Private Equity Carried Interest Waterfall: A Step-by-Step Example Guide

Unlock the intricacies of the Private Equity Carried Interest Waterfall through our comprehensive example guide.

Introduction to the Carried Interest Waterfall:

Discover the mechanism governing profit distribution between general partners (GPs) and limited partners (LPs) in private equity.

Key Components of the Carried Interest Waterfall:

Tranche 1: LP Distributions Up to Hurdle Rate (aka LP Preferred Return):

LPs receive 100% of distributions until they reach the hurdle rate (usually set at an IRR of 8%).

Tranche 2: GP Distributions Under the 80/20 Rule (aka GP Catch-up):

1. • Any remaining distributions are distributed following the 80/20 rule (or any other rule agreed between LPs and GP).

Example Calculation:

1. Step 1: Determine Tranche 1 Distributions:

   • LPs receive 100% of distributions until reaching the hurdle rate.
   • LPs contributed $100 million, and the hurdle rate is 8%.
   • Preferred Return (8% IRR over 10 years): $21,300,000
   • Net Profits after Preferred Return: $78,700,000

2. Step 2: Calculate Tranche 2 Distributions:

   • Apply the 80/20 rule to distributions (net of LP contributions, management fees, and capital calls) until the proportion is satisfied.
   • Management fees: $20 million
   • Distributions for Tranche 2: $78,700,000 - $100,000,000 - $20,000,000 = $41,700,000
   • GPs receive 100% of Tranche 2 until the 80/20 proportion is met.
   • Applying 80/20 rule: $41,700,000 * 0.80 = $33,360,000 (to LPs), $8,340,000 (to GPs)

3. Step 3: Determine Tranche 3 Distributions:

   • Remaining distributions: $50,000,000
   • Applying 80/20 rule: $50,000,000 * 0.80 = $40,000,000 (to LPs), $10,000,000 (to GPs)

Considerations and Implications:

1. Performance Impact: Higher returns increase carried interest distributions, aligning interests.
2. Alignment of Interests: Tranches ensure alignment between GPs and LPs.
3. Complexity and Calculation: Accurate calculation and deduction of fees are vital for equitable distribution.

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