Private markets are preoccupied with the obvious problem of capital. Distributions are down, exits are delayed, and limited partners (LPs) are stuck staring at net asset values (NAVs) that haven’t moved much in two years. But sitting just beneath that liquidity issue is something potentially more disruptive — the General Partner (GP) clawback.
Adam Schwab, portfolio manager at Modern Woodmen of America, explored this problem in a recent report. He noted that for investors with a deal-by-deal waterfall (the typical “American” structure), this risk is not theoretical. It’s mechanical.
Problem At Its Core
At its core, private equity is the classic “80/20 deal”: LPs get their capital back plus a preferred return (often 8%), and then profits are split 80% to LPs and 20% to the GP. The clawback exists to ensure that, over the life of the fund, the GP doesn’t receive more than its agreed share of total profits.
The issue arises because of timing.
Under a deal-by-deal waterfall, GPs can receive carry on early winners before the full portfolio outcome is known. If later investments underperform, the GP may have already been overpaid. That’s when the clawback provision is supposed to restore the 80/20 balance.
A simple math example can illustrate the problem. Imagine a $100 million fund that makes five $20 million investments. One goes to zero.
So, total proceeds are:
- 4 winners × $40m = $160m
- 1 loser × $0 = $0
- Total proceeds = $160m
- Total invested = $100m
- Net profit = $60m
Under an 80/20 split, the GP should receive 20% of $60m, or $12m.
But in a deal-by-deal waterfall, carry is paid on each realized gain. When the four winners exit, each generates $20m of profit. The GP receives 20% of each $20m gain, that’s $4m per deal, or $16m total. Then the fifth deal goes to zero.
Now the GP has already been paid $16m, but is only entitled to $12m based on total fund profits. That $4m difference is the clawback obligation.
Cashing Winners, Holding Losers
In a normal exit environment, this gets resolved at the end of the fund’s life. But today’s private market conditions make this far more dangerous.
That risk exists because any 2018–2022 vintage funds realized early winners in a frothy market. High-multiple SaaS exits. Dividend recaps. Continuation vehicle transactions. Carry was paid.
But much of the remaining NAV consists of companies bought at peak valuations in 2021. These assets are still being marked near prior levels, yet everyone knows many will exit below those marks.
Unfortunately, by nature, private markets do the opposite of traders. They’re cashing in on their winners, while riding out the losers as far as they go.
If even one or two of those “held at cost” or “modestly written-down” positions ultimately sell 30–50% below carrying value, cumulative IRRs can fall below the preferred return hurdle. That triggers clawback conditions — not just excess carry, but potentially a failure to meet the 8% preferred return test
The Zombie Fund Scenario
And here’s where the second problem emerges. LPs may not get made whole.
Most clawbacks are “net of tax.” If the GP paid tax on that $16m of carry, they may only be required to return the amount remaining after tax. The guide is clear that tax mechanics materially reduce recoveries unless properly drafted.
Worse, clawbacks appear at the end of the fund’s life. The fund can limp along for years, holding impaired assets in a typical “zombie fund” scenario, while LPs wait. Meanwhile, the GP entity often has no assets beyond what it distributed to partners. Without strong guarantees or escrow provisions, collection becomes difficult.
Schwab notes that in extreme cases, the response can be: “Sue me.”
This risk won’t hit every fund, as European-style whole-fund waterfalls are structurally safer. Funds with escrows or interim clawback testing are better positioned. But many U.S. buyout funds from the last cycle sit right at or slightly above their hurdle rates. They don’t need a catastrophe, just one or two impaired exits to tip below the line.
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