Clawback

A clawback provision requires a fund manager to repay excess carried interest received. It applies if, at the end, it turns out that the manager has received more over the fund's lifetime than they were entitled to. This ensures that investors ultimately keep their fair share.

The need arises mainly under the American waterfall model, which distributes profits deal by deal: if a fund sells a very successful company early, the manager may already receive carried interest on it, while later losses on other holdings can depress the overall result to the point where investors do not fully recover their preferred return or even their contributed capital. The clawback is therefore calculated at the end of the fund's life through a whole-of-fund reconciliation and is normally capped at the amounts actually received. Because enforcement against individuals can be difficult, investors secure the claim in practice: by holding back part of distributions in escrow, by personal guarantees from the partners involved, or by joint and several liability within the management team.

A further point of dispute is whether repayment is gross or after tax, since the manager has already paid tax on the original distribution. Under the European waterfall the situation arises less often, because carried interest distributions only follow full repayment of capital and the preferred return. Comparable clawback clauses appear outside the fund world in management incentive plans and in bonus arrangements.

For the amount withheld, a tiered arrangement has proven itself in practice, under which part of the distributions is held in escrow until a defined ratio of distributed to paid-in capital is reached, after which the retention falls away. The timing of the reconciliation also needs settling, since an interim test after a few years prevents a clawback claim from building up until the end of the fund's life. Both points are regularly negotiated together with the waterfall.

Note: This explanation is for general information only and does not constitute legal advice. The legal position depends on the individual case and may change with new legislation or case law. For a binding assessment, please consult a qualified lawyer.