Tim Eberle explores the rising tide of Clawback Risk in a changing landscape in Real Deals
The private markets sector has witnessed a significant surge in concern surrounding clawback risks in recent years. Driven by an interplay of macroeconomic factors and evolving industry dynamics, this trend is reshaping how fund managers approach risk mitigation and operational efficiency.
19 March 2025 - Private equity firms are generally protected from having to sell investments to meet withdrawal requests. However, the timing-based nature of their fee structures, especially regarding carried interest calculations, means that postponing investment exits can lead to significant risks. One notable risk is the potential for carried interest "clawback."
Clawback is a mechanism that allows limited partners (LPs) to reclaim any carried interest paid to general partners (GPs) during the fund's lifetime from previous investment exits. This ensures that LPs receive their agreed-upon returns or at least don't suffer losses.
The increasingly heightened focus on clawback risk in private markets is primarily a result of the current macroeconomic and geopolitical landscape. Several key factors are contributing to this trend:
- Extended Hold Periods: Rising interest rates are eroding portfolio company valuations, forcing fund managers to delay liquidation events beyond initially estimated timeframes. This shift towards longer hold periods is aimed at creating additional value and improving exit prospects.
- Time-Weighted Waterfall Calculations: The nature of PE-style waterfall calculations means that the return on investment required for General Partners (GPs) to receive carried interest allocations increases exponentially with each day a portfolio company remains unrealized. This dynamic can lead to situations where even increased exit values may not sufficiently compensate Limited Partners (LPs) for the time-weighted value of their capital.
- Early Realizations vs. Later Underperformance: GPs who have been allocated carried interest based on early fund realizations may find their returns dropping below the Preferred Return threshold due to longer hold times on remaining investments, significantly increasing the risk of clawback.
To address these growing concerns, fund managers are turning to sophisticated risk mitigation strategies, with technology playing a pivotal role. There are various approaches funds can adopt, such as implementing a comprehensive process of downside scenario modeling. This can be performed not only at the time of distribution but also periodically, as part of standard front and back-office analysis. Key components include projected downside valuations, "zero proceeds" analysis (projecting 100% loss on unrealized investments), and post-carry Fair Market Value (FMV) tests.
Given the complexity of waterfall calculations and the multitude of factors involved in downside scenario modeling, fit-for-purpose technology has become almost indispensable. Advanced software solutions can enable funds to handle complex calculations with ease, provide real-time scenario analysis, and offer insights for decision-making on realizing or deferring carried interest.
In addition, utilizing technology provides enhanced reporting and transparency, and more frequent, detailed reporting to LPs can help build trust and manage expectations around potential clawback scenarios.
Streamlining Operations for Complex Fund Structures
For Real Assets funds, particularly those involved in Real Estate and handling complex joint venture structures, technology can play an even more crucial role in streamlining operations. Advanced software can handle unrealized/hypothetical distributions, realized cash distributions, and scenario/projection calculations, as well as allocate deal-specific carried interest calculations.
Deal teams can also leverage this technology to test partners' projections and record hypothetical distributions in financial statements, allowing for more accurate forecasting of actual cash distributions upon asset sales.
Technology can also help to solve the unique challenges real estate funds face (including post-Covid migration patterns, changing work arrangements and interest rate fluctuations).
The Future of Clawback Risk Management
As we look to the future, it's clear that the landscape of clawback risk management in private markets is evolving rapidly. Fund managers who embrace innovative technologies and adopt proactive risk mitigation strategies will be better positioned to navigate these challenges successfully.
The key trends to look for will be the integration of AI and Machine Learning, which could revolutionize scenario modeling and risk assessment, providing even more accurate and timely insights. As fund structures become more complex, we can also expect to see more tailored technological solutions that cater to specific fund types and strategies. Lastly, technology will likely play a growing role in facilitating transparent and real-time communication between GPs and LPs regarding fund performance and potential clawback scenarios.
The rising concern around clawback risks in private markets is not just a temporary reaction to current market conditions but a signal of a fundamental shift in how the industry approaches risk management. By leveraging advanced technology and adopting more sophisticated analytical approaches, fund managers can not only mitigate clawback risks but also enhance their overall operational efficiency and investor relations.
As the industry navigates this new landscape, it's crucial for managers to stay ahead of the curve, embracing innovation and continuously refining their risk management strategies. Those who do so will be well-positioned to thrive in an increasingly complex and challenging private markets environment, ensuring long-term success for both their funds and their investors.
This article was originally published in Real Deals.