1. Topic 2.13:
Distribution Waterfall
Importance of the Waterfall Distribution
General Partner Incentive Structure
Profits and Carried Interest
Distribution of Profits
General Waterfall Distribution
Breakeven IRR
Preferred Return as a Free Option
Clawbacks
LO 2.48
Importance of the Waterfall Distribution
Private equity investments require
numerous critical decisions over a long
investment horizon
Decisions are largely unobservable by
limited partners
Need to align incentives and pay structure
to protect limited partners and maximize
returns
Distribution waterfall sets the rules and
procedures for the distribution of profits 186

2. LO 2.49
General Partner Incentive Structure
Carried interest – Key incentive aligning device;
percentage profit split after meeting hurdle rate;
typically 80/20
Management fees – 1.0%–2.5% of committed
capital; used for operating costs
General partner contribution – 1.0% of committed
capital; aligns interests of the managers and
investors
Vesting – Legal transfer of incentive payments to
managers
Distribution provisions – Specific timing and
provisions of profit distribution 187
LO 2.50, 2.51, 2.55
Profits and Carried Interest
Hurdle rate (preferred return) – Must be distributed
to investors before managers earn carried interest
Clawback – Managers must return funds to
investors from overpayment of carried interest
Carried Interest:
Deal-by-deal – General partner receives profits
on each investment; manager receives profits
sooner; limited partners have exposure to future
losses
Fund-as-a-whole – Calculates carried interest
on the performance of the entire fund; more
likely to align the interests of managers and
investors 188

3. LO 2.52
Distribution of Profits
Hurdle rate (h%) will be specified in the distribution
provisions for the fund
Must estimate value (ah) that must be achieved before
general partners participate in carried interest
t<T
ah = ∑
n=1
Cn (1 + h)T ? t
Managers are entitled to a u% catch-up under the
distribution provisions and will accrue u% of the next
amount, c, earned by the fund
h?u
IRR with full carried interest =
u?c 189
LO 2.52
Example: Distribution of Profits
Investors contribute $100M to a private
equity fund
Hurdle rate is 10% and the fund is worth
$150M at the end of the year
Catch-up rate is 100%
Carried interest split is 80/20
Calculate the distribution of profits and the
full carried interest IRR
190

4. LO 2.52
Example: Distribution of Profits
(continued)
Investors: receive principal plus preferred
return of $110M = 100M × (1 + 0.10)
10M / 12.5M = 0.80 = 80%
General partner: receives 100% of the next
$2.5M earned
2.5M / 12.5M = 0.20 = 20%
80/20 split is achieved; remainder of profits are
split
10% × 100%
IRR with full carried interest = = 12.5%
100% − 20%
191

5. LO 2.52
General Waterfall Distribution
LP GP Total
Return of capital d d
Preferred return
ah – d ah – d
to LP
Catch-up for GP (1 – u)x u(x) x
80/20 split or
(1 – c)y c(y) y
residual
Sum of Sum of
Closing balance a–d
above above
193
LO 2.52
General Waterfall Distribution (continued)
Investors contribute $100M to a private
equity fund
Hurdle rate is 10% and the fund is worth
$150M at the end of the year
Catch-up rate is 50%
Carried interest split is 80/20
Determine the waterfall distribution
194

6. LO 2.52
General Waterfall Distribution (continued)
LP GP Total
Return of
100 $100M
capital
Preferred
110 – 100 = 10 $10M
return to LP
Catch-up for
(1 – 0.5)(6.67) = 3.335 0.5(6.67) = 3.335 $6.67M
GP
80/20 split or 0.80(50 – 16.67) = 0.20(50 – 16.67) =
$33.33M
residual 26.66 6.67
Closing
$140M $10M $150M
balance
195
LO 2.53
Breakeven IRR
Fund A: 100% catch-up, 20% carried
interest, and hurdle rate of 8%
Fund B: 40% catch-up, 20% carried interest,
and hurdle rate of 6%
8% × 100% 6% × 40%
Fund A = = 10% Fund B = = 12%
100% − 20% 40% − 20%
Return Fund A Return Fund B
IRR
(hurdle rate = 8%) (hurdle rate = 10%)
6% 0% 20%
8% 20% 20%
10% 20% (caught up) 20%
12% 20% 20% (caught up) 196

7. LO 2.54
Preferred Return as a Free Option
Distribution of the preferred return is similar
to a call option
Strike price = contributed capital + preferred
return
General partner earns high returns if the
option is deep in-the-money
If returns do not exceed the hurdle rate, the
option is out-of-the-money
Assumes general partner contributed little or
no personal capital
197
LO 2.56
Clawbacks
Provisions in partnership agreement
Ensures equitable final distribution (carried
interest split)
Example:
Asset X (purchased for $170M) is sold for
$200M in Year 1. Asset Y (purchased for
$30M) is sold for $10M in Year 2. 80/20
carried interest split with 10% hurdle rate.
Determine the carried interest at the end of
Year 1 and 2 and the clawback, if any 198

8. LO 2.56
Clawbacks (continued)
End of Year 1 (carried interest):
(20%) × ($30M) = $6M to managers
$30M – $6M = $24M to investors
End of Year 2 (no carried interest):
$20M loss accrues to limited partners
Termination of the fund:
Hurdle rate: $200M × 1.12 = $242M
Limited partners: $170M + $24M + $10M =
$204M
Clawback: $242M – $204M = $38M 199
LO 2.57
Clawback Limitations
Unenforceable if the fund does not contain
liquid assets
Payment is based on the general partner’s
creditworthiness
General partner may extend the life of the
fund to delay
Practical limitations of litigation
200

9. Which of the following statements correctly
compares the preferred returns of a private
equity fund to the returns of a long call option?
A) For returns above the hurdle rate, the fund
managers are out-of-the-money.
B) For returns below the hurdle rate, the fund
managers are at-the-money.
C) For returns below the hurdle rate, the fund
managers are in-the-money.
D) For returns above the hurdle rate, the fund
managers are in-the-money
Which of the following statements correctly
compares the preferred returns of a private
equity fund to the returns of a long call option?
A) For returns above the hurdle rate, the fund
managers are out-of-the-money.
B) For returns below the hurdle rate, the fund
managers are at-the-money.
C) For returns below the hurdle rate, the fund
managers are in-the-money.
D) For returns above the hurdle rate, the fund
managers are in-the-money

10. Assume that limited partners contribute $100M in the first year
of a private equity fund. The fund has a hurdle rate of 10%,
an 80/20 carried interest split, and a 100% catch-up
provision. If all investments doubled over a two-year period
before liquidation, what is the fund’s distribution of profits
over the investment horizon?
A) $20M for general partners; $80M for limited partners.
B) $10M for general partners; $90M for limited partners.
C) $16M for general partners; $84M for limited partners.
D) $20M for general partners; $180M for limited partners
Assume that limited partners contribute $100M in the first year of a
private equity fund. The fund has a hurdle rate of 10%, an 80/20
carried interest split, and a 100% catch-up provision. If all
investments doubled over a two-year period before liquidation,
what is the fund’s distribution of profits over the investment
horizon?
A) $20M for general partners; $80M for limited partners.
B) $10M for general partners; $90M for limited partners.
C) $16M for general partners; $84M for limited partners.
D) $20M for general partners; $180M for limited partners
The limited partners are entitled to $121M (= $100M × 1.12) before any
distributions to the general partner. Since the fund liquidated at
$200M there will be a distribution to the managers. Further, since
the rate of return on the fund is significantly above the hurdle rate,
the catch-up zone can be ignored. Managers will receive 20% of
the $100M profit (i.e., $20M). The limited partners will receive
$80m.