Clawback provision

Clawback provisions protect investors by ensuring fund managers cannot keep performance fees they earned on early gains if those gains are later wiped out by losses. Think of it as a safety net that prevents managers from walking away with compensation based on temporary success.

While high-water marks stop managers from charging performance fees twice on the same gains, clawback provisions go a step further. They actually require managers to give back money they already received and may have already spent.

This mechanism addresses a fundamental fairness issue. Without clawback provisions, a manager could earn substantial performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. during a fund's early profitable periods, then see the fund lose money later, leaving investors worse off while the manager keeps the compensation from the good times.

High-water marks and clawback provisions both protect investors, but they work differently. High-water marks are forward-looking—they prevent managers from collecting future performance fees until they recover past losses and reach new profit levels. Clawback provisions are backward-looking—they require managers to return compensation they have already received.

For example, imagine a fund starts at $100 million, grows to $120 million (triggering $2 million in performance fees), then drops to $90 million. A high-water mark would prevent new performance fees until the fund exceeds $120 million again. A clawback provision might require the manager to return some or all of that $2 million they already collected.

Hedge funds borrowed the clawback concept from private equity, but had to adapt it significantly. Private equity funds typically calculate clawbacks at the end of the fund's life, when all investments have been realized and final returns are known. This approach works for private equity because these funds have definite lifespans, usually 8-12 years.

Hedge funds face a different challenge. They typically operate indefinitely, and investors can withdraw their money at various times. This makes it impractical to wait until the fund closes to calculate clawbacks.

Instead, hedge funds link clawback measurement periods to their lock-up periods Lock-up period A lock-up period is a specified timeframe during which investors in a hedge fund are prohibited from redeeming their investment, designed to provide the manager with stable capital to execute the investment strategy. —the time investors must keep their money in the fund. You'll rarely see clawback provisions in traditional hedge funds that allow monthly or quarterly withdrawals. They're much more common in funds with multi-year lock-ups or other characteristics that resemble private equity.

Funds typically use one or both of two methods to calculate clawback amounts. The first method looks at total compensation over the clawback period. It asks: "If we measured the manager's performance over this entire period instead of year by year, how much performance compensation should they have earned?" Any excess above this amount must be returned.

The second method focuses on investor protection. It ensures that each investor gets back their original investment before the manager keeps any performance-based compensation. This method protects investors from situations where they lose money overall while managers still profit from earlier performance fees.

Some funds give managers a choice between these methods, while others apply both and require repayment based on whichever calculation results in a higher clawback amount.

Clawback amounts are usually capped at the total performance compensation the manager received, minus taxes they paid on that income. This limitation acknowledges a practical reality: managers may have already paid substantial taxes on performance fees they must now return.

For example, if a manager received $1 million in performance fees and paid $400,000 in taxes, the maximum clawback would typically be $600,000. Some agreements further limit this to a percentage of the original compensation, providing additional protection for managers.

Another important limitation affects investors who withdraw early. If you invest in a fund with a three-year clawback period but withdraw after two years, you typically forfeit any right to benefit from clawback recoveries that occur in the third year. This prevents strategic withdrawals designed to avoid losses while still benefiting from potential clawback payments.

Funds use several approaches to implement clawback provisions. One common method allows managers to receive their performance compensation immediately but creates a legal obligation to return money if clawback conditions are triggered later. This gives managers access to their fees while ensuring they can be recovered if needed.

Another approach uses a clawback memorandum accountA special account that holds performance compensation until clawback conditions are satisfied, adjusting based on fund performance.. Instead of paying all performance compensation directly to managers, the fund deposits some or all of it into this special account. The account balance adjusts over time based on the fund's performance. If performance remains strong, managers eventually receive the money. If performance deteriorates, the fund keeps the money to offset investor losses.

Money in clawback memorandum accounts is often invested in the fund's regular investment program, treasury billsShort-term U.S. government debt securities with maturities of one year or less, considered among the safest investments., or other safe investments. This ensures the money remains available for clawback while potentially earning returns.

Investors in funds with long lock-up periods often request compensation structures that mirror private equity practices. They want assurance that if they commit money for multiple years, managers won't receive performance fees based on temporary gains that disappear before the lock-up period ends.

Some managers address this by measuring performance over the same period as the lock-up. For instance, if you invest with a three-year lock-up, the manager might only calculate performance compensation at the end of those three years, rather than annually. This approach aligns the manager's compensation timeline with your investment commitment.

Tax law creates some constraints on clawback design. For example, certain provisional allocation mechanismsTemporary allocation methods used to distribute performance fees subject to later adjustment based on fund performance. don't work for offshore funds that are treated as corporations for U.S. tax purposes. Additionally, Section 457ATax provision requiring immediate income recognition of deferred compensation from nonqualified entities when no longer subject to substantial risk of forfeiture. of the Internal Revenue Code makes it difficult to structure multi-year fee payments in certain situations.

These technical limitations influence how different types of funds can structure their clawback provisions, sometimes requiring creative solutions to achieve similar investor protections within the constraints of tax law.

Hybrid funds—which blend hedge fund and private equity characteristics—commonly use clawback provisions. These funds typically have longer lock-up periods than traditional hedge funds, making clawback provisions more practical and important.

In hybrid funds, the clawback measurement period often matches the lock-up period, creating alignment between when you can withdraw your money and when the manager's performance is ultimately evaluated. This bridges the gap between traditional hedge fund practices (annual performance measurement) and private equity practices (performance measurement over the fund's entire life).

Hybrid funds also commonly include other private equity-style features like hurdle rates Hurdle rate A hurdle rate is the minimum return a hedge fund must earn before its managers can collect performance fees from investors. This requirement protects investors by ensuring managers only receive incentive compensation after achieving a specific performance threshold. —minimum returns that must be achieved before performance fees are paid—and general partner clawbackMechanism requiring general partners to return previously distributed performance fees if fund performance subsequently declines. mechanisms.

The regulatory landscape for clawback disclosures has been volatile recently. In August 2023, the SEC adopted new Private Fund Adviser RulesSEC regulations that would have imposed additional disclosure and operational requirements on private fund advisers before being overturned by the Fifth Circuit Court of Appeals. that would have required enhanced disclosure about clawback provisions. These rules would have mandated written notices to investors within 45 days after each fiscal quarter about post-tax clawback amounts.

However, these enhanced requirements were short-lived. On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit Court of AppealsFederal appellate court that reviews decisions from district courts in Texas, Louisiana, and Mississippi. unanimously struck down the entire set of rules, finding that the SEC had exceeded its authority. As of September 2025, private fund advisers operate under the regulatory framework that existed before 2023.

Despite the regulatory uncertainty, industry practices continue evolving toward greater transparency in clawback provisions. Many advisers voluntarily provide detailed information about how clawbacks work and when they might be triggered, recognizing that clear communication helps build investor confidence and trust.