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FRM Exam Part II · Private Markets Investing

Private Equity Fund Structure, Fees and Waterfalls

Updated 11 October 2026 · Fact-checked

A private equity fund is a limited partnership. The general partner (GP) manages it and the limited partners (LPs) supply most of the capital. The GP earns a management fee on commitments or invested capital, plus carried interest on profits above a hurdle. The waterfall sets the order of payouts, and a clawback returns excess carry.

Understand Private Equity Fund Structure and Fees

A private equity fund is usually a limited partnership. The limited partners (LPs) are investors such as pensions, endowments and insurers. They commit capital but do not run the fund, and their liability is limited to what they commit. The general partner (GP) is the manager. It picks the deals, runs the portfolio and usually commits a small share of its own money.

LPs make a commitment, but they do not pay it all at once. The GP issues capital calls (drawdowns) when it needs cash for deals or fees. Proceeds from exits are distributed back. Funds usually have a fixed life, often around ten years, with an investment period followed by a harvest period.

The GP is paid in two ways. The management fee is a yearly percentage, often about 2%, charged on committed capital during the investment period and often on invested capital afterward. It pays for operations whatever the performance. Carried interest (carry) is a share of profits, commonly 20%, and it rewards performance.

Many funds have a hurdle rate (preferred return), often about 8% a year. LPs must first get back their contributed capital plus the hurdle. With a catch-up, the GP then receives a large share of distributions until it holds its carry percentage of total profit. After that, profits are split, for example 80/20.

The waterfall is the order of payments. In a European (whole-fund) waterfall, the GP gets carry only after LPs have received all contributed capital plus the hurdle across the whole fund. In an American (deal-by-deal) waterfall, carry can be paid on each deal as it exits. This is faster for the GP but riskier for LPs. A clawback makes the GP return carry it received if, at the end, it has been paid more than its share of total profit. Escrows and holdbacks help secure the clawback.

Key formulas to remember

Management fee
Fee = fee rate × fee base (committed or invested capital)
Check which base applies in the period. Commitments are common in the investment period, invested capital after.
Carried interest without hurdle
Carry = carry rate × total profit
Profit is distributions minus contributed capital, usually after fees as stated in the fund terms.
Hurdle amount (compounded)
Hurdle = contributed capital × [(1 + h)^t − 1]
This is the preferred return only. LPs first receive capital back plus this amount.
Full catch-up
Catch-up amount = carry rate ÷ (1 − carry rate) × preferred return
With a 100% catch-up to the GP, the GP gets this much so that it holds the carry rate of total profit. For 20% carry it is 25% of the preferred return.
Clawback
Clawback = carry received − carry rate × cumulative fund profit
Applies when carry paid early exceeds the entitlement at the end. Often capped, for example at after-tax carry.
Waterfall order
1) Return of capital → 2) Preferred return → 3) GP catch-up → 4) Split (e.g. 80/20)
European applies this to the whole fund. American applies it deal by deal.

How to solve Private Equity Fund Structure and Fees questions

Use the same order for any fee or waterfall question. Read the fund terms carefully, since each term changes the answer.

  1. 1List the terms: commitment, fee rate and base, carry rate, hurdle, catch-up percentage and waterfall type.
  2. 2Compute the management fee for each period using the correct base.
  3. 3Work out total contributed capital and total distributions. Decide whether fees count as contributed capital.
  4. 4Run the waterfall in order: return of capital, then the hurdle, then the catch-up, then the split.
  5. 5Check each tier has enough cash before moving to the next. Stop when distributions run out.
  6. 6For American waterfalls, test carry paid deal by deal against the final whole-fund entitlement and compute any clawback.
  7. 7Compute the LP net result and compare it with the gross result to show fee drag.
  8. 8Interpret the result: who bears the risk, and what it means for GP incentives.

Quickest way: Whole-fund carry shortcut

When to use it: Use when the question gives total profit and asks for GP carry with a hurdle and a full catch-up.

  1. Compute total profit = distributions − contributions.
  2. Compute the hurdle amount on contributions.
  3. If profit is below the hurdle, carry is zero.
  4. If profit is above the hurdle, with full catch-up and enough profit, carry = carry rate × total profit.
  5. If profit sits inside the catch-up zone, GP gets profit − hurdle, capped at the carry rate × profit.
  6. Without catch-up, carry = carry rate × (profit − hurdle).

Common mistakes in Private Equity Fund Structure and Fees

  • Applying carry to total distributions instead of profit.

    Students forget that contributed capital comes back to LPs first.

    Fix: Always subtract contributed capital before computing carry.

  • Mixing up the fee base.

    Fees are charged on commitments in one phase and invested capital in another.

    Fix: Read the stated base for each period and apply it separately.

  • Treating the hurdle as a threshold that removes carry on all profit.

    Students confuse a hard hurdle with a soft hurdle with catch-up.

    Fix: With a catch-up the GP gets carry on all profit once fully caught up. Without it, carry is only on profit above the hurdle.

  • Mislabelling European and American waterfalls.

    The names sound geographic, not structural.

    Fix: European is whole-fund and LP-friendly. American is deal-by-deal and pays the GP earlier.

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

    Students stop after paying carry on early winners.

    Fix: Compare carry paid with carry rate × final cumulative profit, and treat any excess as returnable.

  • Forgetting that management fees are paid regardless of performance.

    Focus falls on carry as the incentive.

    Fix: Note that fees give the GP stable income and can weaken incentives, especially on large commitment bases.

Worked examples

Example 1

A fund has $100 million of contributions and total distributions of $180 million. Carry is 20%, hurdle is 8% a year compounded over 3 years, and the GP has a 100% catch-up. Ignore fees. Find the GP carry and the LP net profit.

Show the solution
  1. Total profit = 180 − 100 = $80 million.
  2. Hurdle = 100 × (1.08³ − 1). 1.08³ = 1.259712, so hurdle = $25.9712 million.
  3. Profit exceeds the hurdle, so the catch-up applies.
  4. Full catch-up needed = 0.20 ÷ 0.80 × 25.9712 = $6.4928 million.
  5. After the hurdle and catch-up, used profit = 25.9712 + 6.4928 = $32.464 million, which is less than $80 million, so the GP is fully caught up.
  6. GP carry = 20% × 80 = $16 million.
  7. LP net profit = 80 − 16 = $64 million.

Answer: GP carry is $16 million and LP net profit is $64 million.

Example 2

A deal-by-deal (American) fund with 20% carry and no hurdle sells Deal A first for a profit of $50 million, and the GP takes carry on it. Deal B later loses $30 million. The fund ends with no other deals. What clawback is due?

Show the solution
  1. Carry paid on Deal A = 20% × 50 = $10 million.
  2. Cumulative fund profit = 50 − 30 = $20 million.
  3. Carry entitlement = 20% × 20 = $4 million.
  4. Clawback = carry received − entitlement = 10 − 4 = $6 million.

Answer: The GP must return $6 million, subject to any cap in the fund terms.

Exam tips

  • Identify the waterfall type first. A European structure gives LPs more protection and makes a clawback less likely.
  • Check whether the question uses commitments or invested capital as the fee base.
  • Show the order of the waterfall tiers. Many wrong answers come from skipping the hurdle or catch-up.
  • Link terms to incentives. Management fees are performance-independent, while carry, the hurdle and the clawback align interests.
  • In case-style questions, name the risk: LPs bear interim carry risk in deal-by-deal structures.

Practice questions from Private Markets Investing

Private Equity Fund Structure and Fees 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 Fund Structure and Fees: frequently asked questions

What is the difference between a European and an American waterfall?

A European waterfall pays carry only after LPs get all contributed capital and the hurdle across the whole fund. An American waterfall pays carry deal by deal. The American structure gives the GP carry earlier and increases the chance of a clawback.

What is a hurdle rate in private equity?

It is the preferred return LPs must receive before the GP earns carry, often about 8% a year. It protects LPs from paying carry on weak performance. Whether the GP then gets a catch-up depends on the fund terms.

What does a GP catch-up do?

After the hurdle is met, the catch-up directs a large share of distributions to the GP until it holds its carry percentage of total profit. A full catch-up sends 100% to the GP until that point. After that, profits are split, for example 80/20.

How does a clawback work?

If the GP has received more carry than its share of total fund profit at the end, it must return the excess to LPs. This mostly arises under deal-by-deal waterfalls. Escrows or guarantees often back it up.

Is the management fee charged on committed or invested capital?

Both are used. A common pattern is commitments during the investment period and invested capital afterward. Always follow the terms given in the question.