Happy Friday, Funds Family!

This is the grand finale of our three-part series about how carried interest works in investment funds and SPVs. If you haven’t read Part 1 and Part 2, go check those out first.

Let’s bring it home!

👔 Preferred Returns

In many funds (especially real estate and private equity funds), the waterfall has more steps than the simple 2-step waterfalls we discussed in Part 1 and Part 2.

After (or sometimes before) the “return of capital” step, LPs often receive a preferred return before the GP gets its carried interest.

It might look something like this:

In short, if the fund returns capital to the LPs but does not clear an 8% return, the GP does not get any carried interest. 😭 

Let’s look at an example.

Example 🔍️ 

This example has the waterfall discussed directly above ☝️ and results as follows:

• Capital Contributions: LP invested a total of $100.

• Sale: The Fund sells assets and has $200 to distribute.

• Step 1: Per the first step in the waterfall, $100 (the LP’s capital contributions) goes to the LP.

• Step 2: Per the second step in the waterfall, the LP gets an 8% return on their $100 contribution. Here, let’s assume it’s been one year since the LP contributed the capital, so the preferred return is $8 (8% of $100).

• Step 3: Per the third step in the waterfall, the remaining $92 is split 80% to the LP ($73.60) and 20% to the GP ($18.40).

Here, the LP received $181.60 (100+8+73.6) and the GP received $18.40.

If there were no preferred return, the LP would have received $180 (a capital return of $100 plus 80% of the remaining $100), and the GP would have received $20.

So, obviously, the preferred return is good for the LP. 📈 

🍭 Different flavors of preferred returns

Here are a few ways preferred returns can differ from fund to fund:

• Compounded / Non-Compounded. In some funds, the preferred return compounds annually. In other funds, the preferred return is a “simple” (non-compounded) preferred return.

• Percentage. In lower-risk funds, the preferred return is often lower. For example, in a buy-and-hold multifamily fund, the pref might be just 6%. In higher-risk funds, the pref is usually higher. For example, a development fund might have a pref of 12%.

• Positioning in Waterfall. Some funds have the preferred return after the return of capital step. Other funds have the preferred return before the return of capital step.

• Dual Waterfalls. Some funds have a standard waterfall like we discussed above for dispositions (sales, refinances, etc.) but have a separate waterfall for cash flow from operations. The cash flow waterfall might have no return of capital step at all. Step 1 would be the preferred return and Step 2 would be a profit split. This is more common in buy-and-hold style funds.

GP Catch-Ups 🏃 

People always get confused about this one. Let’s start with some philosophy and then look at an example.

📚️ A bit of philosophy

In a distribution waterfall, the profit split is the percentage of the profits the GP is supposed to get. Simple enough.

But if you look at the example above with the preferred return, the GP didn’t get 20% of the profits at all! 🫢 The GP got 18.4%, even though the profit split is 20%.

This is because the LP got a priority distribution (the preferred return) before the profit split kicked in.

A GP catchup is a provision that “catches the GP up” to the 80/20 profit split after the preferred return.

An 80/20 waterfall can be thought of as: “For every 4 steps forward the LP takes, the GP takes 1 step forward.” 🚶 

The preferred return is the LP taking their 4 steps forward early. The GP catchup is the GP taking 1 step forward before the final phase of the LP and GP taking their 4/1 steps forward simultaneously.

Enough philosophy! 🤓 

Let’s look at an example.

Example 🔍️ 

Here’s the same waterfall as above, but with a GP catchup added.

Let’s walk through the flow of funds in our example.

• Capital Contributions: LP invested a total of $100.

• Sale: The Fund sells assets and has $200 to distribute.

• Step 1: Per the first step in the waterfall, $100 (the LP’s capital contributions) goes to the LP.

• Step 2: Per the second step in the waterfall, the LP gets an 8% return on their $100 contribution. Here, let’s assume it’s been one year since the LP contributed the capital, so the preferred return is $8 (8% of $100).

• Step 3: GP catchup kicks in and the GP gets $2. This is because $2 is 20% of $8 (the profits distributed to the LP in Step 2) and $2 (the profits distributed to the GP in this step.

• Step 4: Per the third step in the waterfall, the remaining $90 is split 80% to the LP ($72) and 20% to the GP ($18).

Here, the LP received $180 (100+8+72) and the GP received $20 (2+18).

The GP catchup results in the GP getting more carried interest 💵 than without the GP catchup. In fact, the GP gets the same amount of carried interest as if there were no preferred return at all.

The result of a setup like this is the following:

• Poor performance 📉: If the fund generates less than a 10% return (8% for the preferred return and 2% for the GP catchup), the GP makes less money than if there were no preferred return / GP catchup.

• Good performance 📈: If the fund generates at least 10%, the GP makes the same amount of money as if there were no preferred return / GP catchup, but the LP got the money first in time, which benefits LPs.

🍭 Different flavors of GP catchups

Above, our example has a 100% GP catchup, which means the GP gets 100% of the distributions in Step 3 until the GP has received 20% of the profits.

Another option (which is more favorable to LPs) is to have a catchup of less than 100%.

For example, Step 3 could give 50% of the profits to the LP and 50% to the GP until the GP has received 20% of the profits.

This is still better than no catchup at all from the GP’s perspective, but it’s less exciting than the 100% catchup. It just takes longer for the GP to catch up. 🐢 

🦞 Clawbacks

Don’t break out the lobster until you’re sure you won’t have a clawback.

A clawback is a provision that requires the fund to “re-test” the waterfall at the end of the fund’s life. You consider all the capital contributions and all the distributions and see if the GP got too much carried interest.

If the GP did get too much carried interest, the GP must return the excess to the fund 💸 (this is the clawing back 🦀 of the carry).

How does a GP get too much carried interest? 🤔 

Here is an example for you.

Let’s say we have a very simple European waterfall with an 80/20 split after a return of LP capital.

Let’s say an LP has a commitment of $100.

The GP calls $50, the investment is a 2x, and the fund distributes $100. The first step in the waterfall is a return of $50 (the LP’s invested capital). The second step of the waterfall is an 80/20 split, so $40 goes to the LP and $10 goes to the GP as carried interest. 📈 

Next, the GP calls the remaining $50 and invests it. The investment completely implodes and is a total loss. Nothing to distribute. 📉 

The clawback re-tests the waterfall at the end of the fund’s life. The clawback sees $100 of total capital contributions and $100 of total distributions. What should happen is the LP receives $100 as a return of capital and the GP gets nothing.

⚠️ But wait!

The GP took $10 of carried interest after selling the first investment (before evaporating the second $50 investment).

The clawback says the GP has to put the $10 back into the fund, which is distributed to LPs. ☹️ 

🍭 Different flavors of clawback

In some cases, LPs might negotiate for the following:

• Personal Guarantees: Technically the GP entity (typically an LLC) is what’s on the hook for the clawback. Sophisticated LPs may insist that the individual fund principals guarantee the clawback obligation.

• Multiple Clawbacks: This isn’t super common, but some hard-negotiating LPs will require multiple clawback “tests” throughout the fund’s life. For example, a clawback after year 7 and a clawback at the end of the fund’s life.

• Carry Escrow: In some cases, the GP may be required to put a percentage of their carried interest in an escrow account so it’s easier to claw back. The GP finally gets the carried interest once it’s clear there won’t be a clawback situation.

Phew! We made it. 😅 

Appreciate you sticking with us for our three-part series on carried interest.

Have a great weekend! 🙌 

⚠️ 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.