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

A pension plan is evaluating a PE fund and compares a deal-by-deal (American) waterfall with a whole-fund (European) waterfall. Which statement best describes the main risk to the LP under the American waterfall?

The main LP risk is that the GP is paid carry on early winners before the fund's full results are known. If later deals lose money, the LP must rely on a clawback, which carries credit and enforcement risk, whereas a whole-fund waterfall defers carry until capital and pref are returned.

  1. AThe GP may receive carry on early profitable deals, which may need to be clawed back if later deals lose moneyCorrect
  2. BThe LP receives carry before the GP does
  3. CThe hurdle rate is applied to the GP's capital only
  4. DManagement fees are eliminated once the first exit occurs

Explanation

Under a deal-by-deal waterfall the GP is paid carry on each successful realization, so the GP can be paid before the fund's overall performance is known. If later investments lose money, the LP depends on a clawback provision and the GP's ability to repay. The other options misstate how waterfalls operate.

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