Clawback Definition

Originally published on August 2, 2002

Clawbacks are written into virtually every limited partnership agreement to make sure that a GP doesn’t make money at an LP’s expense.

Here’s how it works: Say you’re a GP and raised a $100 million fund and made 10 investments at $10 million apiece. Assume two of the investments did well, earning $50 million each, while the other eight were held at cost. That would mean the portfolio is worth about $180 million. If you subtract the $100 million that was invested by LPs, that leaves you with a gain of $80 million, 20% (or $16 million) of which you may take when you distribute 80% of the profits on the two deals to LPs. Now assume that the value of the remaining portfolio falls by half to $40 million, a realistic scenario these days. Instead of being ahead by $16 million, you’re now “over distributed” by $8 million.

Traditionally, GPs wait to see how a portfolio does over its lifetime, betting that it will eventually produce a gain and, thus, eliminate having to pay a clawback. Today, GPs are less certain that their 1999 funds will produce positive returns, so they’re trying to cover themselves before being hit with a major clawback at the end of a fund’s life.

“Imagine you have a fund of $1 billion and you have returned nothing or 10 cents to date, and what’s left in your portfolio is a lot of questionable stuff,” a spokesman for Spectrum Equity Investors says. “How do you say to yourself, I’m going to continue to take the fee and I’m going to deal with it seven years from now [at the end of the fund’s life].”

Yet another factor to consider: What’s a fair fee once most of a fund has been invested? Say you’ve invested 60% of a $100 million fund, but you’re still charging your LPs 2.5% of the fund’s overall size of $100 million. “That’s $2.5 million, and if you divide that by $40 million [the amount of the fund that remains to be invested], that’s a fee of 6.25%,” the spokesman says. “That makes no sense.”