As the SEC, reporters, and analysts dig into the operations of private equity firms, it is becoming obvious that one of the reasons that these financiers have cornered the best legal talent in America is for the express purpose of better fleecing their investors.

A prime example comes up in the use of clawbacks in private equity agreements. For those new to private equity, the clawback provisions are meant to assure that the private equity fund managers do not receive fees meant to reward good performance when the performance was no good.

The prototypical fee structure for a private equity fund is an annual management fee of 2% of assets under management plus 20% of the profits. The majority of funds stipulate that that 20% upside fee (called “carried interest”) kicks in only after a certain rate of return (the “hurdle rate”) has been surpassed. The typical hurdle rate is 8%.

But remember how private equity funds work. Each fund buys a portfolio of companies, and then over time sells them, hopefully at a profit. While some fund agreements provide that no upside fees are paid until the end of the fund’s life, most funds in the US allow the managers (who are members/owners of an entity that serves as general partner) to pay themselves a share of the profits in excess of any hurdle rate on each deal based on the sales price of that portfolio company. Since the most lucrative deals are generally sold early in the fund’s life, and the dogs linger, this raises the possibility that the so-called success fees that the managers pay themselves on those early winners are offset partly or in total by the underperformance of companies sold later.

The famed “clawback” provisions in the limited partnership agreements that govern these deals are meant to remedy that by requiring that the fund managers, who are general partners, settle up with the limited partners at the end of the fund’s life and return any overpayment of profits ultimately washed out by losses.

Now of course, if the limited partners had any spine, they’d dispense with this arrangement and insist that the managers receive no incentive compensation until the funds were wound up, or that the distributions were so large that even if the remaining deals were total losses, the managers would still be entitled to a profit participation. But the tide if anything is going the other way. Eileen Appelbaum and Rosemary Batt report in their new book Private Equity at Work that more and more funds are going to the “pay as you go along” model, which means investors are giving ground on this issue.

As it turns out, this investor indulgence is yet another example of a failure to watch out for their interests, since the clawback language in the limited partnership agreements doesn’t work the way the private industry claims it does. Lee Sheppard parsed some of the limited partnership agreements we found and published in a recent article in Tax Notes (paywalled).

One of the things that laypeople will notice is that the clawback sections in these agreements are larded with tax language. Sheppard explains that there are actually two types of clawback language. One pertains to the ruse the managers use to get capital gains treatment for their management fees, which by any common-sense standard should be treated as labor income and taxed at a much higher rate. She explains in tax terms how these clawbacks are merely window dressing and are never invoked, so we’ll skip over them.

Before we go further, the agreements already have a huge red flag that the clawback terms are one sided. The clawback that relates to the payment of upside fees has the managers providing personal guarantees. Despite the fact that some of the managers at the biggest funds are extremely rich men, these guarantees are inadequate in practice. If fund is enough of a dog, the clawback amount can exceed what the managers have on hand, particularly since the fund lives are long enough that events like divorce can seriously reduce the net worth of these Masters of the Universe.

If the limited partners were serious about getting these overpayments back, they’d demand that the firms also pay for a third party guarantee. Rest assured, major Wall Street firms would be only too happy to provide them to the general partners for an appropriate fee.

The mechanism used for providing for the clawback is that the limited and general partners both have capital accounts, an internal accounting mechanism used to keep track of partners’ gains and losses. Here’s how that in theory provides for the clawback to work:

On dissolution, the general partner has an obligation to restore a deficit in its capital account only to the extent that it exceeds 20% of net distributions and cumulative distributions to the general partner. Usually the general partner’s capital account deficit roughly corresponds to its clawback liability.

But then we get to the cute tax language. The agreements make theoretical general partner tax problems into investor problems. The clawback provisions stipulate that the clawback amount be the lesser of overpayment or the after-tax overpayment. Taxes are assumed to be at the highest conceivable individual rate for someone living in high-tax New York City or San Franscisco. The agreements even assume that the managers cannot benefit from taking capital losses on the dogs. Does anyone believe these men, who typically hire top tax experts to advise them on their personal tax filings, pay the statutory tax rate?

But even with having the clawback amount reduced artificially by the use of unrealistic-in-practice tax assumptions, the general partners’ clever lawyers have other ways to vitiate these provisions. An article by Andrew Needham, a tax partner at Cravath who focuses on the private equity industry, explained in an industry guidebook Private Equity Funds, in section VI. Special Tax Issues for the General Partner and Its Members, provides an example of how to circumvent the clawback provision:

Example: A general partner has a 20% carried interest in a fund. The fund acquires two investments, A and B, at a cost of $100. The fund then sells A for $150 and distributes $10 to the general partner with respect to its carried interest. Assuming that the general partner invested no capital in the fund, it will have a capital account balance of zero immediately after the distribution (i.e., $10 profit allocation less $10 distribution). Assume that B then declines in value to $40. If the fund were to sell B and then liquidate, it would allocate $10 of the $60 to the general partner, generating a pre-tax clawback obligation of $10. Assume instead that the investors “forgive” the general partner’s potential clawback obligation after the sale of A. If the forgiveness occurs after the decline in value of B, the investors will have effectively transferred $10 of their capital to the general partner in a taxable transaction. But what if the fund instead “books down” the capital account balances of the investors and then agrees to allocate the first $10 of book profits to the general partner? The book down would create $60 of book loss, which the fund would allocate $10 to the general partner and $50 to the investors. The general partner’s book capital account then declines to negative $10, but with no immediate tax consequence. If the fund later sells B for $50, it will realize a book profit of $10 (i.e., $50 – $40) and a tax loss of $50 (i.e., $50 – $100). The agreement to allocate the first $10 of profits should qualify as the tax-free grant of a profits interest under Rev. Proc. 93-27 262 because it entitles the general partner to no portion of the current value of B. The fund then allocates the $10 of book profit to the general partner and the entire $50 of tax loss to the investors, leaving the general partner with a book and tax capital account balance at fund liquidation of $0. Because the general partner has a zero capital account balance, it has no clawback obligation.

Even with the assistance of attorneys like Andrew Needham, some funds nevertheless wind up with clawback liabilities that they can’t wriggle their way out of. Surely they have to cough up some dough, no?

That’s not the way it works in practice.

What happens in the event that the managers owe investors money is that they propose that the investors will get a “special deal” on the next fund launched by the same general partner. In real life, it’s highly unlikely that these investors would accept a “special deal” on future drycleaning from a shop that had ruined their suit, yet this sort of arrangement is common.

But it’s even worse than that, since to get the “special deal,” the investors have to commit new funds to the same fund manager who delivered disappointing or poor performance. And of course, we also have the wee time value of money issue. Since the overpayments took place early in the fund’s life, say year four and five, and the clawback was due when the fund liquidated, say in year twelve, the managers have already gotten a bennie by having use of money they weren’t entitled to for seven or eight years. Trying to roll that into the next fund pushes out the supposed day of reckoning a few more years.

And it gets worse than that. The “special deal” is likely to include a reduction in the management fee. The limited partners would presumably regard that more favorably than concessions on the performance fees, since fund managers that failed to produce profits once may well punt again. That outcome would make that type of “special break” worthless and thus allow the managers to retail the clawbacks that should have gone to the limited partners.

But the supposedly better concession of lower management fees often turns out to be three-card monte.

Recall that over time the limited partners have pushed back on some of the other fees that the general partners charge, such as “transaction fees” (merger and acquisition deal fees charged on top of the fees that investment bankers charge) and “monitoring fees” (fees charged to the portfolio companies for babysitting them). But the way those fees have been reduced is not by ending them. Instead, a percentage, typically 80%, is credited against the management fee. So if those fees subject to credit exceed the management fee, the manager keeps them. So any “special deal” on the management fee amounts simply allows the manager to retain more of all those supposedly rebated fees.

As the old saying has it, possession in 90% of the law. Private equity fund investors have put themselves in the position where general partners control the cash flows of the portfolio companies as well as of the partnership. As we’ve seen with bank servicers, they’ve proven unable to resist the temptation to take as much as possible for themselves, both via contractual means and via skimming. But investors continue to regard private equity fund managers as trusted business colleagues even as they continue to pick investors’ pockets.

Private equity fund managers’ greed debunks the second myth of private equity, aka leveraged buyouts. That second myth was that private equity managers were doing good by their investors, working hard to restructure companies and deliver spectacular returns. The details of the clawback practices say otherwise. Those mechanisms demonstrate that regardless of the fund’s performance, the managers come out with a payday sufficient to feather their own nests and those of their ex-wives. Investors, it turns out, are just another class of victims.

Of course, the first comprehensively debunked myth was that private was saving companies rather than plundering them. Even their showcase projects haven’t worked out well. Look at the number of trips through the LBO mill Hostess Brands has made. Now comes the news that the Hostess baking plant in Schiller Park, Illinois – the place where Twinkies were invented in 1930 – is closing. Hell, if you can’t make money selling junk food in America, how good a manager are you, really?