Carry and Waterfall Structures in Private Equity
Explanation
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.
View More Definitions & Explanations
The Origins and Evolution of Private Equity
Private equity (PE) has grown into a global financial powerhouse, but its beginnings can be traced back to the post-World War II era. The formation of the American Research and Development Corporation (ARDC) in 1946 marked one of the earliest institutional private equity efforts.
ARDC’s mission was to fund companies that could repurpose wartime technologies for commercial use. One of its landmark investments was in Digital Equipment Corporation (DEC). A modest $70,000 investment in DEC eventually turned into $355 million, delivering a return of over 5,000 times the original amount. This staggering success demonstrated the potential of private equity to fuel innovation and drive extraordinary financial outcomes.
The Rise of Leveraged Buyouts in the 1980s
The 1980s became a transformative decade for private equity, largely due to the emergence of leveraged buyouts (LBOs). Pioneering firms such as Kohlberg Kravis Roberts (KKR) led this movement, acquiring companies primarily through borrowed capital, implementing operational improvements, and exiting through strategic sales or IPOs. These deals often resulted in significant returns and played a key role in legitimizing private equity as a powerful tool for value creation.
Private Equity Today: A Global Asset Class
Fast-forward to today, and private equity has evolved into a multi-trillion-dollar global industry. PE firms are actively involved in reshaping key sectors, including technology, healthcare, financial services, energy, and consumer goods. The United States continues to dominate the market, but institutional investors are increasingly turning their attention to opportunities in Europe and Asia where valuations are more attractive and growth potential remains robust.
In recent years, PE has also embraced thematic and impact investing. Many funds are aligning their strategies with ESG (Environmental, Social, and Governance) principles or specific global trends, such as digital transformation, renewable energy, and health innovation. This not only broadens investor appeal but also enhances the sector’s influence on global progress.
The Dominance of Private Companies
One compelling statistic underscores the importance of private markets: approximately 83% of U.S. companies with over $100 million in revenue remain privately held. This highlights the vital role of private equity in financing, developing, and scaling enterprises outside the public markets.
In summary, private equity has evolved from a niche investment strategy to a dominant force in global finance. With its origins in innovation and a future driven by strategic investment, operational excellence, and global diversification, PE is positioned to remain a key player in shaping tomorrow’s economy.
