Davis Polk partner Michael Hong was quoted in Private Equity Law Report discussing GP clawbacks.

The article noted that limited LP liquidity caused by a lack of distributions has created a challenging fundraising environment for GPs to navigate. Michael said that the result has been a “buyers market” that favors LPs in negotiations around fund terms and provisions. Although most might expect that to manifest in reductions in management fees and carried interest, that has not been the case. Instead, most negotiating efforts are expended at the margins of economic terms, such as how claw-backs are calculated and structured, Michael continued. “I would say that clawbacks are being wrapped up into the tapestry of more fundamental material economic issues that are up for grabs in the current buyer’s market,” he added.

Discussing clawback risk for funds with a European-style waterfall, Michael noted, “Funds with high recycling capabilities are more prone to sequencing risk because recycling means you have more dry powder that you can call over the life of the fund as compared to funds that have more limited recycling capabilities.”

Noting reasons behind the increased focus on these particular clawback provisions, Michael pointed to the rising popularity of private credit funds in the marketplace in recent years. “As credit funds tend to have greater recycling flexibility than their PE fund counterparts, notwithstanding their European-waterfall features, claw-back risks have found their way into the current zeitgeist of negotiations,” he explained.

On another note, Michael explained that GPs prefer to avoid escrow provisions because they both defer the GP’s receipt of carry distributions and, just as frustratingly, require the cash to sit in the account, earning little compared to the fund’s portfolio. “Often the parties will pre-negotiate for the escrow account to be invested in a prescribed set of low-risk type of instruments,” he said. “There was a time when some GPs had discretionary authority to invest escrow proceeds into deals, but that is pretty rare now.”

Observing that escrow provisions are far less common than GP clawback provisions for managers going to market with new funds, Michael said, “Unless a firm has had an escrow concept baked into its documents since early in their life, it is pretty rare for GPs to offer an escrow option as opposed to a clawback. That said, GPs will sometimes agree to escrow provisions if they are struggling to fundraise – particularly in the current environment – or if LPs were burned by the GP performing poorly in past funds, resulting in a clawback.”

Explaining that individual investment professionals do not sign separate signature pages for guarantee agreements with each LP, Michael noted, “Instead, the guarantee is expressed as a contract for which the LPs are express third-party beneficiaries such that, for all intents and purposes, there is a direct contractual obligation between the employee receiving the carry and the LPs.”

However, he pointed out that not all types of fund managers are expected to grant those types of individual guarantees. “Bulge bracket fund managers that are obviously credit-worthy are not expected to grant those rights to investors; instead, it’s typically middle-market firms with around 25 investment professionals who receive a slice of carry distributions.”

Also, it is highly unlikely that LPs will ever practically need to act upon those individual guarantees, he added. “That would be a ‘hell and damnation’ scenario, as no LP would probably ever invest with that firm again if a clawback devolved to investors suing individual guarantors in court for claw-back obligations,” Michael added. “More often than not, if the GP wants to have any going concern value, then they will negotiate with the LPs to buy themselves some time to eventually repay the money themselves.”

“GP Clawbacks and Related Risk Mitigation Tactics LPs Pursue to Prevent Overpayment of Carried Interest (Part One of Two),” Private Equity Law Report (April 3, 2025) (subscription required)

Copy link to share post