GP Clawback

What is a GP clawback?

A GP clawback is the promise in a fund's partnership agreement that the general partner will give back carried interest it was paid too early. At the end of the fund, the carry the GP actually received is compared with the carry the whole fund's results justify, and the difference goes back to the limited partners.

What is a clawback provision?

A clawback provision is the clause that creates that obligation and says how it is measured, when it is tested, who is on the hook, and where the money comes from. In private funds it usually appears in the distributions article of the limited partnership agreement. ILPA treats it as a last-resort protection rather than a feature, stating that carry clawback situations present one of the more challenging circumstances for the GP and LP relationship and, as such, should be avoided whenever possible, and that the best approach to minimize clawback liabilities is an all-capital-back waterfall structure.

Why the exposure exists at all

The clawback is a symptom of the waterfall. Under a whole-of-fund waterfall, LPs receive all contributed capital and the preferred return before the GP sees a dollar of carry, so by construction the GP is rarely overpaid. Under a deal-by-deal waterfall, carry is paid as individual deals exit. An early winner pays carry before the rest of the portfolio has reported. If later deals disappoint, the GP has been paid on gains that the fund as a whole never delivered.

Three features decide whether the LPs actually get the money back.

• Timing of the test. A clawback measured only at final liquidation can arrive a decade after the carry was paid and spent. ILPA's model documents include an interim test: the deal-by-deal Model LPA defines an Interim Clawback Date as the first anniversary following the end of the commitment period and every year thereafter, a removal date, or a re-advance under the limited partner giveback, and requires the GP to run a hypothetical final distribution of the fund's assets as of that date.
• Who owes it. A clawback owed only by the GP entity is worth whatever that entity holds, which after distributions to individual partners can be very little. ILPA strongly encourages joint and several liability of individual GP members as a best practice, and says that where joint and several liability is not provided, a potential substitution would be a creditworthy guarantee of the entire clawback repayment by a substantial parent company, an individual GP member, or a subset of GP members.
• Where the cash sits. ILPA recommends that accrued carried interest be held in escrow accounts with significant reserves, giving 30 percent of carry distributions or more as its example, and separately notes that an escrow account of at least 30 percent may provide a sufficient mechanism for the clawback guarantee. Its deal-by-deal Model LPA drafts that as a bracketed provision depositing 30 percent of amounts otherwise distributable to the GP into a fund escrow account until the partner has received distributions equal to its commitment plus the preferred return.

Gross of tax or net of tax

This is the number that decides how much LPs actually recover, and the two ILPA documents deliberately sit in different places.

The Principles state that all clawback amounts should be gross of taxes paid and paid back no later than two years following recognition of the liability, with a fallback only where gross repayment is excessively burdensome or impractical, in which case the hypothetical marginal tax rates applied should reflect the actual marginal rate that would apply to the individual members of the GP impacted.

The Model LPA drafts the opposite default. Its clawback caps the GP's contribution at the carried interest received, less the sum of any taxes actually paid or payable by the general partner or its direct or indirect owners, as disclosed and evidenced to the limited partners, with that tax amount deemed reduced by any tax benefit the GP would realize from making the repayment. A practitioner reading a draft LPA should therefore not assume ILPA alignment from the word clawback alone. Read the cap.

Worked example

The figures below are hypothetical. Assume a $100 million fund, a deal-by-deal waterfall, 20 percent carried interest, and no preferred return, which keeps the arithmetic visible.

Step one, the early winner. The fund invests $10 million in Deal A and exits for $50 million. The deal's cost comes back first: $50 million less $10 million leaves $40 million of profit. The GP takes 20 percent of $40 million, which is $8 million. LPs receive $10 million of returned cost plus $32 million, which is $42 million.

Step two, the rest of the portfolio. The remaining $90 million is invested across the other deals, which return $48 million in total. There are no profits there, so no carry is paid and all $48 million goes to LPs.

Step three, the LP position at the end. LPs have received $42 million plus $48 million, which is $90 million, against $100 million contributed. They are $10 million short of their capital.

Step four, the whole-fund entitlement. Total proceeds are $50 million plus $48 million, which is $98 million, and $98 million against $100 million of contributions is a loss. On a whole-fund basis there is no profit, so the carry the GP was entitled to is zero. The clawback is the full $8 million already paid.

Step five, what actually comes back. If the LPA follows ILPA's gross-of-tax recommendation, the GP owes the whole $8 million. If instead the LPA caps repayment at carry received net of taxes actually paid, and the GP's partners paid a combined 40 percent on that carry, or $3.2 million, the capped obligation is $8 million less $3.2 million, which is $4.8 million, before any tax-benefit offset for the repayment. The drafting choice is worth $3.2 million to the LPs in this example.

Step six, the escrow. With a 30 percent escrow, 30 percent of the $8 million carry, which is $2.4 million, was never released to the GP. In the gross case the GP must find $8 million less the $2.4 million already sitting in escrow, which is $5.6 million of fresh cash. That $5.6 million is the number the clawback fight is actually about.

How it shows up in the documents

In the deal-by-deal Model LPA the clawback lives in section 14.7. Section 14.7.1 sets the final obligation and the net-of-tax cap and provides that the contribution is satisfied first by any amount held in the escrow account. Section 14.7.2 builds the interim test around the hypothetical liquidation described above. Section 14.7.3, in brackets, is the 30 percent escrow. Section 14.7.4 obtains undertakings from each individual carry recipient to pay its pro rata share directly if the GP entity cannot, with joint and several liability drafted there as a bracketed option. Section 14.7.5 makes the obligation survive removal and replacement of the GP and the dissolution and liquidation of the fund, and applies it to any former general partner.

The Principles add one more control worth negotiating for: the NAV coverage test should be established to ensure a sufficient margin of error on valuations, at least 125 percent of NAV, and the cost of enforcing clawback guarantees should be a GP, not a partnership, expense. LPs should also have the ability to directly enforce the clawback against individual GPs.

State law does not fill this gap. Delaware's limited partnership statute obliges a limited partner who knowingly receives a distribution that violates the solvency limitation to return it, and extinguishes that liability three years after the distribution. That is a creditor protection aimed at limited partners, not a mechanism for recovering excess carry from a general partner. If the LPA does not create the clawback, nothing else will.

Common mistakes

• Reading the word clawback and stopping. The cap, the tax treatment, the escrow percentage and the identity of the obligors carry all the value.
• Assuming a whole-of-fund waterfall removes the risk. It reduces it. Recycling, late write-downs and giveback obligations can still push a fund below the LP capital line after carry has been paid.
• Ignoring the individuals. Carry is usually distributed out of the GP entity to partners who may have left the firm. Without undertakings from those individuals, the obligation is stranded in an empty entity.
• Letting the fund pay for enforcement. If the partnership bears the legal cost of chasing the GP, the LPs fund both sides of the dispute.
• Treating escrow as dead money. The deal-by-deal Model LPA gives the GP the temporary investment income arising on escrowed amounts, which is a negotiable detail worth raising.

Related terms

An American waterfall is the structure that creates clawback exposure, and a European waterfall is the structure that mostly avoids it. Carried interest is what gets returned. An escrow holdback is the funding mechanism that makes the promise collectible, which is why LPs negotiate the escrow percentage and the release trigger harder than the clawback language itself.