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):
GPs receive 100% of distributions until all distributions (net of LP contributions) are in an 80/20 proportion.
Management fees and capital calls are deducted from aggregated distributions before applying the 80/20 rule.
Tranche 3: 80/20 Proportion Distributions:
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- Any remaining distributions are distributed following the 80/20 rule (or any other rule agreed between LPs and GP).
Example Calculation:
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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
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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)
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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:
- Performance Impact: Higher returns increase carried interest distributions, aligning interests.
- Alignment of Interests: Tranches ensure alignment between GPs and LPs.
- Complexity and Calculation: Accurate calculation and deduction of fees are vital for equitable distribution.