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Clawback provisions are mainly used in corporate and investment/capital management settings. In a corporate environment, these provisions primarily enable the repayment of pecuniary compensation/rewards paid to the employee(s) if certain criteria are triggered.
For example, an executive for a specific product division may be paid a bonus for an exceptional increase in sales volume. However, if later it is established that the increase in sales was spurious, achieved, for example, through supplying the product to acquirers who have an unacceptable repayment record, and hence would have to be written off, the clawback provision would be triggered in this condition.
The bonus would have to be paid back to the employer.
In investment management settings, this stipulation is often used by private equity & hedge funds; in some cases, a modified form of this requirement is used by real estate investment trusts (REITs) as well.
In the private equity (PE) & hedge fund setting, it is applied mainly in the following way:
As there is a profit-sharing agreement in the hedge fund (HF) & PE space, mostly a 2 & 20, which means that the general partner (GP) of the HF or PE fund is entitled to 20% of the profits she generates using the limited partners (LPs) (investment clients) funds invested, and a 2% management fees for the total amount invested.
Often there is a specific hurdle rate of profitability before the GP is entitled to their 20% performance fees, i.e., there may be a hurdle rate of 5%, and if the actual yield on investment(s) is 10%, the GP is only going to be entitled to the profits above 5%, and in this example, 1% of the total 10% profits.
This work examines the clawback provision & the problems with it, providing logical arguments as to why it is a weak risk mitigation mechanism. What steps can be taken to reinforce this requirement so it can function more effectively for risk mitigation are also discussed.
An understanding of the factors discussed here can enable the implementation of better governance in corporate environments and investment management. Moreover, effective shareholder & stakeholder activism requires an in-depth understanding of the governance mechanisms implemented by the entities they invest their hard-earned funds in.
First, a discussion is provided regarding the two settings discussed here, after which the fundamental problems are discussed.
Clawback in a corporate setting
This provision, as described above, can be implemented as a governance mechanism to mitigate the risk of employees using imprudent, unjustified, or straight fraudulent methods to gain pecuniary benefits, benefits which might be in place to encourage performance improvements. It can succinctly be described as a mechanism to prevent executives from enhancing their personal gains at the expense of the company.
The objective of this provision in a corporate setting, thus, is to reduce short-termism and diminish excessive, imprudent risk-taking. This provision is also being adopted by many regulators to prevent the breach of law, financial restatement, or to reduce deficiencies in risk management. Put simply, this clause stipulates that if managerial wrongdoing, etcetera, is uncovered at a later date, the special remuneration (such as a bonus) previously paid to the subject would have to be returned.
Clawback in private equity and investment management
In PE, the profit-sharing between the investment manager (GP), and the investor (LP), mainly, is done in two ways: deal-by-deal (or American) waterfalls and whole-of-fund (or European) waterfalls.
In a deal-by-deal waterfall, the GP receives their performance fees per deal. In this way, the GP is paid before the LP.
In a whole-of-fund waterfall, distributions go to the LP as deals are exited, and the GP does not receive any performance fees until the LP's hurdle rate, as explained above, is met. The whole-of-fund is also calculated after all investments are exited and thus occurs at the aggregate fund level.
In this setting, the provision requires the GP to return previously earned performance fees on profits if later deals register losses.
A similar mechanism is used in the hedge fund industry.
The fundamental problems with the clawback provision
In the corporate setting, a fundamental problem remains with this provision that stems from the regulatory action against managers that are guilty of short-termism or fraud. The first main issue is that if this provision is the entirety of the governance mechanism, then rationally, it cannot be considered very thorough.
For example, an unscrupulous corporate executive would know that if they, using deception or imprudent methods, receive a bonus, the worst thing that can happen is a repayment of the compensation received.
This can be considered analogous to saying to a robber that if you are caught, you would only have to return the looted items & shall face no further consequences. Overall, arguing that such a condition makes absolute rational sense is difficult, and thus, one cannot classify this provision as a robust preventative measure.
Some may argue that such a governance mechanism may even encourage the very behavior it aims to prevent.
For an unscrupulous manager, the payoff can matrix is presented below; a modified game-theoretical approach has been applied below for further clarification of this point: Payoff matrix (for an unprincipled manager, the payoff per $1000 bonus)
As we can see, the dominant strategy (the strategy that maximizes the outcome for the player as per a particular condition), in this condition, for an unprincipled manager, would be the outcome in the lower-left corner.
The outcome can be briefly described as follows: "take the risky, imprudent, or deceptive decisions for self-enrichment at the expense of the shareholders/parties you are supposed to be the agent of; if you are caught, you can simply return the compensation received, if not, you get to keep it."
There is no cost or penalty integrated into this provision, and hence, we see its deficiency as a robust mechanism for risk management.
Assuming this mechanism is robust would be like assuming that bank robbers may be deterred by implementing a legal system, in which the bank robbers that are caught, are only required to return the funds they robbed without any legal sentence (jail time).
Exceptional intellectual capacity isn't required to comprehend that if an unprincipled individual can commit a wrongful act, totally at the expense of others, with the only risk mitigation mechanism being that they may have to return the ill-gotten gains, they may not be deterred; in fact, such a mechanism, due to the absence of any direct impact on the manager, may actually tempt/encourage some to take actions that they wouldn't otherwise, hence, promoting short-termism etcetera, rather than reducing it.
The second issue that we must consider is a technical point. If we assume that the manager may not have acted in an imprudent manner but, say, due to the economic condition, or other exogenous factors, the decision/allocations made by her did not produce the intended results. In such a condition, can we classify the clawback provision as robust or adequate for mitigating the risk of LPs in a PE setting, or shareholders/firms in the case of corporations?
The answer is no, we cannot.
The time value/cost of money is the fundamental factor upon which the second point is constructed.
This can be a serious concern when inflation expectations are high, and the value of money is likely to deteriorate considerably in the future. Alternatively, this can also be a concern of high importance when the amount involved is considerable, for example, an allocation by a pension fund in PE, a substantial allocation in REITs, or a significant allocation in a syndicated PE vehicle.
This factor, succinctly, can be described as follows:
LPs (investors) in HF, PE funds, or shareholders in corporations, may believe that due to a clawback provision in place, if the manager(s) take imprudent decisions for self-enrichment, their gains would be reversed in the future and thus, this risk should be considered as effectively mitigated.
Such a line of reasoning isn't accurate, however. While most of the amount that the manager received may be secured through a clawback, the entirety of the amount would not; the actual losses would depend on the cost of capital for the investors and the amount involved.
A similar logic applies in a corporate setting: Suppose a manager, through unscrupulous methods, attains a bonus, say, of $200,000, knowing that this amount would probably have to be repaid in, say, 3 years' time, as per a clawback in place.
The manager may allocate the money in a stock index, or a risk-free saving account, and the manager would be able to keep the gains on the amount accumulated during the 3 years period before the amount has to be paid back.
Let's suppose the manager allocates the $200K into an index fund that yields a 10% return. At the end of the period, the amount invested in the index fund would have increased to $266.2K (200 × (1.1)^3).
However, the amount that must be repaid would still be $200K, and this condition creates an incentive for the manager to behave in an unprincipled manner, at the expense of the shareholders, without any negative consequences for the manager (monetary or otherwise). A further example:
Suppose in a PE fund that has a deal-by-deal compensation mechanism in place, an unprincipled GP with an understanding of this factor, in the early investment period, spuriously report gains on illiquid investments, extracting his performance fees, while keeping the LP invested.
The GP may know that the fees collected are unjustified & would have to be returned as per the clawback terms, but understanding the time value of money, may want to benefit from the amount wrongly received in the early period, because the value of the amount returned later in the investment period would be less than the value of the amount that the GP would have to repay.
For further clarity, let's suppose that the GP reports a profit of 40% on an illiquid PE deal of $30 million that he reports as closed through, say, an obfuscated syndicate agreement with other combined assets sold to a third party, but suggests that the LP should stay invested.
As per the agreement, he extracts $2.4 million, his 20% performance fees (20% of the $12 million profits), but later, say, after 5 years, reports a loss and has to repay the amount. What's important to understand is that the $2.4 million, the amount that must be repaid, wouldn't have the same fundamental value for the LP who is repaid this amount after 5 years.
Even by discounting the amount at the risk-free rate of, say, 4% (expected long-term real GDP growth + inflation rate in the U.S.), we can see that the amount he extracts at the beginning would have reduced in value when he pays back the amount to the LP.
Let's assume he extracts the amount in the beginning and deposits it in a 5-year risk-free saving account, paying 4% effective annual interest. At the end of year 5, when he must repay the $2.4 million back to the LP, due to the interest earned, he would have $2.92 million in the account, but he would be required to only repay $2.4 million; he would be able to keep the difference between the compounded sum in the saving account (2.92) & the amount he has to repay to the LP (2.4), hence, making $520,000 without any further repercussions.
With larger amounts and more opaque deals during the investing periods, as is the case with most PE allocations, the perverse incentives of the above-explained machination increase.
How can loopholes in the clawback provisions be fixed
History tells us that all loopholes that can be exploited are exploited; history is littered with examples such as the cobra effect or the firearm buyback program in Oakland, etcetera. Therefore, it is crucial that mechanisms that are designed to prevent undesired behavior, etcetera, are robust and thoroughly effective.
As per the first issue/problem discussed in this work, the fact that the losses/repercussions for an unprincipled manager/GP are limited to the unjustified pecuniary reward they can extract is a serious loophole.
Individuals that are suspected of such behavior and then confirmed to be guilty, should face repercussions beyond the return of the monetary sum they received earlier. The extent of the disciplinary action should depend on whether there is a logical possibility that the individual in question did not intend to act in an unjustified manner.
If there is a possibility that the subject wasn't trying to exploit a loophole, as discussed in this work, then, as per regular protocol, they should be given the standard three-strike warnings, with strict disciplinary action taken after the third strike.
On the other hand, if it is confirmed through an inquiry, etcetera, that the person was indeed trying to play/defraud the system, then the logical recourse that should be implemented is the same that is applicable by the law of the jurisdiction for fraud, i.e., charged with fraud as per the laws of the jurisdiction where the incident occurred. This would ensure that employees know that devious behavior would have consequences & the worst outcome wouldn't be limited to the return of the monetary compensation gained unscrupulously.
In a PE setting or even at the firm level, to eliminate the loophole of the time value of money, the clawback should include a penalty equal, at least, to the risk-free rate of return, i.e., at the very least, the organization or LPs should implement a further penalty integrated with the clawback that is at least equal to the risk-free rate compounded by time, in the jurisdiction.
This will eliminate the loophole of time-value of money that ensures that the amount returned to the firm or the LPs in the future is, at the very least, equal to the amount that the manager/GP extracted, bearing in mind the time value of money.
The LPs should also demand that the performance fees of GP be held in escrow until the end of the investment period, as done in the HF industry (at times).
Ideally, when dealing with a PE fund, the LP should demand a penalty that is equivalent to the opportunity cost of capital as per the time involved, & in corporate settings, firms imposing a penalty equal to the weighted average cost of capital (WACC) for the firm.
Nonetheless, doing so would be challenging and may further complicate things. The risk-free rate, for example, the interest rate on the 10-year U.S. government bonds in the U.S., would be simpler to implement.
Lastly, it is important to note that the firm/LPs should implement risk mitigation measures in a way that they aren't perceived to be draconian in nature, i.e., of a level of severity beyond justification, as doing so would surely disenfranchise employees or damage the relationship between the LP(s) and the GP in a private equity relationship.
Best practice would be to issue a memorandum to all employees illuminating the concerns of the firm and empathetically explaining that the firm, as per its long-term objectives, cannot afford behavior that is self-serving/doesn't align with the goals of the firm, due to which reasonable measures must be implemented.
In private equity settings, a frank discussion with the GP, presenting examples of unjustified behaviors by other GPs in the past coupled with a thorough discussion regarding the concerns of the LPs, would be the ideal way.
Nonetheless, in a private equity investment allocation discussion/negotiations, the LPs should establish a best alternative to the negotiated agreement (BATNA). Ideally, the GP with which the LPs are negotiating regarding the alignment of interests should be aware that the LPs have other options that they can choose, i.e., other PE funds that are willing to be more flexible.
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