CFA Level I Exam · Investments in Private Capital: Equity and Debt

Private Equity Fees, Carried Interest and Waterfalls

Updated 7 October 2026 · Fact-checked

Private equity funds charge the limited partners a management fee on committed or invested capital, plus carried interest, a share of profits (often 20%) paid to the general partner once any hurdle rate is met. A waterfall sets the order of payouts, and a clawback returns excess carry if the GP is overpaid.

Understand Private Equity Fees, Terms and Governance

A private equity fund is usually a limited partnership. The general partner (GP) runs the fund. The limited partners (LPs) supply most of the capital and have limited liability and limited say in daily decisions. LPs commit capital, and the GP draws it down over time as deals arise. This is called a capital call.

The GP earns money in two main ways. The management fee is an annual charge, commonly around 1.5% to 2%, based on committed capital or, in some funds, invested capital or net asset value. It is paid whether or not the fund makes money, so it covers running costs. Carried interest (carry) is the performance fee, commonly 20% of profits. It aligns the GP with LPs.

A hurdle rate (preferred return) is the minimum annual return LPs must receive before the GP earns carry. A hard hurdle means carry is charged only on profits above the hurdle. A soft hurdle means that once the hurdle is cleared, the GP earns carry on all profits, through a catch-up. The catch-up lets the GP receive a large share of distributions until the GP has received its full carry percentage of total profit. The GP ends up with carry on all profit only if the catch-up is full (100%) and profit is large enough to complete it. With a partial catch-up, or with too little profit, the GP receives less. A preferred return with no catch-up behaves like a hard hurdle, because only the excess over the hurdle is shared.

The waterfall is the order in which distributions are split. In a European (whole-fund) waterfall, the LPs first get back all contributed capital, and fees and expenses, plus the preferred return, before the GP gets any carry. This is more LP-friendly. In an American (deal-by-deal) waterfall, carry is paid on each deal as it is realised, often after returning capital for that deal and any prior realised losses. The GP is paid sooner, so the LP risk of overpayment is higher.

Because an American waterfall can pay carry early on winners before later losers appear, LPs seek protection. A clawback requires the GP to return carry if, at the end of the fund's life, the GP has received more than its agreed share of total profit. Other key terms include escrow of part of carry, key person provisions, no-fault divorce removal clauses, co-investment rights, and the fund term (often about 10 years). Governance is also supported by an LP advisory committee.

Key formulas to remember

Management fee: Fee = fee rate × fee base (committed capital, invested capital or NAV); Check the base in the question. Committed capital gives a fee even on undrawn money.
Carried interest, no hurdle: Carry = carry rate × profit; Profit is usually after returning capital. Typical rate is 20%.
Hard hurdle carry: Carry = carry rate × (profit − hurdle amount); Only the excess over the preferred return is shared.
Soft hurdle carry: Carry = carry rate × total profit, if the hurdle is met, the catch-up is 100% and profit is large enough to complete the catch-up; Without a full catch-up, or if profit is too small to complete it, carry is lower. With no catch-up, only the excess over the hurdle is shared.
Hurdle amount: Hurdle = capital × [(1 + hurdle rate)^years − 1]; Compounding is typical. Use simple interest only if the question says so.
Clawback amount: Clawback = carry received − carry rate × cumulative total fund profit; Applies when carry paid exceeds the agreed share of whole-fund profit.
Waterfall order (European): 1) Return of capital and fees; 2) preferred return; 3) catch-up; 4) split, such as 80/20; Whole-fund basis. American waterfall applies the order deal by deal.

How to solve Private Equity Fees, Terms and Governance questions

Use this order for any fee, carry or waterfall question. Read the terms first, because small wording changes the answer.

1Identify the terms: fee rate and base, carry rate, hurdle rate, hard or soft, catch-up, and European or American waterfall.
2Compute the management fee on the stated base. Note whether fees are paid from the fund or separately, since this changes LP net return.
3Find total profit, and reduce it by fees if the question says profit is net of fees.
4Compute the hurdle amount if there is one, using compounding unless told otherwise.
5Apply the waterfall order: return of capital, preferred return, catch-up, then the split.
6Calculate carry using the hard or soft hurdle rule. For a deal-by-deal case, do each deal in sequence, tracking realised losses.
7For a clawback, compare carry actually paid with the carry rate × cumulative whole-fund profit. The excess is returned.
8Sanity check: carry should never exceed the carry rate × total profit, and LPs should receive their capital and hurdle first in a European waterfall.

Quickest way: Three-option elimination for fee and carry questions

When to use it: Use when you have about 90 seconds and the options are numbers or short statements.

Compute the ceiling: carry rate × total profit. Any option above it is wrong.
If the hurdle is hard, carry is below this ceiling. Compute carry rate × (profit − hurdle) and match it.
If the hurdle is soft, the ceiling is the answer only if the catch-up is 100% and profit is large enough to complete the catch-up. Otherwise carry is below the ceiling.
For conceptual options, remember: European means LP-friendly and later carry; American means earlier carry and greater clawback need.
For clawback, subtract the entitled carry from carry paid. Pick the positive difference.

Common mistakes in Private Equity Fees, Terms and Governance

Treating the management fee as performance-based.
Students mix it up with carried interest.
Fix: The fee is charged regardless of results. Only carry depends on performance and hurdles.
Charging carry on total profit under a hard hurdle.
Hard and soft hurdles sound similar.
Fix: Hard hurdle: carry only on profit above the hurdle. Soft hurdle: carry on all profit only with a full catch-up and enough profit to complete it.
Mixing up European and American waterfalls.
The names do not hint at the rule.
Fix: European is whole-fund, so carry comes later. American is deal-by-deal, so carry comes earlier.
Using the wrong fee base.
Students assume invested capital.
Fix: Read whether the fee is on committed capital, invested capital or NAV. Committed capital is charged even if undrawn.
Computing a clawback from one deal rather than the whole fund.
Students forget the test is at fund level.
Fix: Add up all profits and losses, compute entitled carry, then compare with carry paid.
Ignoring compounding in the hurdle.
Rushing to a simple percentage.
Fix: Use capital × [(1 + r)^n − 1] unless the question says simple.

Worked examples

Example 1

An LP commits $100 million, all of which is contributed as capital, to a fund with 20% carry and an 8% hard hurdle. After 3 years in total, the whole fund has returned all contributed capital and fees, and has $60 million of profit left over. This $60 million is the whole-fund profit after returning all contributed capital and fees, so it is net of management fees. The hurdle compounds annually on $100 million. What carry does the GP earn on a European waterfall? Options: A) $6.8 million, B) $8.1 million, C) $12.0 million.

Show the solution

Hurdle amount = 100 × (1.08³ − 1). 1.08³ = 1.259712, so the hurdle is $25.9712 million.
Profit above the hurdle = 60 − 25.9712 = $34.0288 million.
Hard hurdle: carry = 20% × 34.0288 = $6.806 million, or about $6.8 million.
Option C, $12.0 million, is 20% of total profit. It would apply only to a soft hurdle with a full catch-up, so it is wrong here.

Answer: A) $6.8 million.

Example 2

A fund pays its GP carry deal by deal. After Deal 1 the GP receives $10 million of carry. Deal 2 then loses money. At the end the whole fund has total profit of $30 million, and the carry rate is 20%. How much must the GP return under a clawback? Options: A) $4 million, B) $6 million, C) $10 million.

Show the solution

Entitled carry on whole-fund profit = 20% × 30 = $6 million.
Carry already received = $10 million.
Excess = 10 − 6 = $4 million.
The clawback returns the excess, not all carry received.

Answer: A) $4 million.

Exam tips

Always check three words first: committed or invested, hard or soft, European or American. They decide the answer.
Expect conceptual questions on which party benefits: European favours LPs, American favours the GP's early cash flow.
For clawbacks, the test is whole-fund profit, so work out entitled carry before comparing.
Use the TI BA II Plus for the hurdle: enter 1.08, press yx, enter 3, then = to get 1.259712. On the HP 12C: 1.08 ENTER 3 yx.
With three options and no penalty, eliminate any answer above carry rate × total profit and guess among the rest.

Practice questions from Investments in Private Capital: Equity and Debt

Private Equity Fees, Terms and Governance in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Private Equity Fees, Terms and Governance: frequently asked questions

What is the difference between a hard and a soft hurdle rate?

With a hard hurdle, the GP earns carry only on profits above the hurdle. A soft hurdle usually comes with a catch-up, so the GP can earn carry on all profits once the hurdle is cleared, but only if the catch-up is full and profit is large enough to complete it. Soft hurdles tend to favour the GP.

What is the difference between European and American waterfalls?

A European waterfall is whole-fund: LPs get back capital, fees and the preferred return before any carry. An American waterfall is deal by deal, so the GP is paid carry sooner on winning deals. This raises the chance of a later clawback.

How do you calculate carried interest?

Find the profit that is eligible for carry, apply the hurdle rule, then multiply by the carry rate, commonly 20%. Under a hard hurdle, remove the hurdle amount first. Under a soft hurdle, take the carry rate of total profit only if the catch-up is 100% and profit is large enough to complete it.

What is a clawback provision?

A clawback requires the GP to return carry if it has received more than its agreed share of total fund profit. It protects LPs, especially in deal-by-deal waterfalls. The amount is carry paid minus carry entitled on the whole fund.