With private equity firms unable to sell or take their companies public, managers are growing concerned about the risk that investors will “claw back” incentive fees they paid in previous years.
Citco reported a 35 percent increase in questions and requests for support from private equity firms for clawback risks in 2023 alone. Citco provides administration services for private equity firms and hedge funds that manage approximately $800 billion.
Clawbacks, which protect investors from paying incentive fees on gains one year, only to experience a loss the next, are a common feature of contracts between private market firms and the allocators. Clawback provisions bar managers from collecting more than a certain percentage (usually 20 percent) of the profits of a fund over its lifespan. If they do, managers are required to return the “excess” incentive fees to their investors.
The risk that investors will seek clawbacks is rising, as managers face challenges in selling companies at a profit or listing them publicly. Managers may have received carried interest — incentive fees — as they sold investments early on in the private market rally. But the drop-off in private equity activity since then could result in investors clawing back some of those fees.
According to Citco, PE firms that delay realizing gains or losses on investments can incur “significant downside risk,” as LPs can then claw back incentive fees.
Private equity firms can lower the risk of facing clawbacks, while also not hurting investors.
“It is important to note here that the process of mitigating clawback risk does not disadvantage LPs in any way,” said Tim Eberle, head of waterfall services at Citco, in a statement. “In fact, the opposite is true: having a defined process for clawback mitigation provides both GPs and LPs with an enhanced framework for transparently managing waterfall distributions — saving both parties the complication of enforcing clawbacks post-tax, thereby preserving the GP-LP relationship.” Waterfalls are the process of distributing profits between managers and investors.
For funds that use American-style waterfall calculations, multiple on invested capital calculations, rather than internal rates of return, can offer stability, according to Citco.
“While this structure certainly does not eliminate the risk of clawback, it gives the GPs the ability to realize carry on profitable realizations, while providing a mechanism to mitigate future clawback risk in adverse macroeconomic conditions,” according to the firm.
Private equity firms may also prepare for these risks by holding carried interest in escrow and run more detailed scenario analyses, according to Citco.