News & Analysis

Carry, bad leaver clauses require extra focus, lawyers warn

When launching a new fund, GPs would be wise to determine whether their waterfall structure and bad leaver provision need updating, according to fund formation lawyers.

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Although a firm’s limited partnership agreement (LPA) may not undergo much change from one fund to the next, there are certain provisions that require special attention with each cycle, fund formation lawyers tell pfm.

In particular, GPs should be careful that their carry structure is still relevant given recent market trends and that their bad leaver provisions are not too narrow to allow partner exits without economic consequences.

Both US and Europe-based firms heading to market with new funds in 2016 are currently being confronted with a carried interest challenge they likely did not face when they launched their previous vehicles. The typical US deal-by-deal waterfall has been shifting, incrementally, to better resemble the traditional European per-fund style waterfall, lawyers say. On the other hand, in a change from previous practice, some European GPs are now offering investors a choice between deal-by-deal carry and per fund carry within funds.

Additionally, the language in a bad leaver provision may require updates, lawyers are advising their GP clients more often. Most bad leaver clauses prevent partners from defecting to a competitor, but LPAs necessitate forethought over nearly a 10-year period, and what a competitor is to a certain firm in 2015 may differ from that in 2022.

A European-focused middle market firm may evolve into a global business or move into sector-specific strategies, one funds lawyer said to pfm, which are details a GP might not think to include in its definition of a “competitor.”

Moreover, drafting the bad leaver provision too broadly is not an option for GPs either, because of the risk that a court could consider such a provision too restrictive and a restraint on trade.

“You’re having to draft the competitor provision relatively tightly but there’s a huge chance that seven years on, what you’ve drafted is too narrow and doesn't result in a reduction of carry when a leaver joins a competitor,” said Simpson Thacher partner Jason Glover.

For more on the LPA changes facing GPs today, especially related to carry terms, see the December issue of pfm.