Recently, while taking Professor David Wessels’ excellent Venture Capital and the Finance of Innovation, I was reminded of one of the fund terms that often ended up being carefully scrutinized and negotiated by limited partners: the recycling provision.
I’ve seen various forms of recycling provisions in practically every post-2008 vintage private equity, real estate, infrastructure, and venture capital fund that I have seen in the six years that I worked with Partners Group’s fund-of-funds arm; I would go as far as to call them pretty much ubiquitous in the industry.
But I am getting ahead of myself here. What is a recycling provision and why is it important?
To understand the recycling provision, we must first understand the lifecycle of a typical portfolio investment, and then the lifecycle of the kind of investments that a recycling provision is meant to address.
The “lifecycle” of a typical portfolio investment
A limited partner makes a capital commitment to a private equity, real estate, infrastructure or venture capital fund. This is a promise to pay up to a specified maximum to the fund (for use in making investments and paying expenses) during the term of the fund, when called upon by the general partner by way of a capital call.1
When the general partner makes a capital call to fund an investment, the limited partner pays the amount specified in the capital call to the fund in the form of a capital contribution. This reduces the balance of that limited partner’s unpaid (or undrawn) capital commitment to the fund by the amount specified in the capital call.
The fund then aggregates the capital contributions of all its limited partners, and uses it to make the investment.
The fund will typically hold the investment for a fairly long time—three to five years is not uncommon—and then dispose of it by way of a trade sale or public offering. The proceeds from the disposal will be distributed to the limited partners in accordance with the waterfall provisions of the fund. The return of these proceeds (which can be conceptualized as consisting of a return of capital and a share of the profit from the investment) does not increase the unpaid (or undrawn) capital commitment and the proceeds are not available to the fund after it is paid to the limited partner,2 in what Professor Wessels describes as a “once and done” approach.
All this is fairly typical, and covers the majority of portfolio investments made by a fund.
Let’s look at a simple example,3 set out in a table for ease of reference:
So, as you can see, at the end of year 5, the undrawn capital commitment is $85 million, even though the limited partner has received a distribution of $20 million. The money-on-money multiple for the investment in Portfolio Company A is 4, and the IRR is 41.42%. This is a very respectable set of numbers. (As an aside, I’d be very happy if that were one of my investments.)
Anyway, we will return to this example later. The main thing to understand is that once a capital contribution from a limited partner is invested and the proceeds of that investment distributed to the limited partner, it is not available to the fund any longer.
The lifecycle of a portfolio investment suitable for recycling
Sometimes, though, a general partner may find that there is an investment that it can make and exit within a very short period of time, which is usually anything less than 24 months.4
We will illustrate this situation with another example, an investment in a portfolio company that is exited in one year, as shown in table 2:
So, as you can see, at the end of year 2, the undrawn capital commitment is $95 million, the money-on-money multiple is 1.5, and the IRR is 50.00%, far better than the 41.42% IRR in the first example. As with the previous situation, the money returned is not available for further investments.
The problems with short-term portfolio investments
A short-term portfolio investment that is profitable can be a very attractive investment option for a general partner. It returns money to investors early, which—as we will see later—can be a bit of a double-edged sword. It can satisfy the preferred return earlier, and thus improve returns to the general partner. It, obviously, enhances IRR calculations.
There are some problems with short-term portfolio investments.
First, it involves a trade-off. Because capital contributions from limited partners, once invested, is not available for future investments even if the investment is exited and the contributed capital is returned to the limited partners, using it in one investment necessarily prevents the general partner from using it in another investment.
Second, many sophisticated limited partners measure a fund’s performance not in terms of the IRR, but by the money-on-money multiple earned by the fund’s investments.5 If an investment has a low money-on-money multiple, it negatively affects the overall investment performance of the fund, and can result in the fund sponsor being seen as less attractive during subsequent fundraises. This creates a bit of a dilemma for fund sponsors: electing to call capital to make a short-term portfolio investment with less risk than a long-term portfolio investment (e.g. a pre-IPO investment) means that they can no longer call that capital to make a long-term portfolio investment with the potential to earn a better money-on-money multiple. This dilemma can lead to general partners choosing to forego such short-term portfolio investments because they view the drag on their money-on-money multiple to be more important than the opportunity to make a profitable investment that improves their IRR and returns money to their limited partners early.
Third, a short-term portfolio investment poses a problem for limited partners: reinvestment risk. Where can the limited partner invest the distribution to earn comparable returns to what it might obtain from the private equity fund? For some limited partners, this is not necessarily a concern: they may find it advantageous to make use of the distributions from one private equity fund in their portfolio to fund capital calls from other private equity funds in their portfolio.6 For others, the reinvestment risk is problematic: they may have few opportunities to reinvest the distributions in investment opportunities that earn comparable returns to what they can obtain from the private equity fund.
The recycling provision
The recycling provision is intended to allow a general partner to recycle the capital7 invested in an investment that is exited within a defined—usually less than 24 months—period of time. It works by permitting the general partner to add the capital used in that investment back to the limited partner’s undrawn capital commitment and call it again to make further investments during the investment period.
A typical recycling provision will look something like this:
The General Partner may increase the Partners’ Undrawn Capital Commitments by an amount equal to all or any portion of the Distributions received by the Partnership during the Investment Period in respect of a Portfolio Investment prior to the second anniversary of the Partnership’s acquisition of such Portfolio Investment, up to and in proportion to the Capital Contributions of the Partners with respect to such Portfolio Investment.
Let’s unpack this tangle of legal drafting a little. The mechanism by which most recycling provisions work is by adjusting the value of a limited partner’s undrawn capital commitments. Here, it permits the fund to recycle all or any portion of a distribution that represents the contributed capital relating to that portfolio investment. It imposes a limitation on the general partner’s ability to recycle capital: it is available only if the portfolio investment is disposed of or if the portfolio investment pays a substantial dividend or return of capital within two years of the fund’s acquisition of the portfolio investment.
In the example of Portfolio Company B above, a recycling provision in the fund documents would allow the general partner to recycle the capital invested in Portfolio Company B by increasing the undrawn capital commitment from $95 million to $100 million (the amount invested in Portfolio Company B) at the end of year 2.
Things to consider when negotiating a recycling provision
When you are negotiating a recycling provision as a limited partner, you will want to consider the following (not exhaustive) matters.
- What is recyclable? Limited partners can permit the general partner to recycle the contributed capital, the amounts in excess of contributed capital (i.e. amounts that are treated as preferred return or profits), or both. As a general rule, it is preferable to limit the recycling to contributed capital, because that allows the limited partner to pocket the returns and keep just the original contributed capital at risk.
- Is there a cap on the capital commitments that can be recycled? Limited partners may consider capping the amount of contributed capital that can be recycled, typically expressing this as a percentage of total capital commitments, e.g. limiting the fund to investing no more than 125% of the total capital commitments. This serves to align the interests of the limited partners and the general partner: a limited partner invests in a private equity fund because they want to access, among other things, illiquidity premia from holding investments for a relatively long period of time. Limiting the amount of capital commitments that a general partner can recycle serves to focus its attention on finding long-term portfolio investments.
- What type of portfolio investments will be subject to recycling? As a general rule, limited partners will want to limit the recycling provision to investments that are genuinely short-term. It is often the case that most recycling provisions will be drafted to only apply to portolio investments that are disposed of within 18 - 24 months from the date of acquisition.
- Is there a time limit on recycling capital commitments? As a general rule, recycling capital commitments should occur only during the investment period of the fund, i.e. the time when the fund is actively making new investments. This often does not need to be explicitly spelled out, since by definition the general partner may make new investments (rather than follow-on investments) only during the investment period.
- Does the general partner have the ability to distribute proceeds from an investment subject to recycling and then re-call the proceeds? Most limited partners will not favor a provision permitting the general partner to re-call distributed proceeds from an investment subject to recycling. The ability to re-call such distributions means, essentially, that the limited partners must hold an amount equal to the distributions subject to recall in liquid, low-yielding assets. This can be particularly detrimental to limited partners that actively manage their private equity portfolio to achieve a particular invested capital target.
So, without further ado, let me present to you a quick example of the kind of recycling provision I would prefer to see if I were negotiating on behalf of a limited partner:
The General Partner may increase the Partners’ Undrawn Capital Commitments by an amount equal to all or any portion of Distributions received by the Partnership during the Investment Period in respect of a Portfolio Investment prior to the second anniversary of the Partnership’s acquisition of such Portfolio Investment, up to and in proportion to the Capital Contributions of the Partners with respect to such Portfolio Investment, provided that the aggregate amount that may be reused pursuant to this clause will not exceed 25% of Total Commitments.
This provision is largely similar to the example that I provided earlier, but it caps the amount that can be recycled to 125% of the aggregate capital commitments.
Conclusion
A recycling provision is often subject to a fair amount of negotiation between the limited partners and the general partner. Because limited partners may have different preferences, it is also a provision where limited partners may well take different positions. There is no single recycling provision that will satisfy all limited partners and general partners.
The devil is, in many cases, in the details. It behooves a limited partner to be discerning when reading the fund’s limited partnership agreement to understand what is going into the recycling provision, least he/she be faced with the old Latin adage of “caveat emptor”. Indeed, it is in this area that the use of competent fund counsel (whether in-house or at a law firm) can be crucial.