Chartered Alternative Investment Analyst Association (CAIA) Exam 2025 – 400 Free Practice Questions to Pass the Exam

A clawback clause is typically designed to protect investors or limited partners in funds, particularly in private equity and hedge funds. It allows for the return of previously distributed profits back to the fund under certain conditions. The correct scenario that necessitates a clawback clause is when early profits are followed by losses.

This situation arises because funds may distribute profits to managers or general partners based on performance, even if those profits are not sustainable. If subsequent performance leads to losses, the clawback provision can require those managers to return a portion of the profits distributed earlier to ensure that investors do not suffer losses while managers benefit from profits that were not ultimately justified by the fund's overall performance.

The other scenarios do not trigger clawback provisions. Consistently high profits (the first option) suggest strong ongoing performance, reducing the likelihood of a clawback requirement. When all investments are liquid (the third option), it implies that the fund could manage the situation without needing to return profits. Lastly, if no previous profits were recorded (the fourth option), there would be no need for a clawback since there would be no distributed gains to claw back. Thus, the scenario of early profits being followed by losses is the one that justifies invoking the clawback clause.