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- 🛠️ Investment Fund Key Terms, Part 20
🎉 Happy Friday, funds family!
Today, we have Part 20 in our many-part series walking through each term in an investment fund term sheet in detail.
Here’s the index of each article in this series (so far):
This week focuses on Carried Interest Clawback.
But first..
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Thanks for reading. Now, let’s jump into the article 😃
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Beware of the clawback! 🦀 It sounds like the villain from a children’s movie.
➡️ What is a clawback?
The carried interest clawback is a contractual obligation requiring the General Partner (or other carry recipients) to return previously distributed carried interest if, at the end of the fund, the GP has received more carry than it is ultimately entitled to.
Think of it as the “true-up” that protects LPs from over-distribution risk.
To be specific, the carried interest clawback essentially re-tests the waterfall as of the date of the final disposition of the fund’s assets. If the GP got more carried interest over the life of the fund if it would have pursuant to this re-test, the excess must be returned to the fund.
➡️ How could the GP get too much carried interest, such that a clawback is possible?
Clawbacks aren’t talking about accounting errors or fraud where GPs send themselves too much carry. Scenarios where a clawback comes into play include the following:
American Waterfalls. In “deal by deal” waterfalls, the GP might earn carry on “winners” even if other deals lose money.
European Waterfalls. Even in “netted” waterfalls, the fund could theoretically call 50% of capital commitments, exit favorably (and the GP earns carried interest), call the next 50% of capital, and have a total loss on this second round of investments.
In both situations above, the clawback is the great equalizer at the end of the fund’s life.
➡️ What are variations on clawbacks?
Most clawbacks are tested at the final distribution of the fund’s assets. However, some agreements might have multiple clawbacks staged throughout the fund’s life.
Some fund agreements have escrow provisions requiring a portion of the carry to remain escrowed in the fund until the clawback risk has been reduced.
Many fund agreements reduce the amount of money the GP must return by the amount of actual taxes the GP paid when it received the carry in the first place.
Some fund agreements require the principals of the GP (the actual humans) to personally guarantee the clawback, as opposed to the obligation resting with the GP entity alone.
⏩ Next up in Part 21 – LP givebacks
Thanks for reading, everyone.
Have a great weekend! 🙌
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