It starts off looking great – early exits, solid IRRs, and carried interest flowing. But what happens when the later deals underperform, and the fund no longer hits its promised return threshold?  

The clawback provision mechanism quietly waits in the background, ready to disrupt GP payouts and LP expectations alike. 

While everyone focuses on deal flow, returns, and exits, clawback due diligence often remain the blind spot in fund due diligence. And in LP-led secondaries, where timing and information asymmetry already add pressure, overlooking clawback exposure can quickly turn a winning deal into a misstep. 

Let’s explore why clawback provisions deserve a front-row seat in your due diligence process and what blind spots to watch before they claw back more than just cash. 

What Is a Clawback Provision? 

Simply put, a clawback is a contractual safeguard that requires the GP to return any excess carried interest previously paid if the fund’s overall returns ultimately fall short of agreed performance hurdles. This means that while a GP may receive carried interest payouts early in the fund’s life based on preliminary profits, those payouts can be “clawed back” if later investments underperform and cause the fund to miss its return targets. 

The clawback mechanism aligns interests by ensuring that GPs do not profit disproportionately relative to LPs once the fund is fully wound down and all gains and losses are tallied. 

Key Conditions Triggering Clawbacks 

Clawback provisions in private equity funds are designed to ensure fairness in carried interest allocation over the life of a fund. They typically hinge on three core conditions that should be closely examined during clawback due diligence: 

• Preferred Return Shortfall: LPs usually have a preferred return depending on the region and economy that must be met before the GP earns carried interest. If the overall fund performance doesn’t meet this hurdle, excess distributions to the GP may be clawed back. 

• Excess Carried Interest: With many funds now offering 50–100% carry above the hurdle to attract top talent, traditional 20% carry structures are becoming outdated. However, if the GP receives more than the agreed carry, clawback provisions ensure the excess is returned to protect investor interests. 

• Catch-Up Period Adjustments: During the catch-up phase, when the GP receives a higher share of profits (often 80%) until the carried interest allocation is fulfilled, clawback provisions can be triggered if the total carried interest paid is out of balance relative to the final fund returns. 

These conditions ensure the carried interest is fairly allocated across the fund lifecycle, preventing GPs from keeping more than their agreed share if early profits are offset by later losses. 

Clawback Due Diligence Blind Spots: The GP Perspective 

• Neglecting the Catch-Up Clawback: Many GPs focus primarily on preferred return and excess carry clawbacks but overlook the catch-up clawback. This oversight is a common clawback due diligence blind spot that can expose GPs to unexpected clawback liabilities if the fund’s later performance deteriorates. 

• Delayed Testing of Clawbacks: Clawbacks are usually assessed only at the fund’s termination, sometimes many years after initial payouts. Without interim clawback testing as part of ongoing clawback due diligence, GPs may face a sudden large clawback obligation, complicating their financial planning. 

• Tax and Cash Flow Implications: Returning carried interest can have complex tax consequences for GPs and impact cash flows, yet these are often not fully considered during fund structuring. 

Clawback Due Diligence Blind Spots: The LP Perspective 

Inadequate Clawback Terms: Not all LP agreements comprehensively cover all clawback scenarios, especially the catch-up clawback. Without detailed terms, LPs risk not recovering excess carried interest. 

Lack of Interim Monitoring: Many LPs rely on end-of-fund clawback calculations and miss opportunities to identify clawback risks early through interim financial reviews. 

Assuming GP Compliance: LPs sometimes trust GPs will voluntarily comply with clawback provisions, but enforcement depends on robust contractual language and LP vigilance and rights to act prudentially at the right time. 

Why Clawback Provisions Are Critical in LP-Led Secondary Transactions? 

Unlike primary investments, where clawback considerations are embedded within the original fund agreement, secondary buyers face the added complexity of assessing potential clawback liabilities that may arise well after the purchase. These obligations can materialize if the underlying fund’s final performance fails to meet the required huedles, potentially forcing the seller or even the buyer, depending on the deal structure, to return previously received carried interest. 

Unfortunately, clawback due diligence in many secondary deals does not adequately capture or analyze these risks. This oversight can lead to mispriced transactions, unexpected financial exposure, and post-sale disputes. As a result, both buyers and sellers must conduct rigorous clawback risk assessments, clearly allocate responsibilities, and negotiate appropriate protections to mitigate future clawback impacts. 

Clawback Due Diligence: Best Practices to Mitigate Risks 

For General Partners: 

• Incorporate Interim Clawback Testing: Rather than waiting until fund wind-up, conduct periodic assessments to identify potential clawback liabilities early in periodic investor committee and Audit Committee meetings. 

• Clear Documentation: Ensure fund agreements explicitly define clawback calculation methods, timing, and obligations, including catch-up clawbacks. 

• Transparent LP Reporting: Maintain open communication with LPs about clawback status to build trust and avoid surprises. 

For Limited Partners: 

• Negotiate Comprehensive Clawback Clauses: Insist that fund documents cover all clawback scenarios — preferred return, excess carry, and catch-up. 

• Request Audit and Review Rights: Secure rights to audit fund distributions and carried interest calculations regularly. 

• Factor Clawback Risks into Valuation: Especially in secondaries, incorporate clawback exposure into price negotiations and risk assessments. 

Where Others Miss the Clawback Traps, MS Delivers Forward-Looking Assurance 

Clawback provisions may not dominate the term sheet conversations, but they can dramatically reshape the economics of a fund. From missed preferred returns to underappreciated catch-up mechanics and LP-led secondary pitfalls, clawback due diligence blind spots are real, and expensive. 

At MS, we help GPs and LPs identify, quantify, and manage these risks before they become real problems. With deep expertise in fund structuring, secondaries, and transaction advisory, we support clients across the lifecycle ensuring every clause, including the clawback, is working for you, not against you.