November 7, 2016

Private Equity Energy Funds Did So Badly They Might Have to Do the Unthinkable – Pay Clawbacks

The law firm Akin Gump issued a warning that might chill the bones of some private equity general partners: clawbacks may be a-comin’. From the firm’s website:

In recent months, managers of private equity funds in the energy sector have been facing a scenario they likely never imagined: having to return millions of dollars of their “carried interest” earnings back to investors.

For newbies to this private equity practice, private equity funds typically pay the profit share, prototypically 20% once a target rate of return has been met. What creates the possibility of a clawback is the fact that for most US funds, the profit computation and any payouts are made every time a portfolio company is sold. By contrast, in “European” deals, the carry fees are paid only at the end of the fund’s life.

The conventional US approach, combined with strong general partner incentives to realize profits on at least some promising deals early in the fund’s life, means that the general partners can pay themselves carry fees that are more than they deserved once the impact of doggy companies, which are sold late in the fund’s life, are factored in. Hence the limited partnership agreements provide for “clawbacks,” as in the recovery of overpayments of carry fees.

Yet as we’ve written, clawbacks are almost never paid in practice. Why? First, the clawback provisions have tax language that is very favorable to the general partners, and has the economic effect that they can hang on what are excessive carry fees based on raw cash flows. Second, possession is 9/10ths of the law. In those instances where the general partner owes limited partner clawbacks, the general partner usually goes to the limited partners and offers them a special deal (details often unspecified!) on their next fund. Needless to say, this approach has the desirable effect of pre-committing those limited partners.

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