Clawback fear returns

A meltdown in the buyout industry may lead to an outbreak of symptoms last seen during venture capital's black plague

There is at least one major benefit to having written about private equity through two painful economic downturns: the lazy luxury of recycling column topics.

Certainly the excesses of the buyout market were different from the excesses of the billiondollar venture capitalists of the year 2000. But the flotsam left in the wake of that mighty black swan, internet mania, may now be examined for clues as to what we might expect as the damage from the credit implosion cuts a swathe through private equity.

The shortened version of what happened to venture capital after the tech meltdown is this – fund sizes reverted to their pre-bubble norm, many firms became smaller, broke apart or went away, lawsuits multiplied, returns fell, and certain GPs found themselves on the hook for clawbacks. But the services of the experienced, dominant venture capital firms eventually became more in demand.

Among these consequences of a down cycle are several that buyout GPs are going to have to deal with:

Smaller funds: it is quite clear that many follow-on buyout funds are not going to be as large as predecessors closed during 2006 and 2007. Not only do many of the most important LPs simply not have the cash, but GPs are having trouble explaining how the amount of capital requested is going to be put to work responsibly. However, the advocates of largeness among buyout GPs have a stronger case than did any venture capitalists after the tech meltdown. The venture capital strategy being what it is, there was simply no justification for huge funds, given the small startups they were supposed to be targeting. Buyout funds, on the other hand, may go after much larger targets as well as deploy capital in much larger slugs, such as through PIPEs (private investments in public equity). What LPs now need to decide is how much of a leash these GPs should be given with regard to investment style. Suffice it to say that non-buyout strategies such as PIPEs and debt purchases have produced mixed results recently.

Fewer partners: smaller funds means smaller fee income means fewer compensation dollars to go around. After the venture capital right-sizing, many firms shed partners. Likewise, many buyout firms are currently going through a partner-assessment process to determine, essentially, which ones should go, according to a prominent fund-formation lawyer.

Defections: the private fund industry seems to be constituted in such a way that it unceasingly produces spin-outs. In good times, the non-founding partners at a firm see all the capital being thrown at good track records and decide to hang their own shingle in hopes of capturing some of the LP largesse. In bad times (ie, now) junior partners take a look at the performance of the current fund and face a decision – work for years on a struggling portfolio with little hope of seeing any carried interest at the end, with the founding partners taking their commanding cut of what little economics are produced, or walking out the door and starting somewhere else with a clean slate, including possibly starting their own shop.

Clawbacks: A scary term from the recent past may haunt the near future of private equity. Clawback provisions kick in when early wins in a fund are followed by dismal losses. They also appear almost exclusively in the US market, where LPs are more likely to allow GPs to pay themselves carry earlier in the life of a fund. (In Europe, most funds are structured such that GPs get paid carry only after the entire cash-on-cash return of the fund is known). In the bygone VC boom market, a handful of funds produced huge returns when tech investments were exited at the top of the market. When the markets then cratered, the remaining portfolio companies died, and the carry already paid out to these unlucky GPs proved far beyond the 80/20 split. According to the legal source, it is not inconceivable that some buyout funds to have benefited early in their lives from dividend recaps and solid exits may find they have paid the GPs too much when the final tally is taken. Clawbacks can be especially tricky in the highly likely event that one or more of the original GPs have left the firm, gotten divorced, lost money or died.

You can be sure that in the current fundraising market, LPs are going to require very strict clawback-prevention measures, including holding winnings in escrow for longer periods of time. This will further push back the day when many GPs next see a dollar of carry.