Private Fund Insights Blog

Most private fund partnership agreements providing for a disproportionate share of the fund’s profits to be distributed to the fund’s general partner as carried interest also provide for the possibility that all or some of those distributions may be clawed back in connection with the dissolution of the fund, and sometimes also on other dates.  While the carry clawback would reverse carry distributions in excess of what were permitted under the distributions waterfall, this is not its real purpose.  The purpose of the clawback can be difficult to describe, but it has to do with the sequencing of investment returns.  Below, we give a highly stylized example of a carry clawback scenario and use this example to illustrate the purpose of the clawback and explore the different ways in which these provisions are commonly drafted. We conclude with a discussion of a couple of the common negotiating points on carry clawbacks in the current market. 

Clawback Example

For purposes of our example, consider the case of a fund, Private Fund, whose investors have made commitments of $200 million, and the partnership agreement of which has a return-all-capital waterfall with no preferred return and a 20% carried interest.  To keep our example simple, we will assume Private Fund has no non-investment expenses. 

Suppose that Private Fund calls $100 million of investor capital, invests those capital contributions in Private Company 1, and then sells that investment a few months later for $200 million.  Under Private Fund's partnership agreement, the $200 million of investment proceeds are distributed as follows:

• First, $100 million to the Private Fund partners in proportion to their capital contributions; and
• Second, $20 million to the Private Fund general partner as its carried interest, and $80 million to the Private Fund partners in proportion to their commitments.

Now, assume that after this distribution is made, the remaining $100 million of commitments are called and invested in Private Company 2.  A few months later Private Company 2 declares bankruptcy and Private Fund’s investment in Private Company 2 is written off as worthless.  At this point, having no remaining capital commitments, the partners of Private Fund agree to liquidate it early. 

Private Fund of course has no property to distribute in its liquidation.  However, its investors notice they made $200 million in total contributions to Private Fund but have only received $180 million in total distributions.  Thus, they have suffered a 10% loss on their investments, but the general partner has received $20 million in carried interest distributions.  In a case like this, most partnership agreements will provide for a portion of the $20 million of carry distributions to be “clawed back” from Private Fund’s general partner and distributed to its partners in proportion to their commitments.    

Purpose of Clawback

A common misconception is that the purpose of the carried interest clawback is to reverse carry distributions made in excess of the amounts permitted under the distributions waterfall.  However, in our example the $20 million carry distribution that is clawed back was made in accordance with the distributions rules.  While it is true that a carry clawback would reverse a distribution made in violation of the distributions rules, the actual purpose is to address situations like the one in our example.  The carry clawback’s purpose is thus to reverse and recalculate prior distributions where, due to the timing of capital calls and investment returns, the general partner receives in excess of the agreed portion (i.e., either the applicable carry percentage or, if capital has not been returned and any hurdle met, 0%) of the total profits distributions.   

Our stylized example was of a fund with a venture capital style return-all-capital waterfall with no preferred return and a single carry tier.  This type of waterfall is the simplest of the types that we regularly see and is also the one that is the least likely to result in a clawback (holding the pattern of investment returns constant). 

Most of the distributions waterfalls we see in our practice are more complicated than the one in the example in one of (or a combination of) three ways.  First, many waterfalls permit carry distributions before the full return of capital.  An example is the traditional buyout fund cumulative deal-by-deal waterfall, under which carry may be distributed once capital contributions attributable to realized investments (and usually a designated portion of general expenses) have been returned.  Second, many waterfalls require that investors have received at least a minimum hurdle return (e.g., 8%) before carry is distributed.  Third, many waterfalls have different levels of carry (e.g., 20%, 25% and 30%) available contingent on meeting different return thresholds.  Each of these three variations on the simplest form of a distributions waterfall complicates the drafting of the clawback, and some — particularly early carry distributions and tiered carry thresholds — also make a situation warranting a clawback more likely to arise.

Drafting

Having considered the purpose and operation of carried interest clawbacks, we can now consider how they are drafted.  While we cannot give an exhaustive list of how clawbacks are drafted in the market, we do most frequently see that their drafting follows one of four basic patterns.  For clarity, in all four cases the clawback is calculated as of the liquidation of the fund and, as we discuss in the next section, potentially also at earlier specified dates. 

As an example of the first of these four drafting patterns, a partnership agreement we recently reviewed provided for the clawback amount calculated with respect to each investor to be determined based on whether the investor had received “the proportion of all distributions to which the Investor is entitled under . . . the distributions waterfall.”  At best this reference to the distributions the investor was entitled to under the waterfall is ambiguous, and at worst it could be interpreted to only provide for the clawback of carry distributions made in violation of the waterfall.  Assuming the partners’ business deal is instead what we have described above in this blog post, we generally believe this drafting should be avoided.

The second way clawbacks are drafted is to provide that the clawback is calculated based on the greater of (a) the total amount of carry distributions, if investors have not been returned all of their capital and the preferred return, and (b) carry distributions exceeding the carry percentage (often 20%) of the total profits distributions made in respect of the investor’s interest.  This has the advantage of being a more precise formulation.  However, if the distributions waterfall has more than one carried interest level, or more than one layer of hurdle calculation, this manner of drafting the clawback can be impractical. 

A third way clawbacks are drafted is by comparing the actual carry distributions with the distributions that would have been made if all distributions had been made at one time on the liquidation of the fund, except that for purposes of calculating any time-based hurdles the actual distribution dates are taken into account.  This is a bit vaguer than the second method but has become increasingly common over the past several years as waterfalls have become increasingly complicated.  The great advantage of this calculation method is that it easily and efficiently handles more complicated waterfalls. 

The final common method of drafting carry clawbacks is by basing them on the positive balances of investor capital accounts following the fund’s final distribution.  Very roughly, capital accounts in the context of private funds are bookkeeping accounts that track the book value of an investor’s interest in the fund.  They are almost always maintained in accordance with IRS regulations, and the rules for their calculation are complex and sometimes counterintuitive.  They are not expected to always reflect the fair value of the investor’s interest in the fund.  While this calculation method also easily handles more complicated waterfalls, it has the disadvantage of being counterintuitive for many practitioners, and it also carries a higher risk than other calculation methods of leading to surprising results.  In our experience, this method is more commonly used by venture capital funds, and its use is often driven as much by tax as by commercial considerations. 

Commonly Negotiated Points

 The negotiation of carried interest clawbacks is always done with an eye to the distributions priority waterfall, as these clauses in a private fund partnership agreement are inseparably linked.  Indeed, the preceding discussion should make it clear that one could almost view the clawback as a part of the distributions waterfall.  There is a natural give and take between how favorable the distributions waterfall is to the general partner and how protective the clawback is for the investors.  One protection that is sometimes included in this mix is for the clawback to apply at one or more times prior to final liquidation, such as at the end of the investment period or at 10 years into the life of the fund.  Note that application of the clawback prior to final liquidation will usually only be possible with a fair market valuation of the remaining investments, and thus interim clawbacks have some resemblance to distributions rules that condition carry distributions on the remaining investments meeting some minimum valuation thresholds.  Those rules have also become more common in recent years, and are part of a complex of protections all relating to the distributions sequence and timing issue addressed by the clawback.  

In addition to negotiating at what times the clawback might be applied, there is also often negotiation over whether the clawback obligation should be guaranteed.  Because the carried interest is typically distributed to the general partner, or to an SPV set up specifically to be a conduit for carry distributions, it is almost always possible that the entity which has the obligation will not be creditworthy by the time the obligation arises.  Because of this, most partnership agreements require some or all of the ultimate recipients of the carried interest to guarantee the obligation.  Investors sometimes seek for joint and several guarantees, although in practice this has been common only in certain narrow circumstances. 

A third common point of negotiation relates to the effect of taxes on the clawback.  Presumably, any distributee of carried interest paid taxes on that carry, and thus did not receive the entire amount.  General partners often argue that the clawback obligation should be limited to the distributions received net of taxes.  Further, the amount of taxes borne on a carry distribution varies based on several factors, including many factors particular to the recipient, such as the recipient’s place of residence and their household income.  Accordingly, general partners typically seek to calculate the clawback obligation based on assumed hypothetical taxes, often set at the highest amount that could have been borne by an individual in the jurisdiction with the highest tax rates applicable to any of the carry recipients.  Investors have often negotiated both of these points, and in more recent years have also sometimes advocated that the reduction for hypothetical taxes should be reduced to account for the tax benefit of the clawback.  It should be noted here that such tax benefit could be difficult to calculate in practice. 

One final negotiating point has become more common in recent years as distributions by funds of securities in kind, including in respect of the carry, have also become more common.  Where a portion of the carry distributions have been in the form of securities rather than cash, it may often be the case that the carry recipients have retained those securities in the interim, whether because they desire to avoid the tax implications of selling them or for some other reason.  General partners have often sought to permit the satisfaction of the clawback by the return to the fund of the securities.  Here the negotiation is often around valuation and related questions regarding liquidity.  For example, if the securities being contributed are illiquid, one might doubt whether they can be valued reliably.  Even if they are publicly traded, it is possible they will represent a meaningful portion of the stock’s float, and thus it might nonetheless be difficult to obtain a reliable valuation.  Finally, general partners have sometimes argued that simply returning the stock should be sufficient, even if it has declined in value, as that would constitute the return to them of everything that was distributed.  There is an obvious parallel here to the treatment of taxes, but this has commonly been resisted quite vigorously by investors. 

Conclusion

 Private investment funds are intended to be long-lived entities, and as such the fortunes of their investment portfolios can wax and wane over time.  Because funds’ investments are usually not all sold at the same time, there is a risk that profits with respect to the investments that are disposed first do not necessarily mean that the investments sold afterwards will be as profitable.  Put differently, there is a risk that the division of profits between the partners early in the life of a fund may not be consistent with the fund’s total profitability at the end of its life.  Carried interest clawbacks are meant to address this risk, and while the example in this article was highly stylized for the purpose of illustration, these are nonetheless realistic risks that both investors and general partners should keep in mind. 

To discuss structuring or negotiating carried interest clawback provisions, please contact a member of our Private Funds & Investments Practice Group.