Two clauses are negotiated here and they look alike. One of them makes the other worse, and the escrow that removes the exposure is never named.
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.
Worked in full in How to Read a Limited Partnership Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
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.
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 |
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.
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 |
“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.
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 |
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.
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 |
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.
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.
This article is one calculation from How to Read a Limited Partnership Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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