Private Equity Tutorials
- Private Equity Basics
- What is Private Equity?
- Private Equity Analyst
- How to Get Into Private Equity?
- What is Growth Capital?
- Term Sheet in Private Equity
- LP vs GP
- Clawback in Private Equity
- Types of Alternative Investments
- Private Equity Course
- Private Equity vs Hedge Fund
- Project Finance vs Private Equity
- Private Equity Books
- Venture Capital Books
- Venture Capital
- Private Equity Firms
- List of Top Private Equity Firms
- Private Equity in India
- Private Equity in Russia
- Private Equity in France
- Private Equity in Germany
- Private Equity in South Africa
- Private Equity in UK
- Private Equity in Canada
- Private Equity in China
- Private Equity in Singapore
- Private Equity in Hong Kong
- Private Equity in Brazil
- Private Equity in Dubai
- Private Equity in Mexico
- Private Equity in Australia
- Private Equity in Saudi Arabia
A clawback or having such a provision in a contract is a special clause included in employment and financial contracts. It is generally used for referring any money or benefits which have been given out but are required to be returned back due to certain special circumstances which will be mentioned in the contract.
In September 2016, Wells Fargo was fined $185 million for engaging in fraud over the years which included opening credit cards without a customer’s consent, creating fake email accounts to sign up customers for online banking services, and forcing customers to accumulate late fees on accounts they never even knew they had. Wells Fargo also fired 5,300 employees in relation to the scam.
Wells Fargo announced that it will “clawback” compensation of $41 million from their Chief Executive John G Stumpf.
- Clawbacks in Private Equity
- Clawbacks in Financial Employment Contract
- Why are Clawbacks being added?
- Calculation of General Partner ClawBack
- General Partner ClawBack – Timing
- Best Practices When Preparing a Clawback Agreement
- Wells Fargo Scandal & Clawbacks
Clawbacks in Private Equity
This term is very extensively used in the Private equity/hedge fund world. Such funds are generally set up as a General Partnership which involves the PE firm or the hedge fund manager as the General Partner with the investors as Limited Partner. The compensation is commonly structured using the 2/20 rule with 2% as the Management fees and 20% as the Incentive fee if the fund is performing above a given threshold.
Clawback provision permits the LP’s to “claw back” any carry forwarded amount which was paid during the life of the fund on prior portfolio investments in order to normalise the final carry to the originally agreed percentage. Thus, the clawback provision prevents the LP’s from paying any additional amount and then suffering a subsequent loss.
This provision is the ultimate tool for limited partners to align total investment returns across multiple funds. Understandably, PE firms don’t prefer such a provision as they add risk to the future returns/operations. As hedge funds and PE firm’s transition from older partners to newer partners, the provision can become harder to manage. This is due to the fact that the carry forward amount has been paid on investments that the older partners were accountable to and the clawbacks now kicking in for investments which are managed by the newer partners. When such a provision is bought into effect, the firm needs to make sure that it has the mechanisms to pay the difference which can also include a “claw-back reserve” but more often the obligation is handled by eliminating or reducing the future amount of management fees.
Clawbacks in Financial Employment Contract
Clawback is also increasingly used in financial employment contracts generally to be controlled for the amount of bonuses and perks which have been paid off. If an employee has been given a generous amount of bonus but certain conditions are required to be satisfied, however, if subsequently any condition is not met, then the amount of bonus paid will have to be returned back from the employee. Many bonuses continue to be paid on complex financial instruments for number of years post its creation. In such an instance, if the initial performance should worsen, this provision forces the original sales agent to pay back a portion of their bonus.
Let us consider a simple example: Say a business has a CEO whom it wants to reward for keeping the company profitable. Hence a clause in included in the employment contract which states the CEO will receive an additional $100,000 bonus if the profits of the firm increase 10% over the next 2 years. The corporate financial statements show the profits have increased 12% over the given next 2 years and hence the bonus amount is disbursed out.
Subsequently, the auditors find out that the profits had only increased by 8%. It is difficult to comment whether this change was a deliberate attempt to hide the facts or an error. However, since the provision of the contract stated a clawback of the bonus amount if profit is not increased by 10%, the CEO will have to release back the bonus amount which was initially paid. This will have to be done since it is a legal contract and thus legally enforceable.
Earlier in 2014, Yahoo issued a disclosure stating that hackers stole data on 500 million users. Again, in December 2016, Yahoo announced that the data theft may have affected more than a billion accounts. With the shareholders losing over $350 million due to these breaches, SEC is looking into whether Yahoo employees hid data breach from their customers and shareholders.
Yahoo did have a clawback provision and Marrissa Mayer (Yahoo CEO) pay is covered by it. However, as per the company policy, clawback can be implemented only in the event of reporting incorrect financials, basically only in case of accounting fraud. This implies that clawback doesn’t cover these hack incidents and Marrissa Mayers may be safe.
Why are Clawbacks being added?
While a financial instrument whether a IRS (Interest rate swap) or CDS (Credit Default Swap) may initially be profitable, if the economy is faltering, it can decline rapidly. The derivatives market is a high risk and high reward proposition. Hence, as derivatives lose their value, the losses for banks can worsen. As a hedge against this risk, banks have included clawback provisions.
Another key reason is the government getting involved for the bailout of banks. As banks and other financial institutions were getting exhausted with money just like in the Eurozone crisis, their top executives continued to receive impressive bonuses whilst their financial instruments had become “non-performing”
This concept was introduced to manage risk as well as prevent future instances of fraud. Banks can reclaim a hefty portion of the bonus paid to their staff. Any restatement of accounts can trigger a claw-back provision. Certain bankers or employees had deliberately miscalculated the future earnings which would be re-stated once the bonus amount was disbursed out. Claw-back provision prevents intentional and unintentional accounting errors.
Calculation of General Partner ClawBack
GP claw-back provisions may require them to return excess emoluments if any of the below conditions are met:
- A Limited Partner (LP) has not been provided its Preferential Return which is generally in the range of 8-11%
- The GP has received carried interest (profit in excess of the investment) in excess of the contractual rate (generally 20% but often less for real estate funds)
- Limited Partner has not received its share of profits for the “catch-up period”. Generally, post the preferred return, carried interest is generally split as 20% to the LP and 80% to the GP (or in some cases, it maybe a 50-50 split), until the GP has received 20% of the entire profit amount.
General Partner ClawBack – Timing
For the majority of the private market controlled funds, the GP clawback is applicable only once at the end of the fund’s life which is an indication that there exists no mandate to return back excessive distributions only at the time of dissolution and not during the life of the fund.
Practically, many funds continue its existence and do not dissolve long until the majority of investments have been liquidated in order to hold the remaining securities which are generally illiquid in nature. In such a situation, computation of the clawback and return of excessive distributions would also be subsequently delayed. In order to avoid such delays, the clawback agreements should consider following suggestions:
- The clawback should be tested on a periodic basis. Certain funds have a yearly or bi-yearly test of the clawback. If a testing model gives an indication that a clawback obligation can be triggered, the fund should undertake futuristic distributions to the limited partners only as their liabilities are limited.
- Heading towards the end of the life of the fund, the clawback calculation should be made once the investment of the fund has been largely disposed of and should not be postponed due to the existence of illiquid investments which cannot be easily disposed of.
- Extension of the fund’s investment could be stipulated on “testing” the clawback before the extension, with a return of previously made disbursements if supported by the terms of the clawback.
A Certain portion of the distributed carry (share of the profits of an investment paid to the manager in excess of the investment made by the General Partner) is used for the payment of taxes. Sponsors often argue that they cannot return what they no longer own and in turn seek to limit clawback to the after-tax provision of interim carry distributions. Additionally, determining the actual taxes paid on every dollar of carry is difficult to compute.
Best Practices When Preparing a Clawback Agreement
There are certain points which should be kept in mind for successful implementation of a clawback provision in any kind of an agreement:
- Incorporation into a Protective Order: Agreements with such a provision are binding only on the parties to the agreement and typically cannot be enforced against third parties who may seek to obtain protected materials inadvertently produced during litigation. To gain protection against the same, the court should be requested to enter a protective order incorporating specific terms of the clawback agreement which can then be binding on third parties as well.
- Establish Relevant procedures: Necessary steps must be defined which are required to invoke the clawback such as whether a party must request the clawback within a stipulated period of time after learning about the inadvertent production, whether the clawback request must be in writing and whether the requesting party must explain the grounds on which the document is privileged or protected.
- The parties may disagree on the contents of an agreement for various reasons. The clawback agreement can establish a framework for the resolution of such disputes in a cost-effective manner.
- Confidentiality: Complex commercial litigation can involve producing materials with “confidential”, “highly confidential”, and “attorney’s eyes only” designations. If this is an issue in the litigation procedure, a clawback agreement can provide a method of reassessing document designations in the event that a highly sensitive document (like a trade secret) is incorrectly produced with proper vetting.
- The goal if any clawback agreement is to make sure that incorrect communications or work product will not result in any waiver of any protections over the provided material or subject matter. This concept should be clearly stated in the agreement.
A well-designed agreement with such a clause can save time and expense, especially in a complex business litigation where internal counsel were involved in matters involving litigation.
Some examples of clawback provisions can be listed as follows:
- In life insurance, a clawback provision might require payments to be returned if the policy is canceled any time during the duration.
- If dividends are received, they may be clawed back under specified circumstances such as selling the shares within the lock-in period.
- There can be clawback provisions in Pensions.
- Government contracts with contractors may include clawback of payments to the contractors if certain requirements are not met.
- In executive pay agreements, a clawback provision may require the executive to reimburse specified amounts back to the organization, if the executive breaches a non-compete agreement and joins another competitor within a certain time frame after leaving the company.
Wells Fargo Scandal & Clawbacks
Wells Fargo and Company which is an American International banking and financial services firm was struck by a scandal in September 2016. In this, around 5,300 employees were convicted of opening as many as 2 million accounts without knowledge of the customers for the purpose of meeting its sales targets. The employees moved funds from customers’ existing accounts into newly created ones without knowledge or consent.
The firm is being slapped with one of the largest penalty with the bank made to pay $185 million in fines along with $5 million to refund customers. This led to the CEO being made to exit the firm with the execution of its clawback clause through which he had to return $41 million in stock awards.
The U.S. regulators are considering banks to postpone compensation for senior officials and to allow clawbacks for incorrect judgment or illegal actions over the previous 7 years. The law is targeted to be brought into effect in 2019 and regulators are attempting to get it finalized at the earliest. Though, the legal advisors of the banks are concerned that the Wells Fargo scandal will result in them imposing tougher and concrete requirements into their proposal such as requiring the banks to decide in a short span of time (as less as 30 days) on clawing back compensation once the discovery of any misconduct.
Clawback provisions were strengthened at all top US Banks post the 2008 Financial crisis primarily to hold executives responsible for risk taking. However, proposed time period for clawback is 3 years which is substantially lower than the current time period of 7 years.
Great Britain introduced laws last year which permit banks and financial institutions to seek recovery of bonuses from bankers which are deemed to have acted irresponsibly up to 10 years after they were disbursed. Standard Chartered Bank has said it will claw back bonuses from as many as 150 senior staff if found guilty of breaching internal rules around risk-bearing. It should also be noted that clawing back money from people who have already left the bank can be faced with financial and legal difficulties.
The rules vary from one bank to another but they generally permit the banks to bring back stock awards or penalize for misconduct, taking unreasonable risks or displaying poor performance. Executives can also be punished if the banks have to restate its results by a significant amount.