A fund pays out 24 million of carried interest on a deal-by-deal
waterfall. The whole-fund test at the end says none of it was due. The clawback clause is
triggered, the escrow is at the usual thirty per cent, and the limited partners are told they
are protected. On the clause as drafted they will recover 7.20 million of the 24
— and 6.00 of it is an unsecured promise from an entity whose only asset was the carried
interest it has already distributed.
Two things are usually negotiated in this clause and they look like variations on the same
point: the tax rate the clawback is computed net of, and the size of the escrow. They are not
the same negotiation, they are not worth the same, and one of them makes the other one worse.
What the clawback is actually for
Almost every clawback is expressed net of tax: the manager repays what it received after
the tax it paid on it, because it cannot repay money the revenue authority has. That is
defensible. It is also the largest single reduction in the clause.
Clawback measured
The manager repays
Investors remain short by
Gross — the carried interest actually overpaid
24.00
0.00
Net of tax at 37%, the negotiated rate
15.12
8.88
Net of tax at 45%, the clause as drafted
13.20
10.80
In millions. The fund overpaid carried interest of 24 on a deal-by-deal waterfall; the whole-fund test at the end says none was due.
At the drafted rate the manager repays 55 cents on the dollar. The
remaining 10.80 million is not a shortfall the clause forgot about — it is a shortfall the
clause creates, deliberately, and the limited partners bear it. That is worth reading twice
before the escrow is discussed, because everything downstream is a fraction of this number
rather than of the 24.
What the escrow covers, and where it stops
An escrow of 30% on 24 million holds 7.20 million. The obligation is 13.20 million. So 7.20
million is collateralised and 6.00 million is not.
Escrow
Held
Obligation at 45% tax
Protected
Uncollateralised
× the 30% case
20%
4.80
13.20
4.80
8.40
0.667
30%
7.20
13.20
7.20
6.00
1.000
40%
9.60
13.20
9.60
3.60
1.333
50%
12.00
13.20
12.00
1.20
1.667
55%
13.20
13.20
13.20
0.00
1.833
60%
14.40
13.20
13.20
0.00
1.833
70%
16.80
13.20
13.20
0.00
1.833
Every point of escrow above 55% is dead money: the obligation is already covered.
“Fifty per cent rather than thirty roughly doubles the protected amount” is
the sentence that gets written in the negotiation note. It does not. It multiplies it by
1.667 — five thirds — because the protection is capped by the
obligation, not by the escrow. The recommendation is right and the number attached to it
overstates the gain by a third.
The rule the clause never states
Write it out and it collapses to one line. With C of carried interest to be
clawed back, a tax assumption of t and an escrow of e:
uncollateralised = C × max(0, (1 − t) − e)
Which is zero the moment e reaches 1 − t. At the drafted 45% tax
rate that is an escrow of 55% — not thirty, not fifty. Below it there is
always an uncovered balance; above it every further point is dead money held against an
obligation that is already met.
Assumed tax rate
The obligation
Escrow that removes the exposure
Uncollateralised at a 30% escrow
0%
24.00
100%
16.80
20%
19.20
80%
12.00
30%
16.80
70%
9.60
37%
15.12
63%
7.92
45%
13.20
55%
6.00
50%
12.00
50%
4.80
Uncollateralised = C × max(0, (1 − t) − e). Zero when e reaches 1 − t.
The table has a use beyond this fund. Read the escrow you are being offered against the
tax assumption in the same clause: if the first is below one minus the second, you know the
size of the gap before you know anything else about the manager.
And the trap: the two negotiations work against each other
Now the part that is genuinely counterintuitive. Suppose the limited partners win the tax
argument and the clause is computed at 37% rather than 45%. That is a real win: the
manager’s obligation rises by 1.92 million.
Clause as drafted (45%)
Negotiated down (37%)
Change
What the manager owes
13.20
15.12
+1.92
Held in escrow at 30%
7.20
7.20
—
Collateralised
7.20
7.20
—
Uncollateralised
6.00
7.92
+1.92
Winning the tax argument is worth 1.92 — and all of it lands in the last row.
The escrow did not move. So the obligation rose by 1.92 million, the collateral did not,
and every euro won on the tax clause landed in the uncollateralised column.
The limited partners are owed more and secured on exactly the same amount — which is
worth something only to the extent the manager is good for it, and the whole reason a clawback
needs collateral is that the entity often is not.
That does not make the tax negotiation pointless. It makes it second. The order
is: fix the escrow at one minus the tax assumption, then argue about the tax assumption —
because on that order every point won on tax is automatically collateralised, and on the usual
order none of it is.
Three lines for the next side letter
Ask what the clawback is net of, and compute one minus that rate. Ask what the escrow is,
and compare the two numbers: the gap between them, times the carried interest at risk, is your
unsecured exposure and it exists on day one. And if the escrow is being negotiated upward, price
the move against the obligation rather than against the previous escrow — the protection
is capped, and past 55% the extra points buy nothing at all.
None of this requires a view on the manager. It is four numbers that are already in the
document, arranged so that the exposure is visible before it is needed.
The workbook behind this article
Every figure above is a live formula in the companion file for
How to Read a Limited Partnership Agreement, which also holds the escrow grid, the closed-form rule at six tax assumptions, and the interaction between the tax clause and the collateral. It is free, and it needs no account and
no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
This note is drawn from How to Read a Limited Partnership Agreement. The book is on Amazon.
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.