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FRM Part II · FRM Exam Part II · Private Markets Investing

A limited partner is comparing two fund terms. Fund A has a deal-by-deal (American) waterfall; Fund B has a whole-fund (European) waterfall. Both have 20% carry. Which statement best describes the risk to the LP of Fund A relative to Fund B?

In a deal-by-deal waterfall the GP can take carry on early winners before later losers occur, so it may be overpaid and need to return money through a clawback. The LP therefore faces clawback and collection risk, which is lower under a whole-fund waterfall.

  1. AThe GP may be paid carry on early profitable deals before losses on later deals, creating clawback risk for the LPCorrect
  2. BThe LP bears lower credit risk because carry is paid only after all capital is returned
  3. CThe GP receives carry later, which increases the GP's incentive to delay exits
  4. DThe preferred return is higher in Fund A, reducing LP net returns

Explanation

Deal-by-deal waterfalls allow carry to be distributed on successful early exits, so later losses may leave the GP having been overpaid, requiring a clawback whose collection carries risk. Whole-fund waterfalls defer carry until contributed capital and the hurdle are returned across the fund.

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