A basic principle in LP secondaries transactions is that the buyer steps into the shoes of the seller and assumes the economic risks and benefits associated with the transferred interest. There are, however, important exceptions from that principle, most prominently the excluded obligations.
A key type of excluded obligation is the LP clawback of distributions relating to the period prior to the cut-off date. The reason for such liabilities remaining with the seller is simple; the seller has already received the economic benefit of the distribution, and the buyer would typically not have priced in any risk of having to pay back such distributions.
The topic often comes up in situations where the seller vehicle intends to liquidate shortly after closing a sale of LP interests. Who would then be responsible for paying back clawed-back distributions? Could and should the buyer take on any such risk?
The considerations are particularly relevant in tail-end transactions where the NAV and purchase price are small in comparison to distributions received by the seller in the years prior to the cut-off date, which may imply that there are significant distributions that could be clawed back.
This article summarises the key aspects of LP clawback provisions that a secondaries buyer ought to consider, and our observations from purchase and sale agreements (PSA) we have negotiated. While we intend to provide a broad overview of the topic, more in-depth analysis is often required, and the facts and specific dynamics of each transaction require independent consideration.
LP clawback
Limited partnership agreements (LPA) typically include LP clawback provisions in some form or another that involve the limited partners being liable to return distributions received from the fund in order to satisfy, among other things, indemnity claims and related liabilities.
From the GP’s point of view, LP clawbacks operate as a safety net allowing the fund to cover liabilities that may arise, in particular following exits of assets. As a balancing mechanism, LPAs customarily limit the operation of such clawback rights in time and amount.
Relevance for secondaries buyers
Once a transfer takes effect, the buyer of an LP interest effectively steps into the shoes of the seller and assumes the seller’s rights and obligations in the partnership. And even though it may not have received the benefit of previous distributions, the buyer faces the risk of having to assume the seller’s clawback liability as per the LPA.
While secondaries buyers accept the risk that distributions after the cut-off date could be recalled, such buyers typically do not price in the risk they have to pay back distributions that were made to the seller before the cut-off date. Needless to say, repaying such distributions would be unpleasant news for any buyer and risks ruining returns on the investment.
PSA market standard
The prevailing standard mechanism to allocate LP clawback liabilities is that the seller remains liable for any clawbacks that are in substance attributable to distributions they have received, the benefit of which has not flown to the buyer. While there may be several ways in which PSAs incorporate this in writing, it is generally through the concept of excluded obligations: liabilities that the buyer does not assume, and which remain with the seller, who ought to be liable for and indemnify the buyer against a subsequent liability.
Although a buyer will ideally be best placed if the seller assumes full responsibility for any clawback obligations accruing before the cut-off date for the investment, it has become increasingly common for sellers to seek to negotiate a limit on its clawback liability.
Some agreements may look to limit the seller’s liability by making it contingent upon the GP’s adherence to specific time constraints in the event of a clawback. Other types of limitations may on the one hand impose a maximum ceiling for seller liability, usually set at the final allocated purchase price; on the other hand, it may also involve minimum thresholds, set at a certain percentage of the final purchase price.
A review of a set of historical PSAs over a 12-month period indicates that, in a clear majority of cases, the seller is fully liable for LP clawback risks relating to distributions prior to the cut-off date. However, it should be noted that in about 36% of the cases, the seller’s liability for clawback obligations is limited.
The most common limitation would be to agree that the seller is only liable for recalls of distributions within a certain time period, typically one to two years after closing. Other limitations sometimes seen are that the amount of seller liability is limited by a threshold and/or a cap.
*Including cases where W&I coverage is involved.
Ways to mitigate risks
Guarantor arrangements: In case of an uncreditworthy seller or one that is set to liquidate, buyers can explore the possibility of proposing guarantor agreements with a related party of the seller, which can provide comfort if the GP does invoke its right to a clawback. In our experience it is, however, rare that the seller manages to line up a willing and able guarantor.
W&I coverage: If neither the seller, nor a related party is willing or able to take on the obligation to indemnify the buyer for any of the excluded liabilities, buyers can be in a better position if the transfer process mandates W&I policies to cover off the seller’s obligations under the PSA. In this case, it would be prudent to review the W&I policy documentation to avoid potential pitfalls surrounding aggregation and exclusions.
Diligence on the funds: Buyers may also seek to limit risk at the due diligence stage by requiring GPs to answer the question whether or not the GP anticipates any indemnification liabilities leading to a material obligation including potential clawbacks. It is also important to review the LPA of the target fund in order to assess the GP’s ability to claw back, whether or not subject to qualification in time or amount. This can in some cases lead to the conclusion that the GP does not have (or no longer has) the right to recall previous distributions.
Risk-based approach: The extent to which the risk of a potential clawback liability remains material would depend on a combination of factors. For example, investments in tail-end portfolios would inevitably mean a higher risk of a clawback than relatively younger portfolios, and it is often a case of balancing probabilities in deciding the approach that a buyer ought to take while negotiating clawback provisions.
Buyers should also consider concentration risk where a diversified portfolio may result in the investment value being spread across several units, which may very well be subject to optimal terms that balances out the inherent risk that the buyer assumes.
Disclaimer: The information provided in this article is for general informational purposes only and does not constitute legal, tax, or financial advice. Readers should consult with a qualified professional for advice tailored to their specific circumstances. DMX Partners Limited is not responsible for any actions taken based on the content herein.
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