Clawback is a promise; escrow is the money.

A fund that pays carry before its last position is sold pays it on an account that is not closed. The positions sold so far have produced gains above the hurdle, and the waterfall has paid the manager its share. The positions still held may lose, and if they do, the fund's whole-life gain is less than the carry paid assumed, and the manager has been paid carry on gains the fund did not make. The clawback is the manager's promise to repay the excess at the end. The escrow is money set aside from the carry paid, held by a third party, against the promise. The two are described together and they are different things: a promise is an unsecured claim against a manager that may by then have nothing, and an escrow is cash. A document that provides a clawback and no escrow has provided the register with a claim; a document that provides both has provided the register with the money.

This note sets out why carry is paid before the end, the clawback's mechanics, the guarantee beneath it, the escrow's mechanics and its cost, the net-of-tax question, the interim test that reduces the need, the whole-fund versus deal-by-deal choice, the lender's reading, the continuation vehicle's effect, a comparison, a worked clawback as a type, cases, what each party holds, the sequence, questions, terms and what to read.

Why carry is paid early

A whole-fund waterfall pays carry only once all contributed capital and the hurdle on it have been returned, and the manager on a ten-year fund may see carry in year seven. A deal-by-deal waterfall pays carry on each position's sale, once that position's capital and hurdle are returned, and the manager sees carry at the first exit. Managers prefer the second and investors the first, and the usual settlement is a whole-fund waterfall with an interim carry distribution once a test is met, or a deal-by-deal waterfall with a clawback. In either, carry is paid while positions remain, and the question of the excess at the end arises.

The clawback's mechanics

At the fund's end, or at an interim test date, the administrator computes the carry the manager would have received had the waterfall run once on the whole life, and compares it to the carry paid. If the paid exceeds the computed, the excess is the clawback amount, and the manager repays it within a period. The document says whether the computation is at the fund's end only or at interim dates, whether it is net of the tax the manager paid on the carry, whether the obligation is the manager's or its principals' severally, and whether it is secured.

The repayment obligation is the manager's. The manager is a company whose assets are its charge income, which has stopped by the fund's end, and whose carry has been distributed to its principals as it arrived. A clawback against a manager with no assets is a claim against nothing, and the document reaches behind the manager to the principals by a guarantee.

The guarantee

The principals guarantee the clawback, severally, each for the carry it received. The guarantee is a personal obligation of each principal for its share, and its worth is the principal's worth at the fund's end, which the register cannot assess and does not control. Principals leave, die, become insolvent or move to jurisdictions where the guarantee is unenforceable, and the register's claim is against each of them in turn. The guarantee is better than nothing and worse than money, and the document that provides it has provided the register with a list of people to sue.

Why a promise and money are described together

The clawback and the escrow appear in the same clause of most documents, under one heading, and the memorandum summarises them in one sentence: carry paid early is subject to clawback, secured by escrow. The sentence makes the escrow sound like the clawback's security, and in a sense it is; but the sentence does not say what percentage is escrowed, whether it is net of tax, what the release test is, or what the register holds for the balance. A register that reads the sentence and not the clause believes it holds money for the whole clawback, and it holds money for the escrowed percentage and a promise for the rest. The two are described together because the manager's counsel drafted them together, and they are read apart because each is worth something different.

The excess, computed

The excess is the difference between carry paid and carry that a single whole-life run of the waterfall would have produced. The computation needs every cash flow in and out, by date, and the waterfall's order applied once to all of them. The administrator runs it, and the computation is disclosed to the committee with its inputs. A computation that uses the valuation of unsold positions, at an interim date, is an estimate; a computation at the fund's end, with every position sold, is a fact. The document says which dates use which, and the escrow's release at an interim date is on the estimate's strength, with the agreement's terms for a later shortfall.

The order of recourse

When the clawback is due, the document fixes the order: the escrow first, then the manager, then the principals under their guarantees. A document that lets the register choose its order lets it sue the principals while the escrow sits; a document that fixes the escrow first applies the money before the promise. The principals' counsel asks for the order, and the register's counsel accepts it because the escrow is the money it wants first anyway.

The departed principal

A principal that leaves the manager during the fund's life has received carry and holds a guarantee for it. The document says that the guarantee survives, that the departing principal's future carry is reduced or forfeited under the manager's own arrangements, and that the departure does not release the guarantee for carry already received. The manager's internal carry arrangements with its principals, which the register does not see, are drafted to match: a departing principal's vesting and forfeiture are what make the guarantee's survival real, because a principal who forfeits unpaid carry has less to guarantee.

The escrow

The escrow is a portion of each carry distribution, a stated percentage, paid into an account held by a third party on terms that release it to the manager when the clawback risk has passed and to the fund when the clawback is due. The escrow agent is the administrator, the depositary or a bank, under an escrow agreement with the fund and the manager as parties. The percentage is the document's, and the release test is the document's: at the fund's end, at an interim test, or when the remaining positions' value exceeds a threshold of the capital at risk.

The escrow costs the manager the time value of the escrowed carry, and the escrow agreement says whether the escrowed money is invested and who receives the income. A manager that resists the escrow as a cost is asked what the clawback promise is worth without it, and the answer is what the principals are worth at the end.

The escrow agreement's terms

The escrow agreement is a contract among the fund, the manager and the agent, and it carries terms the constitution does not: the account's name and jurisdiction, the agent's instructions and the signatories, the investment of the money and the allocation of its income and loss, the release mechanics and who may instruct a release, the application mechanics and who may instruct an application, the agent's charges and who bears them, and the agent's liability. A release instruction that the manager alone may give is an escrow the manager controls; one that needs the committee or the administrator is an escrow the register controls. The agreement's drafting is where the escrow's worth is set, and a constitution that provides an escrow in a sentence and leaves the agreement to the manager has left the worth to the manager.

The agent's standing

The agent is a regulated person in the fund's jurisdiction or in one whose law the agreement chooses, and its standing matters because the escrow is only as safe as the agent. An administrator that is also the agent holds the money in a client account under its own regulation; a bank holds it as a deposit; a depositary holds it under its custody obligations. Each is a different protection in the agent's insolvency, and the register's counsel reads the agent's regulatory position for what happens to the escrow if the agent fails.

The interim release

An interim release returns escrowed carry to the manager before the fund's end, on an interim computation showing no excess and a remaining-position value above a threshold. The release reduces the escrow to what the remaining risk needs. A document that permits interim release on the manager's computation has an escrow that empties as the manager reports; one that requires the committee's reading and the valuer's report releases on evidence. The release is partial, leaving a residual escrow sized to the remaining positions, and the agreement says how the residual is computed.

The clawback in the manager's own accounts

The manager's accounts carry the clawback as a contingent liability and the escrow as a restricted asset, and the manager's auditor reads both. A manager that distributed carry to its principals without noting the contingent liability has a balance sheet that overstates what it can pay, and a lender to the manager reads the accounts for it. The manager's internal carry arrangements provide for the principals' obligations to the manager for clawback, matching the guarantees to the register, so that the manager can collect from its principals what the register collects from it.

Net of tax

The manager paid tax on the carry when it received it, and a clawback of the gross amount takes back tax the manager cannot recover. The usual term is a clawback net of the tax paid, computed at an assumed rate or on the manager's actual position. The net-of-tax term reduces the register's recovery and reflects the manager's real receipt, and the escrow percentage is set with it in view: an escrow of the net-of-tax amount holds what the clawback would recover.

The interim test

A fund that pays carry only once an interim test is met reduces the clawback risk before it arises. The test is usually that the remaining positions' value, at the last valuation, exceeds a multiple of the capital remaining at risk, or that a stated proportion of contributed capital has been returned. A test that is strict pays carry late and reduces the clawback to a remote risk; a test that is loose pays carry early and makes the clawback the register's real protection. The test and the escrow percentage are set together, because each does what the other leaves.

The register's reading at subscription

A prospective holder reads the clawback clause at subscription for four things: the percentage escrowed, the net-of-tax basis, the release test and who controls it, and the guarantee's survival on departure. The four tell it what it holds if the fund's later positions lose. A holder that reads the memorandum's sentence and not the clause has read a promise and an escrow without their sizes, and the difference between the sentence and the clause is what the holder discovers at the fund's end. The anchor's counsel reads the clause and the escrow agreement together, because the agreement is where the release control sits, and asks for the agreement's form to be settled before the first close rather than at the first carry distribution.

The valuation beneath the interim test

Every interim computation, and every interim release, rests on a valuation of the unsold positions. The valuation is the valuer's, under the valuation policy, and the valuer's independence is what makes the interim test a test rather than a manager's statement. A test that reads the manager's own mark of its own positions as the input for releasing the manager's escrow is a test the manager sets for itself. The document ties the interim computation to the valuation the annual accounts carry, made by the appointed valuer, and the committee reads the valuer's report before reading the release request.

Whole-fund and deal-by-deal

A whole-fund waterfall with no interim distribution has no clawback, because carry is paid once at the end on the whole account. The clawback exists because carry is paid before the account closes, and the more the waterfall pays before the end, the more the clawback holds. A deal-by-deal waterfall pays the most early and needs the clawback most; a whole-fund waterfall with an interim distribution pays less early and needs it less. The choice of waterfall is the choice of how much the register relies on the clawback, and the escrow is sized to the reliance.

The lender's reading

A capital-call lender has no interest in the clawback, because it is paid from drawdowns, not from carry. A lender to the fund's positions reads the escrow, because escrowed carry is fund money held by a third party and a charge over it is a security the lender may ask for. A lender to the manager, against its charge income, reads the clawback as a contingent liability of its borrower and the guarantee as a contingent liability of the principals, and prices both.

The continuation vehicle

A continuation vehicle that buys the fund's remaining positions crystallises the fund's whole-life account: the positions are sold, the proceeds are known, and the clawback computation runs on the fund's end. The manager's carry on the continuation sale is the last carry the fund pays, and the clawback test runs on it. A manager that rolls its carry into the continuation vehicle, as the conflict's mitigation, has not been paid the carry and the clawback is computed on what was paid in cash. The escrow is released at the fund's end if the account is in credit and applied if it is not.

By instrument · by protection	What the register holds	Its worth at the end	Its cost to the manager
Clawback promise alone	An unsecured claim against the manager	The manager's assets, usually none	None
Clawback with principals' guarantee	Several personal claims	Each principal's worth and reachability	The principals' exposure
Escrow of a percentage of carry	Cash with a third party	The escrowed amount	Time value of the escrow
Interim test before carry	Carry deferred until the risk is low	The deferral itself	Later carry
Whole-fund, no interim distribution	No early carry	Nothing to claw back	Carry at the end only
Carry rolled into the continuation vehicle	Carry not yet paid in cash	The rolled units	Deferred liquidity

A clawback, as a type

A fund with a whole-fund waterfall and an interim distribution once a test is met pays carry in year five on three exits. The document escrows a stated percentage of each carry distribution with the administrator under an escrow agreement, net of tax at an assumed rate, and the principals guarantee the balance severally. Two of the remaining positions lose in years seven and eight. At the fund's end the administrator runs the whole-life computation, finds carry paid exceeds carry computed, net of tax, and applies the escrow; the shortfall is claimed from the manager and, on its failure to pay, from each principal for its share. The register received the escrow within the period and the guarantee's balance within the year.

The structure paper's page

The structure paper carries a page on carry timing: the waterfall chosen, the interim test, the clawback's computation dates and net-of-tax term, the escrow's percentage and agent and investment, the guarantees and their survival, the order of recourse, and the continuation vehicle's effect. The page is written at the fund's design because the anchor negotiates the escrow percentage against it, and because the manager's internal carry arrangements with its principals are drafted to match.

The onshore positions and the computation

A fund holding through onshore vehicles receives its cash flows as distributions from those vehicles, and the whole-life computation runs on what the fund received, by date, not on what the onshore vehicles earned. A position sold onshore whose proceeds are held onshore pending an approval or a repatriation has produced a gain the fund has not received, and the computation at that date treats it as unrealised until the cash arrives. The timing of onshore repatriation is a timing of the clawback computation, and the administrator's computation records it.

The second fund's reading

A manager raising its second fund has a first fund whose carry was distributed early, escrowed or not, and whose clawback is computed or pending. The second fund's prospective holders read the first fund's escrow as evidence of how the manager treats the register's protection, and a first fund whose escrow was released on the manager's own computation has a record the second fund's anchor reads. The second fund's clawback clause is drafted against the first fund's experience, and a manager whose first fund's clawback was paid from escrow rather than from a chase of principals raises the second with a clause the register accepts.

Four cases, as types

A document provides a clawback without escrow or guarantee. At the fund's end the manager has no assets; its principals have left; the register's claim is against a company that is struck off the following year.

A document provides a clawback and a guarantee. One principal is resident in a jurisdiction whose courts do not recognise the guarantee's governing law; one is insolvent; one pays. The register recovers a third.

A document provides an escrow at a percentage set without regard to the net-of-tax term, and the escrow holds less than the net clawback. The balance is claimed from the principals and recovered in part.

A document provides an interim test, an escrow sized to the net-of-tax clawback, and a guarantee for the balance. The clawback is computed at the end, the escrow covers it, and the guarantee is not called.

What each party holds

The manager holds the clawback obligation, the escrow's funding from each carry distribution, and the principals' guarantees.

The principals hold their several guarantees.

The administrator holds the whole-life computation at each test date and at the end.

The escrow agent holds the escrowed carry under the escrow agreement.

The committee holds the reading of each computation and the release of the escrow.

Counsel holds the clawback clause, the guarantee, the escrow agreement and the net-of-tax term.

Where it surfaces

It surfaces at the first carry distribution, when the administrator asks what percentage to escrow and with whom. It surfaces at the escrow agreement's signing, when the agent asks whether the money is invested and who bears the loss if it is. It surfaces at a principal's departure, when the departing principal's counsel asks whether the guarantee survives. It surfaces at the interim test, when the remaining positions' valuation is the computation's input and the valuer's independence is the computation's worth. It surfaces at the continuation sale, when the fund's end arrives earlier than its term. And it surfaces at the fund's end, when the register learns what it holds: cash, or a list of people.

The cost of getting it wrong

A register that relies on a promise against a manager with no assets has lost the excess in full. A register that relies on guarantees has lost the excess to the extent of the principals' reach and worth. A register that relies on an escrow sized without the net-of-tax term has lost the difference. Each is a loss the waterfall's early payment created and the document could have held, and the cost of holding it is the escrow's time value, which the manager bears as the price of early carry. A manager that wants early carry and no escrow wants the register to carry the risk of its own losses, and a register that reads the clause says so.

The committee's reading

The committee reads each carry distribution's computation, the escrow's funding, and each test-date computation. It reads the valuation that drives an interim computation for the valuer's independence. And it reads the escrow agreement's release provisions when the manager asks for a release, because a release on an interim estimate is the committee's decision under most documents. A manager that presents the computation with its inputs, the escrow statement and the valuer's report has a committee that reads once.

A timeline, as a type

At the first close the document fixes a whole-fund waterfall with an interim distribution once a stated proportion of contributed capital is returned and the remaining positions' value exceeds a multiple of capital at risk; an escrow of a stated percentage of each carry distribution, net of tax at an assumed rate, with the administrator as agent; and several guarantees from the principals. In year five the test is met on three exits; carry is distributed, the escrow is funded, and the committee reads the computation. In year six a principal departs; the guarantee survives and the manager's internal forfeiture reduces the departing principal's unpaid carry. In year eight two positions are sold at a loss; the interim computation shows an excess; the escrow is held rather than released. In year ten the last position is sold; the whole-life computation runs; the escrow is applied; the balance is claimed from the manager and, on its failure, from each principal for its share; and the register receives the escrow within the period and the balance within the year.

The sequence

1. The waterfall's timing is chosen: whole-fund with an interim test, or deal-by-deal; the clawback's reliance follows.
2. The clawback clause is drafted: computation dates, net of tax, the manager's obligation and the principals' guarantee.
3. The escrow percentage is set to the net-of-tax clawback the waterfall's timing implies, and the escrow agreement is signed with the agent.
4. Each carry distribution funds the escrow and the balance is paid.
5. At each test date the administrator computes, the committee reads, and the escrow is released or held.
6. At the fund's end the whole-life computation runs, the escrow is applied, and the guarantee is called for any balance.

Questions a manager asks

What escrow percentage. Enough to hold the net-of-tax clawback the waterfall's timing could produce; a document that states the percentage states what the register relies on.

Is the escrow invested. Under the escrow agreement, in cash or near-cash, with income to the manager or the fund as the agreement says.

Can the guarantee be avoided. By an escrow that holds the whole clawback; most registers want both.

Does the clawback run at interim dates. If the document says so; interim computations catch an excess early and reduce the end-of-life claim.

What if a principal leaves. The guarantee survives departure for the carry it received; the document says so, and the principal's carry entitlement is reduced by the clawback on departure.

Does the continuation vehicle trigger it. The fund's end does, and a continuation sale is the fund's end for the remaining positions.

Terms used

Clawback: the manager's obligation to repay carry paid in excess of the whole-life entitlement.

Escrow: the portion of carry held by a third party against the clawback.

Guarantee: the principals' several obligation for the clawback their carry represents.

Net of tax: the clawback's reduction for tax the manager paid on the carry.

Interim test: the condition, on value or capital returned, before carry is distributed early.

Whole-life computation: the waterfall run once on the fund's entire account.

What to read

The constitution's waterfall, clawback and escrow provisions; the escrow agreement; the principals' guarantees; the administrator's test-date computations. On this site, the economics room under Structures and the worked continuation structure.