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Welcome to our training on the claw Back provision! This is a topic that is crucial to your understanding
of how investors and managers structure obligations regarding distributions within a PE fund.
This video will help you to understand the basics of the clawback provision and when
it would be applied. Private equity investments are by their nature
generally illiquid. Thus, private equity funds are often managed on a deal by deal basis.
In other words, upon disposition of a single investment, absent recycling, the limited
partners will typically be distributed their capital contributions and a preferred return
(if applicable) both solely with respect to that investment, and the remaining proceeds
from that investment will be shared by the investors and management. In effect, the management
group will share in the proceeds of an investment (receive its �carry�) before the investors
have been returned their capital with respect to other investments by the fund.
The problem arises when certain investments subsequently sour. After all the investments
are disposed of and the fund liquidates the investors may not receive their capital contributions
or preferred return (if applicable) on an aggregate basis. The clawback obligates the
management team to return all or a portion of the share of profits previously received
from prior deals if subsequent deals are not all profitable.
There are other solutions to this problem. First, some funds mandate the return of the
investors� aggregate capital contributions to the fund before the management team may
share in any profit. Second, some funds mimic hedge funds and include a �fair value test�
that restricts distributions of profit to the management team unless the net asset value
of the fund at the time of the distribution exceeds 100% or more of the unreturned capital
contributions. Nevertheless, most private equity funds include a clawback provision.
Typically, the clawback is triggered upon the liquidation or termination of the fund
and is measured by two alternative thresholds; one from the investors� perspective and
the other from the management team�s perspective. The first threshold is whether or not the
investors have received their capital contributions and preferred returns (if applicable). The
second threshold is based on whether or not management has received more than its share
of carry determined on aggregate basis including all the fund�s investments.
Regardless of the threshold, the clawback amount is almost always limited to the �after
tax� carry amount, i.e., the share of profit or proceeds received by the management team
less the tax on such share. However, this limitation is phrased (often incorrectly)
in a variety of different forms. Problems often arise because of the confusion among
income allocations and cash distributions and the definition of �carry�.
The clawback provision can be defined as the general partner�s promise that, over the
life of the fund, the managers will not receive a greater share of the fund�s distributions
than they bargained for. This means that the general partners will have agreed to keep
only a certain percentage of the fund�s profits (say 20%); any distributions in excess
of this 20% would have to be returned to the fund�s limited partners.
Most limited partnership agreements for private equity funds have two separate clawback components:
The limited partner clawback and the general partner clawback. General partner clawback
provisions can require the general partner to return distributions if any of the following
conditions hold true if a limited partner has not received its preferred return, the
general partner has received carried interest in excess of the contractual rate, or a limited
partner has not received its �catch-up period� share of profits. A limited partner clawback
operates in a similar manner but will �clawback� funds from the limited partners instead of
the general partners.
For years, private equity funds have been structured to provide performance-based compensation
to fund managers. In the early years of the U.S. private equity industry, most fund managers
received distributions of carried interest only after the fund's investors had received
distributions from the fund equal to their capital committed to the fund. Under this
arrangement, it was very unlikely that fund managers would receive carried interest distributions
in excess of what they were entitled to. As the private equity industry has evolved,
many fund managers negotiated for earlier distributions of carried interest. During
the fund-raising frenzy of the late 1990s and early 2000s, fund managers negotiated
front-loaded distribution provisions and, as a result of early portfolio gains followed
by significant losses, many of these managers received carried interest distributions in
excess of their share of the fund's cumulative profits, generating clawback obligations.
Traditional clawback provisions are not triggered until the fund dissolves or liquidates. Beyond
the obvious time value concerns, investors are not interested in chasing down individual
fund managers, some of whom may have left the fund group or otherwise spent the money.
And, it is common for clawback obligations to be net of the managers' tax liability attributable
to the carry. How to address the clawback issue? Common
approaches include the following: * Pay it back now. Estimate the potential
clawback liability and contribute the amount back to the fund's limited partners. This
is the simplest and most straightforward way of dealing with the problem. This approach
requires a potentially large cash contribution by a group of individual managers who may
not all have the financial ability or desire to make the required contribution.
* Create reserve accounts. Some fund managers set up reserve accounts often funded by management
fees. This can be a desirable approach if the fund's portfolio has a legitimate chance
to realize sufficient gains that could ultimately eliminate the clawback problem.
This approach is sometimes undesirable because it could pit existing members of the fund
group -- who are entitled to the current income of the management fee -- against former members
of the fund group who are not entitled to management fee income but are on the hook
for a portion of the clawback. * Management fee waiver. The most common clawback
management tool being is the waiver by managers of future
management fees in exchange for the waiver by investors of future clawback payments.
This method raises complicated tax and accounting issues that involve amendments to the fund's
partnership agreement and negotiations with limited partners.
Clawback management is a hot issue in today's fund-raising environment. Limited partners
are looking closely at how fund managers have handled past clawback obligations and are
focusing much attention on funds' distribution mechanics and clawback provisions.