While generating goodwill among investors is certainly a driving factor in the recent rash of VC fund management fee reductions, an increasing threat of clawback liabilities is also causing fund managers to consider reducing fees in exchange for a reduction of future clawback liability (if any). Many fund managers once believed that clawbacks only affected vehicles minted in boom years and invested just before the bust (see “Boom-Bust Clawback” below), but they are quickly learning that even earlier funds that produced massive IRRs during the up-market could be subject to clawback triggers.
Fortunately, there is good news in both scenarios. Up-market funds can rely on the fact that their clawback liabilities should be small compared to prior distributions. For the boom-and-bust funds, there is still time to protect individual general partner assets. These funds also still feature active portfolios and have the right to continue receiving management fees.
With careful planning, members of the general partner may be able to take advantage of the time left in the lives of their funds to protect their assets and, if they are ready to take on some carefully considered risk, significantly reduce the size of their clawbacks by capturing the value of future management fees in a tax-efficient manner. (This will be discussed in greater detail in Part 2.)
Quantify the Liability
The first step in managing a fund clawback liability is to understand exactly how the clawback operates. In general, each clawback provision is designed to ensure that the general partner does not receive distributions in excess of its capital contribution plus its share of gains (or losses) generated by the fund. Because clawback provisions tend to be very mechanical in application, seemingly small variations in language can result in significant liability differences (see “Clawback Mechanics,” next page).
Once the operation of the clawback provisions have been analyzed, the GP must determine how much it potentially will owe to the fund under a range of different portfolio valuations. This usually can be accomplished by assuming that the fund dissolves today, sells all of its assets at their current fair market value, makes all allocations of gain and loss realized in accordance with the fund agreement, and then distributes all of its assets in accordance with the fund agreement. The net hypothetical profitability of the fund and the ending capital account balances of the partners should provide the necessary data to determine the clawback amount based on current portfolio valuations. By making further assumptions about the portfolio’s potential exit valuations, the GP can project a range of possible clawback amounts.
Since the GP typically does not retain significant assets, it must call capital from its respective members to satisfy any clawback obligation. The member’s obligation to satisfy the clawback can normally be thought of as a full recourse debt. In theory, all of a member’s assets are available for satisfaction of the clawback, but state law and the member’s own estate planning will ultimately determine the property the GP can reach.
Each GP member’s share of the clawback obligation to the fund will normally be determined by the firm’s operating agreement, which can vary significantly. Some partnerships allocate liability based on the total distributions each member received, while other partnerships consider only the carried interest distributions each member received. Clawback liability in some partnerships may be based solely on the allocations of carried interest profit each member received-which means that actual distributions to the members are completely ignored-or on the magnitude of each partner’s negative capital account.
There are even differences within each theoretical approach to the clawback allocation issue. For example, two different GP operating agreements may allocate the clawback based on “carried interest distributions received,” but they may take different approaches to determine whether any given distribution constitutes a carried interest distribution or a return of capital distribution. Some agreements will make this determination by characterizing the underlying distribution from the fund, while other agreements will treat all distributions to the members of the GP as first constituting a return of capital until all capital contributions have been returned. Such seemingly small definitional variations can create significant differences in how the clawback liability is shared among the members.
Know Thy Clawback
Additionally, the complexities of clawbacks in a capital account-driven system and the opportunities for unintended consequences multiply dramatically in those general partner entities that allow members to contribute capital in proportions different from those in which the carried interest is allocated. For example, the disjunction between obligations to fund the GP and the benefit of receiving carried interest allocations may cause unintended “shifting” of capital among the members.
The best allocation schemes minimize the chance that relatively small changes in circumstances will result in large shifts of liability among the members and eliminate any circumstances that might result in a “shifting” of capital among the members. Unfortunately, not all GP operating agreements were written to achieve this ideal. Accordingly, members of a GP must understand the provisions governing how clawback liability is borne and how such allocation might change as partners retire or are expelled or portfolio valuations change.
If the allocation language yields unexpected results, the time for consensus building to eliminate unintended consequences is now, rather than at the end of the partnership when the clawback liability has fully matured and many members of the GP may have retired.
Steven R. Franklin is a founding partner and head of the Private Equity Fund Practice Group of Gunderson Dettmer Stough Villeneuve Franklin & Hachigian LLP. Stig A. Colberg is an associate. The law firm is based in Menlo Park, Calif. It may be found on the Web at www.gunder.com.