🎉 Happy Friday, Funds Family!

We were supposed to update an article on state investment advisers laws (as we promised ⚖️last week), but we’ve had an avalanche of fund clients holding closings, and we’re going to have to push that to next week. (Sorry to all those who couldn’t wait for a surely tantalizing hit of regulatory goodness.)

Hopefully this article on distribution waterfalls will satisfy you. 🤷 

We’re back with another 🛠️ breakdown of fund waterfall mechanics — this time focusing on GP capital contributions (the GP’s “co-invest”).

If you need a general refresher on how investment fund distribution waterfalls work, we’ve got you covered:

• 🛠️ Part 1: What is Carried Interest? 

  Introduces the concept of carry, explains how waterfalls work in single-asset SPVs, and reminds GPs why it’s critical not to forget the waterfall clause in your fund docs.

• 🛠️ Part 2: Multi-Asset Fund Waterfalls 

  Breaks down American (deal-by-deal) vs. European (netted) waterfalls, including how expenses and partial realizations can shift the economics between LPs and GPs.

•  🛠️ Part 3: Preferred Returns, GP Catch-Ups & Clawbacks 

  Walks through preferred return mechanics, how the GP catch-up works (with philosophy and math), and when clawback provisions come into play.

With that background out of the way, let’s examine how to deal with the capital the GP invests alongside the LPs.

📐 The Setup

Let’s illustrate using a simple example. Assume a single investment made with $100 total capital:

• $90 from the LP

• $10 from the GP

The investment doubles in value and is sold one year later for $200. We’ll assume an 8% preferred return to the LP and an 80/20 split of profits thereafter to the LP/GP.

Contrary to what you might think, in most investment funds, the GP’s capital doesn’t run through the LP waterfall. That means the waterfall only governs the $180 attributable to the LP’s share of the deal. You can think of the waterfall as a provision where the GP extracts a tax (i.e., the carried interest) from LP profits. The GP doesn’t need to tax its own profits, so that capital doesn’t run through the waterfall.

Let’s walk through the steps.

🔁 Step-by-step example

1️⃣ GP Receives Allocation

First, the amount to be distributed ($200 per the example above) is preliminarily allocated among the partners (GP and LP) in proportion to their capital contributions.

The GP is allocated 10% ($20) and the LP is allocated 90% ($180).

That $20 allocated to the GP is distributed to the GP. And that’s it. Nothing more happens with that $20, and it doesn’t run through the waterfall.

That leaves the $180 that was allocated to the LP…

2️⃣ LP Allocation Goes Through Waterfall

Next, the LP allocation ($180) runs through the waterfall.

Waterfall Step 1: Return of Capital

First, 100% of the LP’s $90 capital contribution is returned.

Waterfall Step 2: Preferred Return

Second, the LP receives a preferred return on its $90 investment. In this example, we used an 8% pref. Assuming a one-year holding period, that’s $7.20.

Waterfall Step 3: Profit Split

The remaining profits ($82.80) are split 80/20 between the LP and GP.

• 80% to LP: $66.24

• 20% to GP: $16.56

The GP’s total economics? $20 attributable to capital interest + $16.56 attributable to carried interest = $36.56.

The LP’s total economics? $90 return of capital + $7.20 preferred return profits + $66.24 additional profits = $163.44.

As you can see, the GP’s 10% capital interest is separate from its 20% carried interest allocation — they don’t need to match. Most funds decouple capital interest and carried interest percentages, treating them as independent economic rights.

Does GP capital ever run through the waterfall?

We have seen some JV documents and smaller funds where the GP capital runs through the waterfall alongside LP capital, but it’s unnecessary (and, as we discussed above, basically just amounts to the GP paying itself carry).

Another scenario could be where there are two GP members: (i) one who is the “operator”; and (ii) one who is the “capital provider.” If the capital provider is a large enough slice of the fund, the operator and the capital provider may agree that the capital provider’s contributions (which run through the GP) should have to pay carry…to the GP. This is an unusual setup (and might not be the most tax efficient way to structure things), but we have seen it in the past.

/ WRAPPING THE CASE

/ JURY TRIAL

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⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.