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Private Markets Pathway · Private Equity

Private Equity Fees, Terms and Distribution Waterfalls Explained

Updated 7 October 2026 · Fact-checked

A distribution waterfall is the rule set that decides who gets cash from a private equity fund and in what order. LPs usually get capital back and a preferred return first, then the GP earns carried interest. To solve it, list the tiers, apply them in order, and check the split.

Understand Fees, Terms and Distribution Waterfalls

A private equity fund is run by a general partner (GP) and funded mostly by limited partners (LPs). The GP earns money in two main ways: a management fee and carried interest.

The management fee is a yearly charge, usually a percentage of committed capital during the investment period. It often steps down later or moves to invested capital or net asset value. It pays the GP's running costs and is paid whether or not the fund makes money.

Carried interest (carry) is the GP's share of profits, often 20%. It rewards performance. A hurdle rate (preferred return) is the minimum annual return LPs must receive before the GP earns carry. A catch-up lets the GP then receive most or all of the next distributions until the GP has its full carry share of total profit. A clawback makes the GP return excess carry if, over the life of the fund, it was paid more than its agreed share.

The waterfall sets the order of cash. In a deal-by-deal (American) waterfall, carry is calculated on each investment as it is sold. The GP can earn carry early, even if other deals lose money, so a clawback matters. In a whole-fund (European) waterfall, the LPs must receive all contributed capital (and usually the hurdle) across the whole fund before the GP gets carry. This is more LP-friendly and delays carry. Some deal-by-deal terms require return of capital on realised deals plus write-downs of unrealised ones, which reduces the gap.

The tie to the client: an LP compares terms on net returns, timing of cash and alignment. A GP wants earlier carry. Fees paid on committed capital reduce net returns even in weak years, so the LP's net IRR is lower than the gross IRR.

Key rules to remember

Management fee
Fee = fee rate × fee base (committed capital, invested capital or NAV, per the terms)
Read which base applies in each period. Fee is paid regardless of performance.
Carried interest, no hurdle or catch-up
Carry = carry rate × total profit
Profit = distributions − contributed capital (after fees if the terms say so).
Hurdle (compound)
Preferred return = capital × [(1 + h)^t − 1]
Use simple interest only if the question says so. Hurdle is on LP contributed capital.
Full catch-up size
Catch-up amount = carry rate ÷ (1 − carry rate) × preferred return (for a 100% GP catch-up)
E.g. 20% carry: catch-up = 0.25 × preferred return. Then GP has 20% of profit so far.
Standard tier order
1) Return of contributed capital → 2) Preferred return → 3) GP catch-up (if any) → 4) Split, e.g. 80/20
Whole-fund applies this on the whole fund. Deal-by-deal applies it deal by deal.
Clawback
Clawback = carry paid − (carry rate × cumulative fund profit), if positive
Often limited to after-tax carry or a set cap. Follow the stated terms.

How to solve Fees, Terms and Distribution Waterfalls questions

Use this order for any waterfall or carry question. Write the tiers before you do any arithmetic.

  1. 1Identify the waterfall type: whole-fund (European) or deal-by-deal (American), and whether the fee is paid on committed capital.
  2. 2List the terms: carry rate, hurdle rate and basis (compound or simple), catch-up percentage, clawback.
  3. 3Fix the cash flows: contributions, fees, and distributions by date.
  4. 4Apply tier 1: return LP contributed capital (and fees if the terms include them).
  5. 5Apply tier 2: compute the preferred return on contributed capital for the time held.
  6. 6Apply tier 3: calculate the catch-up, limited by cash left. Then split the rest by the carry ratio.
  7. 7Total GP carry and LP proceeds. Check that they add up to total distributions.
  8. 8If asked, test for clawback by comparing carry paid with carry rate × total profit, and state the conclusion.

Quickest way: Tier-by-tier subtraction table

When to use it: Use for any calculation item with cash to distribute and set terms, especially under time pressure.

  1. Write the cash available at the top.
  2. Subtract capital returned to LPs. Stop if cash runs out.
  3. Subtract the hurdle amount. Stop if cash runs out; GP carry is zero.
  4. With full catch-up, GP takes 0.25 × hurdle for 20% carry (or carry ÷ (1 − carry) × hurdle). Cap it at cash left.
  5. Split what remains 80/20.
  6. Check: GP carry ÷ total profit. If a full catch-up is reached, it should equal the carry rate.

Common mistakes in Fees, Terms and Distribution Waterfalls

  • Applying the carry rate to total distributions instead of profit.

    Candidates forget that capital is returned first.

    Fix: Always subtract contributed capital before any carry split.

  • Confusing which waterfall is LP-friendly.

    The names American and European sound arbitrary.

    Fix: Link European to whole fund: LPs get capital and hurdle back across the fund first, so carry is later and safer for LPs.

  • Treating the hurdle as a cap on LP returns.

    Hurdle sounds like a limit.

    Fix: It is a threshold the LPs must reach before GP carry. After catch-up, LPs keep their share of all further profit.

  • Computing the catch-up as 20% of the hurdle.

    Candidates apply the carry rate directly.

    Fix: For a full catch-up, the GP needs 20% of total profit, so the catch-up = 0.20 ÷ 0.80 × hurdle = 25% of the hurdle.

  • Ignoring the clawback in deal-by-deal examples.

    Candidates stop once early carry is calculated.

    Fix: Compare cumulative carry paid with carry rate × total fund profit. Any excess is returned to LPs, subject to the terms.

  • Using simple interest for the hurdle when compounding is stated, or vice versa.

    Rushing past the term sheet wording.

    Fix: Underline the compounding basis in the vignette before calculating.

Worked examples

Example 1

A fund has LP contributed capital of $100 million (all paid in, fees ignored). The hurdle is 8% compounded annually, held for 3 years. Carry is 20% with a 100% GP catch-up, whole-fund waterfall. The fund distributes $200 million in total at the end of year 3. Calculate the GP's carried interest.

Show the solution
  1. Tier 1: return capital, $100 million. Remaining: $100 million.
  2. Tier 2: preferred return = 100 × (1.08³ − 1) = 100 × 0.259712 = $25.9712 million. Remaining: 100 − 25.9712 = $74.0288 million.
  3. Tier 3: full catch-up = 0.20 ÷ 0.80 × 25.9712 = $6.4928 million to the GP. Remaining: 74.0288 − 6.4928 = $67.5360 million.
  4. Tier 4: split 80/20. GP gets 0.20 × 67.5360 = $13.5072 million.
  5. GP carry = 6.4928 + 13.5072 = $20.0000 million.
  6. Check: total profit = 200 − 100 = $100 million; 20% = $20 million. Matches.

Answer: GP carried interest = $20 million. LPs receive $180 million.

Example 2

A deal-by-deal fund (no hurdle, 20% carry, no catch-up) sells Deal A, which cost $50 million, for $90 million. Later it sells Deal B, which cost $50 million, for $30 million. Carry is paid on each deal's gain with no clawback in the early stage. Calculate the carry paid after Deal A, the carry the GP should have earned over the whole fund, and the clawback.

Show the solution
  1. Deal A profit = 90 − 50 = $40 million. Carry paid = 0.20 × 40 = $8 million.
  2. Deal B loss = 30 − 50 = −$20 million. No carry is paid on it.
  3. Whole fund profit = 40 − 20 = $20 million.
  4. Carry earned on the whole fund = 0.20 × 20 = $4 million.
  5. Excess carry = 8 − 4 = $4 million.
  6. The clawback requires the GP to return the excess, subject to the stated terms.

Answer: Carry paid after Deal A is $8 million. The GP's entitlement over the whole fund is $4 million. The clawback is $4 million.

Exam tips

  • Write the tier order first, then fill numbers. Item sets reward the correct order even when arithmetic is simple.
  • In essays, a correct number typed on its own earns full credit for a calculation, so keep the answer clean and in the units requested.
  • For a command word like 'justify', link the waterfall type to the client: an LP prefers whole-fund, a GP prefers deal-by-deal.
  • Always read whether fees are on committed or invested capital, and whether the hurdle includes fees.
  • Answer only the number of responses asked for, in the order given. Extra responses are not evaluated.

Fees, Terms and Distribution Waterfalls in other exams

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

Fees, Terms and Distribution Waterfalls: frequently asked questions

What is the difference between European and American waterfalls?

A European (whole-fund) waterfall pays the GP carry only after LPs get back all contributed capital and the hurdle across the whole fund. An American (deal-by-deal) waterfall pays carry as each deal is realised. American terms favour the GP on timing and so need a clawback.

How do I calculate GP carried interest?

Work through the tiers: return capital, pay the preferred return, apply any catch-up, then split the rest by the carry rate. Add the GP's amounts from the catch-up and the split. With a full catch-up and enough cash, carry equals the carry rate × total profit.

What is a hurdle rate in private equity?

It is the minimum annual return the LPs must receive before the GP earns carry. It is also called the preferred return. It is usually applied to contributed capital and often compounds.

Why does a clawback exist?

Under a deal-by-deal waterfall the GP can be paid carry on early winners, and later losses can leave it overpaid. The clawback makes the GP return the excess, so that over the fund's life it gets only its agreed share of profit.