What Does Clawback Provision Mean?
The clawback provision is a term used in the private equity world. Private equity funds are typically set up as general partnerships with the PE firm as the general partner and the investors as limited partners. The compensation for the PE firm is typically structured as a "2 and 20" fee where the 2 refers to the management fees charged, and the 20 refers to the carried interest on any returns above the preferred return.
A clawback provision allows the LPs to "claw back" any carry paid during the life of the fund on previous portfolio investments in order to normalize the final carry to the originally agreed percentage. Therefore, the clawback provision protects the LPs from paying a carry on one investment, and then having a subsequent investment incur losses.
Divestopedia Explains Clawback Provision
The clawback provision is the ultimate tool for limited partners to align total investment returns across fund investments. Understandably, PE firms don't like clawback provisions since they add risk to future returns/operations, but they appear to be here to stay.
As PE firms transition from older partners to newer partners, the clawback provisions can be even harder to manage. This is because sometimes the carry has been paid on investments that the older partners were accountable to, with clawbacks now kicking in for investments that newer partners are now managing. When clawback provisions kick in, the PE firm must ensure it has mechanisms to pay the carry back. These can include a "clawback reserve," but more often the obligation is handled by reducing or eliminating future management fees.