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Private Equity fees – Clawback

John Barber from Bridgepoint

Most fund documents also contain often highly complex formulas covering escrow arrangements and clawbacks. These can vary significantly in their construction and impact, but in simple terms, they are mechanisms that require the GP to reserve some share of the carried interest it receives (via an escrow or a similar set-aside mechanism) to provide sufficient resources to allow LPs to claw back a portion of the carried interest previously paid to the GP if it has turned out to represent an excess share of the fund's gross profits, that is, more than the 20 percent the GP is typically due.

As noted above, under most funds' terms, a GP becomes entitled to carried interest once the LPs' drawn down capital plus the accrued preferred return on it has been returned and paid, respectively. The drawn-down capital is the key point of distinction. It is perfectly possible, in the event that a fund's earlier investments produce big wins, for those proceeds to cover the then drawn-down capital and preferred return, therefore giving the GP entitlement to carried interest, while a portion of the fund's original capital remains uncalled and available for new investments. If in turn the balance of the original capital goes thereafter into investments that prove to be loss-making, the fund may not have sufficient cash flows to repay the drawn-down capital and preferred return associated with them.

In those circumstances, through carried interest earned on the earlier, profitable investments, the GP could have received more than 20 percent of the fund's ultimate gross gains, given that the LPs have had to absorb the loss of the remaining uninvested capital by themselves. If, however, some of the carried interest earned earlier by the GP has been placed in escrow, the LPs have a readily accessible means to seek repayment of carried interest and to try to bring the balance of profits earned back into 80/20 alignment via an exercise of clawback provisions. Certainly, moving to recover funds held in escrow is far easier than pursuing individual members of the GP to repay carried interest distributions they received directly, which may well have been spent before the over-distribution scenario arises.

Clawback in 4 Simplified Steps:

1. Carried Interest Distribution: Once LPs' capital and preferred return are covered, the GP gets their profit share, typically 20%. They might receive this if early investments yield high returns, even if some fund capital remains uninvested.

2. Escrow Mechanism: A part of the GP's carried interest is reserved in an escrow to cover potential future profit discrepancies.

3. Potential Losses: If later investments in the fund result in losses, the GP's previously received carried interest might exceed their 20% entitlement of the total fund profits.

4. Executing Clawback: If the GP's share surpasses 20%, LPs can "claw back" the excess from the escrow to maintain the intended profit distribution, usually 80/20 between LPs and GP.

For many years, these lesser economic provisions did not attract as much LP interest in negotiations of terms and were often regarded as quasi-'boilerplate', covering scenarios with a very low probability of arising. This changed in 2001-02, when many previously high-flying US venture capital funds with seemingly stratospheric returns crashed rapidly after the technology, media, and telecommunications (TMT) boom turned to bust. Many such funds had recorded monumental gains on earlier investments benefiting particularly from IPOs issued via the gravity-defying NASDAQ, and had paid out carried interest to their GPs of considerable scale. Unfortunately, however, later investments that missed the window often led to catastrophic losses, leaving funds as a whole underwater and the LPs seeking redress, via escrows and clawbacks, from GPs that had received - in light of time - excess carried interest rewards. To a lesser extent, these unfortunate scenarios also played out in buyout funds that suffered unusually high levels of loss-making and written-off investments (relative to historic norms) during the GFC and its aftermath. Therefore, as theoretical estimations became practical experiences for LPs in these circumstances, some of it hard and costly, since then 'what if' terms such as escrows and clawbacks have received far more attention, across funds of all types, not just venture capital funds.

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