What is a 'Clawback'
A clawback provision is generally associated with private equity funds. Based on the compensation structures for private equity funds, clawback provisions protect limited partners for paying fees they shouldn't. Clawbacks provisions enable investors to normalize the final carry of the fund by taking back carry paid on previous investments to avoid incurring losses on other investments in the portfolio.
BREAKING DOWN 'Clawback'Clawback provisions are typically triggered when a fund is being liquidated, and depending on previous distributions, may result in the general partners of the fund to return all carry to investors. Taxes are often a major factor with clawbacks, as some portion of distribution carry is earmarked to pay tax liabilities.
Why Clawbacks Exist
When private equity was a new asset class, the general partners of the fund only received distributions from the fund they managed after all limited partners had received their initial capital contributions back. Typically, this could be up to 10 years after the start of the fund. Over time, private equity managers negotiated with their investors and new contracts and funds allowed general partners receive distributions earlier.
Clawbacks were created to protect limited partners in three ways. If the total fund does not reach its target preferred return, known as the hurdle rate (which is usually around 8%), a clawback could be triggered. Second, if at the end of the fund's life it is determined that the general partner earned profits exceeding the contractual ceiling (usually around 20%), a clawback could be triggered. In a third, more complicated case, a clawback may be triggered if a limited partner has not received his share of catch-up period profits.
Clawbacks are triggered at the end of a fund's life when all investments have been liquidated. At that point, any excess carried interest received by the general partners is calculated, taken back and distributed to the limited partners, pro rata.
Private equity firms do not find clawbacks favorable, as they add elements of risk and uncertainty to fund's returns and the firm's operations. Nonetheless, clawbacks are extremely popular among limited partner investors and will likely remain a staple in private equity contracts for years to come.
Another Clawback Definition
Another definition of a clawback consists of money or benefits that are distributed to an investor and then taken back as a result of special circumstances. For example, purchasing certain investments provides taxable benefits contingent upon holding periods. When an investor sells these investments before they have reached maturity, the tax benefits must be forfeited.