Most private equity funds require managers to distribute promptly to its limited partners the proceeds received from a portfolio company exit or refinancing. But many funds permit the manager to retain, or distribute and then recall, these proceeds to make new or follow-on investments. This is referred to as “recycling.”
Recycling provides flexibility and greater access to capital and effectively increases the size of the fund. It also may enable managers to distribute capital to satisfy earlier the preferred return and enhance IRR calculations, while preserving their ability to redeploy capital in an attempt to earn additional carried interest distributions.
Some investors are sensitive to recycling and may seek to limit its use. They may prefer to pocket returns rather than put their capital at additional risk. Additionally, the use of recycling often delays investor distributions. If distributions are made subject to recall, investors may have to hold the recallable amounts in low-yield liquid assets. Or, with respect to funds-of-funds, they may have to make capital calls to their own investors to satisfy the recall.
On the other hand, many investors favor recycling: it enables a manager that successfully realizes early returns to deploy capital throughout the investment period, maximize the number of investments the fund makes, and potentially generate greater net returns. The investor may not have a better place to deploy capital that is returned early. Additionally, if the aggregate amount of investments exceeds the investors’ original commitments, the excess typically is not included in the management fee base, at least during the investment period.
The details in the fund’s governing documents can be critical. They should define clearly what can be recycled and how the recycling will affect the fund’s economics. They often limit recycling to proceeds representing a return of some portion of investor capital and cap the fund’s aggregate investments at a percentage of the total commitments ranging from 110% to 130%. Investors also may limit recycling to capital attributable to fees and expenses, investments liquidated within one or two years of purchase, any short-term financing or bridge investment, or some combination of these.
In many instances, managers have the right to recall capital after it has been distributed. By distributing the capital, the manager can stop the accrual of a preferred return on such amount, increase the investors’ IRR, and realize its full carried interest (if any) on the deal that generated the distributions.
A manager also may be able to withhold disposition proceeds, but treat such amounts as having been distributed and recontributed to the fund. This is especially helpful if the manager has another investment opportunity to be funded promptly. The manager benefits from the administrative convenience of retention and avoids the risk of investor delay or default on a capital call. Furthermore, the manager still is able to take all its carry distributions, even when investors are subject to withholding on their distributed amounts.
A more investor friendly approach is to permit a manager to retain and reinvest proceeds (both capital and gains) until a threshold is reached (such as110% – 130% of total commitments), but not to recall proceeds or treat them as distributed and recontributed to the fund. In these circumstances, the preferred return continues to accrue on the recyclable capital. Without an immediate use for the proceeds, however, this can represent expensive money for the manager. Moreover, if any portion of the reinvested proceeds would have represented carry distributions, the manager would bear a larger portion of any future losses on the recycled amounts. Nevertheless, this approach still enables a successful manager to reap greater rewards if the recycling is profitable.
Kader Crawford is a transactional attorney at Robinson Bradshaw whose primary focus includes fund formation and private investment transactions, alternative investments, joint ventures and various lending transactions.