Clawback Provision

A clawback provision is a term in a contract that obliges a party to give back money it has already received if specified conditions are later met. In private investment funds, it requires the fund manager to return performance payments that turn out, over the life of the fund, to be more than its agreed share of profits. In employment, it requires executives or other staff to repay bonuses that were based on results later shown to be wrong, or that were followed by misconduct or failure.

The purpose in both settings is to make sure that pay reflects the final outcome and not an interim one. A clawback differs from malus, which is the reduction or cancellation of an award before it has been paid. This entry deals mainly with clawbacks in private funds and then with those in remuneration.

In a private equity or similar fund, the manager's share of profits is its carried interest. Where carry is paid deal by deal, as each investment is sold, the manager may receive carry on early successes and the fund may then suffer losses on later investments. Taken as a whole, the fund may have earned less than the level at which carry is due, or investors may not have received their preferred return.

The clawback corrects this. At the end of the fund's life, and sometimes at interim points, total distributions are tested against the distribution waterfall applied to the fund as a whole. If the manager has received more than its entitlement, it must pay the excess back to the fund for distribution to investors.

A simple example: a fund makes two investments of 50 million each. The first is sold for 100 million and the manager takes carry of 10 million on the 50 million gain. The second is written off entirely. Over the whole fund, investors put in 100 million and the investments returned 100 million, so there was no profit and no carry was due. The manager must return the 10 million.

The amount recoverable is usually capped at the carry received net of the tax paid on it, on the argument that recipients cannot return money already paid to the tax authority. Investors can therefore be left short even when the clawback is enforced in full.

Collecting the money is a practical problem. Carry is distributed to individual partners, who may have spent it, left the firm or died by the time the fund is wound up ten or more years later. Fund agreements address this in several ways:

• Escrow. A portion of each carry distribution, often 20% to 30%, is retained in an escrow holdback until the fund's final accounting.
• Guarantees. Each carry recipient guarantees its own share of the obligation, and sometimes the management firm or its parent guarantees the whole.
• Interim tests. The clawback is calculated periodically during the fund's life, so that excess carry is returned or future carry withheld before the amounts grow.
• Waterfall design. A whole-fund waterfall, under which no carry is paid until investors have received all their contributions and the preferred return, makes a clawback far less likely to be needed.

A manager with its own money at stake through a general partner commitment has a further incentive to avoid over-distribution.

Fund agreements often contain a second, separate provision working in the other direction. A limited partner clawback, or giveback, allows the fund to recall distributions already paid to investors in order to meet the fund's liabilities, typically indemnity claims or warranty claims arising from the sale of an investment. It is normally limited in amount, for example to a percentage of distributions or of the investor's limited partner commitment, and in time, often two or three years after the distribution.

Clawbacks of pay became widespread after the financial crisis of 2007 to 2009, when bonuses had been paid on profits that later reversed. In the United States, under the Dodd-Frank Act and a rule adopted by the Securities and Exchange Commission (SEC) in 2022, listed companies must have a policy to recover incentive pay that was awarded to executive officers on the basis of financial results later restated, covering the three preceding years and regardless of fault.

In the United Kingdom and the European Union, remuneration rules for banks require a substantial part of variable pay for senior staff and risk takers to be deferred and to remain subject to malus and clawback for a number of years. Triggers include misconduct, material failures of risk management and a significant downturn in financial performance. For those covered by the Senior Managers Regime, the periods are longest. A hedge fund performance fee, by contrast, is rarely clawed back once paid.

Clawbacks are easier to write than to enforce. Recovering money from individuals may require litigation, employment and tax law may limit what can be reclaimed, and in some jurisdictions repayment of earnings already taxed gives no tax relief. Firms accordingly prefer deferral and malus, which keep the money within reach. In funds, actual clawback payments are uncommon, largely because escrow arrangements and whole-fund waterfalls prevent the excess from arising.