Drafting the "Carry" in Partnership Agreements for Private Equity Funds

Practical Law Legal Update w-000-7073 (Approx. 7 pages)

Drafting the "Carry" in Partnership Agreements for Private Equity Funds

by Practical Law Corporate & Securities

Article VIII: Distributions

Section 8.01 Distributions. Subject to Sections 6.05 [Default by Partners], 8.02 [Tax Distributions], 8.05 [Retention of Distributable Cash] and 4.11 [Removal of the General Partner], the Partnership shall make distributions of Distributable Cash to the extent constituting (i) proceeds of a Disposition of a Portfolio Investment, within 90 days following the receipt thereof, (ii) income, dividends, distributions or interest from a Portfolio Investment, within a reasonable period of time following the end of the fiscal quarter in which such amounts are received and (iii) income from Temporary Investments, within a reasonable period of time following the end of the fiscal year in which such amounts are received or more frequently in the sole discretion of the General Partner, in each case in the order of priority set forth below. Notwithstanding any other provision of this Agreement, distributions shall be made only to the extent of Available Assets and in compliance with the Delaware Act and other applicable law. Distributable Cash shall initially be notionally apportioned among the Partners (including the General Partner in its capacity as a Partner, and the amount so apportioned to the General Partner shall be distributed to the General Partner) in proportion to their relative Capital Contributions with respect to the applicable Portfolio Investment or Temporary Investment. The amount apportioned to each Limited Partner shall be distributed as follows:

(a)	Return of Capital: First, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash on a cumulative basis pursuant to this clause (a) equal such Limited Partner's Capital Contributions;
(b)	Preferred Return: Second, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash on a cumulative basis pursuant to this clause (b) equal the Preferred Return;
(c)	Catch Up: Third, 100% to the General Partner until distributions to the General Partner of Distributable Cash on a cumulative basis as Carried Interest Distributions equal 20% of all distributions of Distributable Cash made pursuant to Section 8.01(b) and this Section 8.01(c); and
(d)	80/20 Split: Any balance, (i) 80% to such Limited Partner and (ii) 20% to the General Partner.

Drafting Note: Distributions

Section 8.01 deals with cash flow distribution (often referred to as the distribution waterfall) from the fund to the investors and the general partner. A distribution waterfall provides for proceeds from investments to be paid in an order of tiered priority.

Limited partnership agreements typically deal with waterfall provisions by addressing the following:

Return of capital contributions to the investors.
Preferred return on the capital contributions.
Catch-up distributions to the general partner.
Carried interest distributions (carry) to the general partner.
Clawback.

Return of Capital and Preferred Return

Waterfall provisions provide for a priority return of all capital contributions made by the limited partners (as well as any capital contributions of the general partner).

Once capital contributions are returned, most waterfall provisions obligate the fund to provide investors with a preferred return on their investment (also known as a hurdle). The mechanics of the preferred return are as follows:

The investors must receive their preferred return before the general partner begins to receive its share of the proceeds.
The preferred return rate is typically 8% annually compounded. General partners do not usually negotiate preferred return rates because they prefer to convey a message to the investors that their fund is expected to generate returns well in excess of the preferred return rate.
Real estate funds generally offer slightly higher rates while debt-focused funds may offer lower rates (particularly when interest rates are low).
The preferred return typically accrues from the date on which the contributions are made.
Some funds offer a preferred return on invested capital only, excluding a return on contributed capital used for fund expenses. This Standard Document provides for preferred return on all capital contributions.
In some funds, the preferred return is limited to partners' capital contributions with respect to realized investments only plus an allocable portion of capital contributions relating to the fund's investment expenses for those realized investments. In this model, limited partners will not receive a priority return of capital contributions relating to investments that have not been harvested or investment expenses paid in connection with those investments before the general partner starts to receive carried interest distributions.

Catch-Up

After investors receive their contributed capital (see Section 8.01(a)) and preferred return (see Section 8.01(b)), the waterfall provision generally provides for a "catch-up" distribution to the general partner out of the remaining profit, if any.

All of the cash available at this point (as is the case in this Standard Document, see Section 8.01(c)) typically goes toward fulfilling the catch-up distribution until the general partner's share of the profits reaches the carried interest rate (commonly 20%). Until this split is reached, the general partner cannot be said to have received its carried interest.

For further explanation and an example of a catch-up calculation, see Practice Note, Structuring Waterfall Provisions.

80/20 Split

Any profit to be distributed after the general partner receives its catch-up is split according to the same carried interest rate that marked the end of the catch-up phase. As in this Standard Document, the carried interest rate is typically 20%; because of this, any distribution of profit made after the general partner catch-up is 80% to the investors and 20% to the general partner. This is referred to as the 80/20 split.

Distribution Waterfalls

There are various types of carried interests paid under fund waterfall provisions, including:

Back-ended carry.
Deal-by-deal carry with loss carry-forward.
Deal-by-deal carry without loss carry-forward.

Back-Ended Carry

A back-ended model (known also as whole-fund or total-return waterfall) requires that limited partners receive distributions of their full invested capital plus their full preferred return before the general partner receives any carried interest distributions.

This formulation substantially delays the receipt of carry by the general partner. Because private equity funds make multiple investments and hold most or all of them for years, the general partner may not receive any carried interest until the tail end of the life of the fund.

The back-ended carry arrangement is more favorable to investors. Back-ended carry structures reduce the possibility that the general partner:

Receives excessive carry that must later be recouped through a clawback payment (see Section 4.04 and the related drafting note).
Delays recognition of unrealized losses by waiting to dispose of losing investments and eliminate any need to value assets or to determine write-downs.

Back-ended carry arrangements can however offer the following advantages to general partners:

Limited partners may be willing to forego the clawback entirely or relax protections to collect a clawback payment, such as escrow arrangements or personal clawback guaranties.
The back-ended carry structure simplifies fund accounting, which can be particularly helpful in funds that make many investments.

However, back-ended carry arrangements can result in phantom income for the general partner (meaning, recognition of taxable income by the general partner without corresponding fund distributions to pay the tax). As a result, the right of the general partner to receive tax distributions is a particularly important feature of private equity funds with back-ended carry structures (see Drafting Note, Tax Distributions).

Historically in the US, the back-ended carry waterfalls have been used in first time funds or funds where capital raising was difficult. Currently this model is increasingly used by sponsors of different types of funds and is adopted in this Standard Document. ILPA also recommends this model as best practice.

Deal-by-Deal Carry with Loss Carryforward

A deal-by-deal carry with loss carryforward model allows the general partner to start receiving carried interest distributions before the limited partners have received distributions of their full invested capital plus their full preferred return. The carried interest distributions for any harvested investment are reduced to the extent of any previously realized losses on harvested investments and write-downs (or permanent impairments of value) attributable to investments not yet sold.

This formulation is an intermediate model between the back-ended carry and the deal-by-deal carry without loss carryforward. The general partner is able to receive carried interest distributions on profitable investments while the limited partners are protected because losses (either realized losses on investments that have been sold or write-downs or permanent impairments) up to the point of the carry calculation are taken into account. This is not equivalent to a clawback because, absent an actual clawback provision, the general partner is not required to return any carried interest distributions it has already received. Prior losses only serve to reduce carried interest distributions that the general partner has yet to receive.

As with the back-ended carry model, a clawback is required with the deal-by-deal with loss carryforward model to recoup any excess carry that the general partner has received when the performance of all of the fund's investments are taken into account.

To change the waterfall to a deal-by-deal carry with loss carryforward, replace Section 8.01(a) with the following:

"(a) Return of Capital: First, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash on a cumulative basis pursuant to this clause (a) equal such Limited Partner's Capital Contributions relating to all Realized Investments."

This alternate provision requires a return to limited partners of their invested capital with respect to all harvested investments or investments that have been written off (see definitions of Realized Investments, Disposition and Write-off) before the general partner receives any carried interest distributions.

A more typical provision requires that the limited partner also receive a return of allocable expenses relating to realized investments before the general partner receives carried interest distributions. To take this approach, replace Section 8.01(a) with the following:

"(a) Return of Capital: First, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash on a cumulative basis pursuant to this clause (a) equal the sum of (i) such Limited Partner's Capital Contributions relating to all Realized Investments and (ii) the product of (A) a fraction, the numerator of which is such Limited Partner's Capital Contributions relating to all Realized Investments and the denominator of which is such Limited Partner's Capital Contributions relating to all Portfolio Investments and (B) such Limited Partner's Capital Contributions applied to the payment of Investment Expenses."

Deal-by-Deal Carry without Loss Carryforward

This model is not typical today. It allows the general partner to receive its carry when profitable deals are harvested without regard to losses from prior deals or write-downs or permanent impairments in value.

This structure is viewed as an overly manager-favorable term that does not align the interests of the manager and investors. Investors fear that the general partner may be encouraged to make risky investment decisions knowing that potential gains on successful deals will not be affected by losses on others. However, the concept of deal-by-deal carry may still be found in a club or pledge fund where investors are permitted to decide whether they will participate in a particular deal.

With a deal-by-deal carry without loss carryforward model, a clawback provision is essential. Depending on the performance of the fund's investments, a large clawback payment may be owed and escrow arrangements or guaranties to ensure payment by the general partner may be requested by the limited partners.

To change the waterfall to a deal-by-deal carry without loss carryforward, replace clauses (a) to (c) of Section 8.01 with the following:

"(a) Return of Capital: First, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash equal such Limited Partner's Capital Contributions relating to the applicable Portfolio Investment or Temporary Investment;

(b) Preferred Return: Second, 100% to such Limited Partner until distributions to such Limited Partner of Distributable Cash equal an amount equal to the Preferred Return with respect to the Capital Contributions described in clause (a) above;

(c) Catch Up: Third, 100% to the General Partner until distributions to the General Partner of Distributable Cash as Carried Interest Distributions equal 20% of the distributions of Distributable Cash made pursuant to Section 8.01(b) and this Section 8.01(c); and"

This alternate provision allows the general partner to receive carried interest distributions with respect to each harvested investment once the hurdle has been met for that particular investment. For more details on waterfall provisions, see Practice Note, Structuring Waterfall Provisions.

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