Inside a hedge fund

Clawback clauses: taking back pay and profits that were not really earned

Inside a hedge fund · Published 2026-11-01

A clawback is a contractual or legal right to recover money that has already been paid, when it later turns out that it should not have been. In finance, clawbacks appear in fund agreements, in bankers' and executives' pay, and in securities law. They all respond to the same problem: rewards are often paid on results that look good at the time and later reverse.

The underlying problem

Performance-based pay rewards people for gains measured over a period. If those gains are later reversed, through losses, restatements or misconduct, the reward has already been paid. Without a clawback, the incentive is to take risks that pay off in the short term, collect the reward, and leave others to bear later losses. Clawbacks, along with deferral and high-water marks, are tools to align pay with results over a longer horizon.

Clawbacks in private equity funds

The most established clawback in fund management is the general partner (GP) clawback in private equity and venture capital. The GP receives carried interest, a share of profits, often 20 per cent. In a "deal-by-deal" or "American" waterfall, carried interest can be paid as individual investments are sold profitably, before the fund's overall result is known. If later investments lose money, the GP may have received more carry than it is entitled to on the fund as a whole. The clawback requires the GP to return the excess at the end of the fund's life, usually net of taxes already paid on it.

Because returning money years later is difficult, agreements often add protections: escrow of part of the carry, guarantees by individual partners, or a "European" whole-fund waterfall in which carry is paid only after investors have received their capital and preferred return. The Institutional Limited Partners Association's principles discuss these mechanisms.

Why hedge funds use high-water marks instead

Hedge funds typically charge a performance fee annually or quarterly on realised and unrealised gains. Investors can enter and leave at different times, so a fund-level clawback at the end of a fund's life does not fit. Instead, hedge funds use a high-water mark: the performance fee is charged only on gains above the highest previous net asset value per share on which a fee was paid. If a fund loses 10 per cent, it must recover that loss before charging a performance fee again. Some funds add a hurdle rate, a minimum return before fees apply.

High-water marks protect investors from paying twice for the same gains but do not return fees paid on gains later lost. Some funds have experimented with deferring a portion of performance fees and adjusting them for later losses, which works like a partial clawback.

Bonus clawbacks and malus at banks

After the 2008 financial crisis, regulators required banks to tie bonuses more closely to long-term outcomes. Two tools became standard:

The Financial Stability Board's Principles for Sound Compensation Practices (2009) set the international framework. In the EU, the Capital Requirements Directive requires malus and clawback for material risk-takers and limits variable pay relative to fixed pay. In the UK, the Prudential Regulation Authority requires that variable pay for material risk-takers be subject to clawback for at least seven years from award, extendable in some cases.

Executive pay at listed companies

In the United States, section 304 of the Sarbanes-Oxley Act of 2002 allows the SEC to recover bonuses and stock sale profits from a company's chief executive and chief financial officer when the company restates its financial statements because of misconduct. Section 954 of the Dodd-Frank Act of 2010 went further, directing the SEC to require listed companies to adopt policies recovering erroneously awarded incentive pay from executives after an accounting restatement, regardless of fault. The SEC adopted Rule 10D-1 in October 2022, and the stock exchanges' listing standards implementing it took effect in 2023. Covered companies must recover incentive pay received during the three fiscal years before the restatement that exceeds what would have been paid under the restated figures.

Other uses of the term

"Clawback" also describes the recovery of tax benefits when conditions are not met, for example when an investment held for tax relief is sold before a required holding period, and the recovery of payments from investors in a fraud. In the Madoff case, the court-appointed trustee pursued investors who had withdrawn fictitious profits, recovering billions of dollars for victims; these are sometimes called clawback actions.

The practical limits

For investors reviewing a fund's documents, the questions are concrete: how and when are performance fees calculated, is there a high-water mark or hurdle, are fees deferred, and what happens to fees paid on gains that later disappear? Our articles on seed capital and accredited investors cover other parts of a fund's legal framework.

A numerical illustration

Suppose a private equity fund receives 100 million in commitments, invests it in five companies, and has a 20 per cent carried interest with a deal-by-deal waterfall. The first two exits produce a profit of 40 million, and the general partner receives 8 million of carry. The remaining three investments are then sold at a combined loss of 30 million. Over the whole fund, the profit is only 10 million, which would justify carry of 2 million. Under a clawback, the general partner must return the 6 million excess, typically reduced by taxes it paid on the carry. These numbers are hypothetical and ignore the preferred return and fees, but they show why investors insist on clawbacks and escrows in deal-by-deal structures.

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