- 35% increase in GP queries on clawback mitigation;
- Due to lack of liquidations and SEC Private Fund Reporting Rules;
- 6 main ways of mitigating clawback risk.
New York/London, January 2024: Private Markets General Partners (GPs) are increasingly focused on the risk posed by Limited Partners’ (LPs) clawback provisions on Private Markets funds – given GPs may have to delay investment realizations due to one of the most difficult portfolio investment liquidation markets in decades, allowing LPs to “claw back” any previous carried interest paid to GPs.
Q4 2023 hedge fund letters, conferences and more
While the practice of mitigating clawback risk in Private Markets waterfall distributions is still in its relative infancy, its importance is growing due to the SEC’s recent Private Fund Reporting Rules requirement to enhance reporting to LPs on GP and LP clawbacks. As a result, the Citco group of companies (Citco) has seen a 35% increase in overall enquiries and active support on clawback risk in 2023 alone, based on its in-house Waterfall team’s wide experience in supporting Citco’s overall Private Markets book of clients with more than $800B in assets under administration (AUA), across Private Equity, Private Credit and Real Assets.
While the largely closed-end nature of Private Markets firms’ capital structures mostly shields them from the obligation of liquidating investments in order to meet redemption requests, the time-weighting associated with their fee arrangements – in particular the calculation of carried interest – means that the delaying of investment realizations also carries with it significant downside risk, perhaps most notably in the form of carried interest “clawback”. To be clear, this is a provision that allows LPs to “claw back” any carry paid to GPs during the life of the fund on previous investment realizations, to ensure LPs receive their agreed return or do not incur a loss.
Therefore, Citco outlines the most effective means of mitigating clawback risk in “The Drawbacks of Clawbacks - A Waterfall guide to mitigating Private Markets clawback risk”. While various structural mechanisms could be incorporated into a fund’s Limited Partnership Agreement to hedge against the risk of clawback, the guide focuses on three specific recommendations – on which Citco has provided detailed support to its Private Markets clients:
- Non-time weighted Preferred Return calculations;
- European-style expense recoupment provisions;
- Carried Interest escrow requirements.
In addition to structural implementations to mitigate the risk of clawback, current market conditions are also compelling a growing number of Citco’s clients to realize the increasing importance of including supplemental scenario modelling at the time of a distribution. This helps to assess the risk of future clawback when deciding whether to realize or “defer” carried interest associated with a profitable realization event. The report also discusses three scenario models of increasing interest to GPs that can be incorporated into the capital distribution process in order to mitigate the risk of a future clawback event:
- Contemporaneous unrealized waterfall calculations;
- “Zero Proceeds” waterfall calculations;
- “Loss-to-Clawback” analytics.
Tim Eberle, Head of Waterfall Services, Citco Fund Services (USA) Inc. said: “It is important to note here that the process of mitigating clawback risk does not disadvantage LPs in any way. In fact, the opposite is true: having a defined process for clawback mitigation provides both GPs and LPs with an enhanced framework for transparently managing waterfall distributions - saving both parties the complication of enforcing clawbacks post-tax, thereby preserving the GP-LP relationship.
“Also, given the SEC’s Private Fund Reporting Rules requirement to enhance reporting to LPs on GP and LP clawbacks, these pre-emptive measures can only be seen as a positive outcome.”
The guide’s recommendations focus on American-style waterfall calculations – which carry a greater risk of resulting in clawback than the more conservative European-style.
European-style waterfalls prioritize LP distributions until they have recouped their aggregate capital contributions and the associated preferred return in a fund overall before the GP is eligible for an allocation of carried interest. In contrast, an American-style waterfall is applied to individual investment deals – or on a “deal-by-deal” basis – rather than to the fund overall, allowing the GP to realize carried interest on individual profitable realizations once the LP has received their “hurdle rate” or preferred return.
About the Citco group of companies (Citco)
The Citco group of companies (Citco) is a network of independent companies worldwide. These companies are leading providers of asset-servicing solutions to the global alternative investment industry. With over $1.8 trillion in assets under administration and operations spanning across 36 countries, Citco’s unique culture of innovation and client-driven solutions have provided Citco’s clients with a trusted partner for more than four decades.
