A “clawback” clause is written into virtually every limited partnership agreement to make sure that a GP doesn’t make money above the set carry percentage level. Here’s how it works:
Say you’re a GP and raised a $100 million fund. The fund makes 10 investments at $10 million apiece. Assume two of the investments do well immediately and return $50 million each to the, while the other eight remain held at cost. That means the portfolio is worth about $180 million at that particular point. If the LP agreement permits early distributions, a general partnership could take its share at that time and, with a standard carry of 20%, you would get $16 million of the profit after the original $100 million invested by LPs is returned to them.
The problem arises when the value of the illiquid portion of the portfolio falls after the distribution is made. For example, continuing the above scenario, let’s say that the GP lost everything on its eight other investments. Now, instead of an $80 million profit, the fund is at break-even, and 20% of zero profit is zero. But the general partners already pocketed $16 million. Oops! Because of the “clawback” clause in the LP agreement, the GPs need to give that money back to their LPs. Simple enough if the GPs put the money in the bank and didn’t touch it, but what if they used it to buy planes or mansions? The lesson is that GPs shouldn’t take their percentage of the carry until after their LPs are repaid in full.
Many LP agreements now address this risk by controlling distribution policies, requiring GPs to keep carry profits in escrow or imposing clawback requirements through a “true-up” once a year.