Considerations of Private Equity Fund Clawback Liability

As previously discussed in Structuring a Carried Interest, funds will often grant an interest in profits known as a carried interest to its general partner (GP) in order to incentivize the GP to maximize profits overall.

The form of carried interest can vary widely, but generally will fall into one of two structures: first, it can be accrued on a deal-by-deal basis; or second, it can be based on the performance of the entire fund. This article discusses how clawbacks work in the context of private equity carried interest and discusses some ways to avoid or manage clawback liability.

How Do Clawbacks Work?

When a fund allows for a carried interest, a common provision in the agreement is for a clawback from the GP. In essence, if the GP receives a distribution against its accrued carried interest that it ends up not being entitled to (often for failing to meet certain performance levels), the GP must return it to the fund so that it can be allocated back to the limited partners (LPs). Effectively, it serves as a deficit restoration obligation (DRO) for the GP in the event that its book capital account is negative.

For example, assume a fund calculates a 20% carried interest based on overall performance. In the first year, the fund has unrealized gains of 100, and accrues a carry of 20 to the GP. The GP then takes a distribution of that 20 as cash. In the second year, the fund has an unrealized loss of 100. Inception to date, the fund has no profit, and thus the GP is entitled to no carried interest. However the GP has already taken a distribution of 20. If the fund liquidates with no further gains, a clawback provision protects the rights of the LPs to receive that cash back.

The Decision to Incorporate a Clawback

There is no requirement for a partnership to have a clawback provision in its agreement. Partnership allocations are however required to have substantial economic effect, and one component of that is a DRO, which is a required obligation by a partner in a partnership agreement to restore any deficit (positive or negative) balance in their capital account when the partnership liquidates. A DRO can mirror a clawback provision for a GP since any partner with a negative book capital account upon liquidation would be required to make a contribution at least equal to the deficit. But even a DRO is not necessarily required if a partnership meets an alternative test for economic effect, such as a qualified income offset. Ultimately, it is up to the fund manager to decide how the fund should operate and whether to incorporate a clawback provision. If an LP investing in a fund wishes to protect its interest, it would either need to confirm that a clawback exists in the agreement, or request it prior to signing.

How to Manage or Avoid a Clawback Liability

 

Limits on Distributions

At its simplest, a fund can avoid any possibility of a clawback (whether required by the agreement or purely from an investor relations standpoint) by making no distributions to the GP until it is absolutely certain the GP is entitled to a carry. This is perhaps easiest in a deal-by-deal structure, where the economics of a particular deal, and thus the carried interest calculation, are certain at its completion. Similarly, a hedge fund calculating a carried interest on a quarterly basis should be able to determine the carry at the close of each period. But where a carry is based on the overall performance of the fund since inception, it may not be possible to be certain how much carried interest the GP is entitled to until liquidation.

This simple case however, is unlikely. Even if the GP wishes to avoid taking distributions of carried interest until the calculation is certain, it will still likely receive ongoing allocations of taxable income based on the accrued book carry. Tax allocations to the GP cannot simply be made upon liquidation when the carry is determined and distributed since there may not be enough taxable income during the year to allocate for the carry in full. The GP will likely receive allocations as income is recognized, meaning that the GP will likely want tax distributions, if nothing else. Tax distributions are not apart from the carried interest; they are, in fact, debited from the GP’s capital account, and reduce any future carried interest distributions. If the GP is ultimately entitled to less carry than the tax distributions it received inception to date, and if the agreement contains a clawback provision, the GP would be required to pay back its tax distributions whether or not it receives a tax benefit for losses allocated in later years.

Balance Competing Interests

Since there is no requirement for a clawback provision, funds have flexibility to write them in ways that balance the competing interests of the GP and LPs. While LPs may insist on a clawback, the GP may be able to negotiate a cap on the amount, such as a clawback only for distributions in excess of the GP’s tax liability. The GP should also plan for some amount of liquidity, either itself or from its members, just in case there is a clawback. If a manager feels that one or more members would be unable to recontribute a clawback obligation to the fund, it may wish to require that cash is put in escrow, or simply not distributed out of the GP until a particular event.

Fund Capitalization

The GP can also avoid or mitigate a clawback through a fund capitalization, which generally occurs near or after the term of the fund. While a fund is winding down, the GP may decide to continue to manage its remaining investments which can be accomplished by creating a new fund. The remaining assets of the existing fund will be sold or contributed to the new fund along with new buyer capital. Investors of the existing fund may have the option to sell their interest or roll it over into the new fund either on existing fund terms or new fund terms. New investors can: 1) purchase interest from existing investors who choose to sell or 2) commit to additional capital for add-on or new investments. Meanwhile, the GP generally will be required to roll over its interest in the existing fund to the new fund.

The fund capitalization described above allows for a greater time period for the GP to earn carry and potentially reduce or eliminate the clawback liability. The clawback related to the investors that cashed out from the existing fund will have settled with the new investor capital. Investors that choose to roll over into the new fund may be willing to re-set the valuation over which carried interest distributions are payable, factoring in any clawback amount. From a tax perspective, under this scenario there is no tax gain or loss to report at the GP level. The GP’s tax basis in the existing fund will be carried over to the new fund, which should be close to its equity investment. The GP would have received tax income allocations close to carried interest distribution in year(s) distributed causing little to no change in basis. It is important to note that a fund recapitalization offers multiple potential upsides with clawback flexibility merely being one of them.

Timing

Another consideration is the timing of the clawback liability. Generally, the clawback liability is applied once at or near the end of the fund’s term when there is no additional carried interest expected. For their own benefit, however, LPs are more likely to request interim clawback test dates from the investment period through the end of the fund term. Periodic testing can help mitigate clawback obligations. If testing shows there may be an obligation, the fund can prevent future distributions to the GP. Additionally, the fund should make the clawback calculation if there are only straggler investments since there would be no additional carried interest at that point. These investments could delay the liquidation of the fund or even cause the fund to extend the term, which could cause tension amongst the LPs.

The Takeaway

The handling of the clawback provision, or lack thereof, and how the obligation is paid can be a source of conflict between the LPs and the GP. To ease this tension, it is important when a fund is created to discuss clawback obligation details and for the partnership agreement to include proper provisions, if applicable, that meet both the LPs and GPs’ expectations.