevalent in Europe and are expected to become as prevalent as in US funds.
Other innovative techniques for GPs in the US, such as funding of the GP’s commitment to the fund through a management fee reduction mechanism, have recently become more common in Europe.
Some techniques that are commonly used in the US 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 placement fees, have also recently become more common in Europe.
The global markets for private equity funds continue to evolve. While the future cannot be predicted, there is an increasing adoption in Europe of a number of US-style terms and provisions, which is expected to continue.
•Marwan Al-Turki is a partner at Debevoise & Plimpton