Claw Back Provision - Private Equity - YouTube

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.