Clawback and Aggregation

Carry on

What happens if a venture fund hits several home runs early in its life, liquidates these investments at a large profit, and then strikes out with the lion's share of its residual capital? In the absence of what is known as clawback protection, the GP can pocket its specified share of the gains on the early winners (typically 20% to 30%), collect its annual management fee for the partnership's remaining life, and profit from the whole exercise even though the fund as a whole proves disappointing to the LPs. To guard against this spectacle, LPs do several things. First, they demand that there be a netting of gains and losses for purposes of determining the dollars paid to the GP in the form of its carried interest over the partnership's life. This netting of gains and losses is often referred to as "aggregation." Aggregation clauses provide strong incentives for GPs to improve the performance of troubled investments.

Worth the Wait

Since most GPs understandably do not like to wait until a partnership is liquidated to receive at least a portion of their carried interest, GPs whose clients insist on clawback privileges typically negotiate an arrangement under which a portion of the GP's after-tax carried interest is escrowed during the life of the fund. An alternate means of helping ensure that clawback and aggregation clauses have teeth is to make the individuals managing the fund jointly and severally liable for returning to the LPs any excess distributions the GP has received.