and then highly unsuccessful in a later time period. In this case, the fund earns high profits followed by large losses.
In both cases, it is possible that incentive fees, or carried interest, could be paid during the earlier profitable stage, even though subsequent losses could cause the investment to have no profit over its entire lifetime. Thus, a limited partner could end up paying incentive fees for an investment that lost money over its lifetime. Clawback provisions are designed to address this problem for limited partners.
Consider a fund that calculates incentive fees on a fund-as-a-whole basis and makes two investments, A and B, of $10 million each. Investment A is successful and generates a $10 million profit after three years. Investment B is not revalued until it is completely written off after five years. Assume that the fund managers are allowed to take 20 % of profits as carried interest calculated on an aggregated basis. How much carried interest will they receive if there is no clawback provision, and how much will they receive if there is a clawback provision?
Without a clawback provision, the fund earned $10 million after three years and distributed a $2 million carried interest to the managers. When the second investment failed, the incentive fee is not returned. In the case of a clawback provision, the fund distributed a $2 million incentive fee to the managers after three years, but when the second investment failed, the incentive fee is returned to the limited partners, since there is no combined profit.
The goal of clawback provisions is to protect the economic split agreed between the GP and LPs. The clawback provision is sometimes called a giveback or a look-back, because it requires a partnership to undergo a final accounting of all of its capital and profit distributions at the end of a fund's lifetime. Clawback provisions are the opposite of vesting. Vesting of fees is the process of making payments available such that they are not subject to being returned.
A clawback provision is a promise to repay overdistributions, but such a promise is only as good as the creditworthiness of the GP. The GP is normally organized as a limited liability vehicle with no assets other than the interest in the fund. In the partnership agreements of many funds, the clawback provision simply binds the GP and requires his or her cooperation and financial support.
The sentiment that clawbacks are worthless is not uncommon. Situations arise in which LPs are unable to receive the clawbacks they are owed. Attempting to enforce the clawback provisions may lead to years of litigation without resulting in any return of cash. The simplest and, from the viewpoint of LPs, most desirable solution is to ensure that the GP does not receive carried interest until all invested capital has been repaid to investors. With this approach, however, it can take several years before the fund's team sees any gains, and it could be unacceptable or demotivating to the fund managers. An accepted compromise for securing the clawback obligation is to place a fixed percentage of the fund manager's carried interest proceeds into an escrow account as a buffer against potential clawback liability.
Clawbacks typically refer to GP clawbacks, or corrective payments to prevent a windfall to the fund manager. However, it is also possible for LPs to receive more than their agreed percentage of carried interest. Consequently, some partnership agreements also address so-called LP clawbacks.
3.5.6 Hard Hurdle Rates
A hurdle rate, or preferred return, specifies that a fund manager cannot receive a share in the distributions until the limited partners have received aggregate distributions equal to the sum of their capital contributions as well as a specified return, known as the hurdle rate. In other words, a hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees. This section details hurdle rates and discusses a hard hurdle rate. A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate.
Consider a $10 million fund with 20 % incentive fees that lasts a single year and earns a $2 million profit. Ignoring a hurdle rate, the fund manager would receive $400,000, which is 20 % of $2 million. But with a hard hurdle rate of 10 %, the fund manager receives the 20 % incentive fees only on profits in excess of the 10 % return, meaning $200,000. The first $1 million of profit goes directly to the limited partners. The fund manager collects an incentive fee only on profits in excess of the $1 million, which is the profit necessary to bring the limited partners' return up to the hurdle rate. Thus, the manager receives an incentive fee of $200,000.
The sequence of cash distributions with a hard hurdle rate is as follows:
■ Capital is returned to the limited partners until their investment has been repaid.
■ Profits are distributed only to the limited partners until the hurdle rate is reached.
■ Additional profits are split such that the fund manager receives an incentive fee only on the profits in excess of the hurdle rate.
3.5.7 Soft Hurdles and a Catch-Up Provision
A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved. Returning to the example of a one-year $10 million fund with a hurdle rate of 10 % and profits of $2 million, a soft hurdle rate of 10 % allows the fund manager to receive 20 % of the entire $2 million profit, or $400,000. As long as the resulting share to the limited partners allows a return in excess of the hurdle rate, then the hurdle rate can be ignored in terms of computing the incentive fee. The limited partners receive $1.6 million, which is a 16 % return.
The soft hurdle in this case allows the fund manager to receive an incentive fee on the entire profit. A soft hurdle has a catch-up provision that can be viewed as providing the fund manager with a disproportionate share of excess profits until the manager has received the incentive fee on all profits. The sequence of cash distributions with a soft hurdle rate is as follows:
■ Capital is returned to the limited partners until their investment has been repaid.
■ Profits are distributed only to the limited partners until the hurdle rate is reached.
■ Additional profits are split, with a high proportion going to the fund manager until the fund manager receives an incentive fee on all of the profits.
Once the fund manager has been paid an incentive fee on all previous profits, additional profits are split using the incentive fee. This is called a catch-up provision.
Fund A with an initial investment of $20 million liquidates with $24 million cash after one year. The hurdle rate is 15 %, and the incentive fee is 20 %. What is the distribution to the fund manager if the fund uses a hard hurdle? What is the distribution to the fund manager if the fund has a soft hurdle and a 50 % catch-up rate?
The first $20 million is returned to the limited partners in both cases. With a hard hurdle, the limited partners receive the first $3 million of profit, which is 15 % of the $20 million investment. The fund manager receives 20 % of the remaining profit of $1 million, which is $200,000. The limited partners receive 80 % of the remaining $1 million, which is $800,000, for a total profit of $3.8 million. With a soft hurdle, the limited partners receive the first $3 million of profit, which is 15 % of the $20 million investment. To fulfill the catch-up provision, the fund manager receives 50 % of the remaining profit up to the point of being paid 20 % of all profit. In this case, 50 % of all of the remaining
