Clawback Provision

A provision included in certain real estate partnership agreements, whereby a special distribution tier is included in the equity waterfall that allows for the limited partner (LP) to “clawback” cash flow previously distributed to the general partner (GP).

Reasons for including the clawback provision vary, but generally are related to instances where the GP is distributed cash flow before the LP reaches a preferred return hurdle. In the event at the end of the venture the LP has not achieved some preferred return, the GP must give back some or all distributions previously made to the GP until such point that the LP hits its preferred return.

Putting ‘Clawback Provision’ in Context

Scenario:

Sunshine Development Partners, LLC (the General Partner or GP) has entered into a joint venture with a private equity firm (the Limited Partner or LP) to develop Lakeview Estates, a multi-phase residential community project in Orlando, Florida. The venture involves acquiring 200 acres of raw land and developing it into residential lots over five phases. The total development cost is projected at $100 million, with the LP contributing 90% of the equity capital and the GP contributing the remaining 10%.

Project Structure:

The joint venture agreement outlines a waterfall structure where the LP is entitled to a 10% preferred return on its equity contribution before any promote is distributed to the GP. The preferred return and promote are calculated at the end of each phase, which allows the GP to receive a performance-based incentive if the phase meets or exceeds the expected return.

Clawback Provision in Action:

During the first two phases of development, Sunshine Development Partners successfully met the LP’s preferred return hurdle, and the GP was distributed a $2 million promote based on the strong performance of those phases. However, in the third phase, unexpected delays and higher-than-anticipated construction costs resulted in the LP achieving only an 8% return, below the 10% preferred return.

Given the underperformance of the third phase, the clawback provision in the joint venture agreement was triggered. This provision allows the LP to recover $400,000 from the previously distributed promote to the GP, ensuring that the LP is partially compensated for the shortfall in its preferred return.

Conclusion:

The clawback provision serves as a protective mechanism for the LP, ensuring that the GP is incentivized to maintain consistent project performance across all phases. It aligns the interests of both the LP and the GP, by requiring the GP to return a portion of its promote if future phases underperform, thereby reducing the LP’s overall risk in a multi-phase development project like Lakeview Estates.