Carry and Waterfall Structures in Private Equity

Carry and Waterfall Structures in Private Equity

Waterfall Structure

• The all-contributions-plus-preferred-return-back-first model is widely recognised as best practice in private equity.
• Enhancing the deal-by-deal model includes:
  • Return of all realised cost for a given investment, including the makeup of partial impairments and write-offs.
  • Full return of all fees and expenses incurred to date (rather than on a pro-rata basis for the exited investment).
• Unrealised investments should be valued at the lower of cost or market when determining waterfall allocations.
• Establish carry escrow accounts with significant reserves — typically 30% or more of carry distributions — and require further reserves for potential clawback liabilities.
• Carry on recapitalisations should only be paid once the full amount of invested capital is realised for each relevant investment.
• The preferred return must be calculated from the date of capital contribution to the date of distribution.

Calculation of Carried Interest

• Carried interest should be calculated based on net profits, not gross profits.
• No carry should be paid on current income.
• Carried interest should be calculated on an after-tax basis. Taxes imposed on the fund (e.g., foreign withholding tax) should not be considered as distributions to partners.

Clawback Provisions

• Clawback liabilities must be determined and disclosed to LPs at the end of each reporting period.
• Disclosures should be accompanied by a clear plan from the GP on how clawback amounts will be resolved.
• All clawbacks should be calculated gross of taxes paid and repaid no later than two years from liability recognition.
• Joint and several clawbacks should be enforced to support robust escrow practices and repayment assurance mechanisms from the GP.