Private equity (PE) funds often include intricate compensation structures to align the interests of both limited partners (LPs) and general partners (GPs). One key aspect of this structure is the “catch-up period,” which dictates how profits are distributed between the LPs and GPs after the initial returns. Understanding the mechanics of the catch-up period, especially in the context of preferred returns, is essential for investors and fund managers alike. We have also built a Private Equity Cash Flow Model Template which is being used by PE funds to model out their investment cash flows through to GPs and LPs via an American Waterfall and European Waterfall distribution structure.
Basics of Private Equity Compensation Structure
In private equity, the typical compensation structure includes:
- Management Fees: A fixed percentage of the fund’s assets, typically around 1.5% to 2%, which the GPs charge annually to cover operational expenses.
- Carried Interest: The share of profits GPs receive after the LPs have received their initial investment back, usually around 20%. However, this profit-sharing is subject to certain hurdles, including a preferred return (often referred to as the “hurdle rate”) and the catch-up period. Learn more on Wikipedia.
What is a Preferred Return?
A preferred return, or hurdle rate, is the minimum return that LPs must receive before the GPs are entitled to any performance-based compensation (carried interest). This ensures that LPs earn a certain level of return before the GPs start sharing in the profits. Typically, this preferred return ranges from 6% to 8% annually. For example, if a private equity fund has a preferred return of 8%, the LPs must receive an 8% return on their invested capital before the GPs can claim their carried interest.
The Catch-Up Period: Balancing the Scales
Once the preferred return threshold is met, the catch-up period begins. This is the phase where GPs are “caught up” to ensure they receive their full share of the carried interest.
How Does the Catch-Up Work?
- Post-preferred return phase: After LPs have received their preferred return, the next set of profits will often go entirely to the GPs until they have caught up to the agreed percentage of carried interest.
- GP’s entitlement: In many cases, GPs will receive 100% of the profits in the catch-up phase until the profit distribution reaches the predetermined split, often 80/20 in favor of the LPs.
Example of a Catch-Up Period in Action
Imagine a private equity fund with the following structure:
- Preferred return: 8%
- Carried interest: 20% (GP) / 80% (LP)
- Total fund size: $100 million
Step-by-step, the process would work like this:
- Preferred return phase: LPs must first receive an 8% return on their $100 million investment. This means the LPs need to receive $8 million before any carried interest is paid to the GPs.
- Catch-up phase: After the LPs receive the $8 million preferred return, the GPs will typically receive the next set of profits, often 100%, until the profit distribution is in line with the 80/20 agreement. A comprehensive guide on this topic is available at Rundit.
- Sharing phase: Once the GPs have received their catch-up, any further profits are split according to the predetermined 80% (LP) / 20% (GP) structure.
Let’s assume that after the preferred return, the fund generates an additional $10 million in profits. In the catch-up phase, GPs will receive 100% of that $10 million (or enough to ensure their total share is 20% of the overall profits). Once the catch-up is complete, any remaining profits will then be distributed according to the usual 80/20 split between LPs and GPs.
Why is the Catch-Up Important?
The catch-up period is crucial because it incentivizes GPs to achieve high returns for the fund. By structuring the compensation in this way, GPs only begin to receive their performance-based compensation (carried interest) after they’ve delivered solid returns to their investors. It ensures that both the LPs and GPs are aligned in their goals: maximizing the fund’s returns. Learn more about the catch-up provision and waterfall calculations.
Different Variations of the Catch-Up Period
The standard catch-up structure described above can vary depending on the agreement between the LPs and GPs. Here are a few common variations:
- 100% Catch-Up: The GP receives 100% of the profits during the catch-up phase until they are entitled to the full carried interest (as described in the example).
- Partial Catch-Up: In some funds, GPs may only receive a portion of the profits (e.g., 50%) during the catch-up phase, rather than the full 100%. This results in a slower catch-up process for GPs.
- Tiered Carried Interest: Some funds may have multiple hurdle rates and catch-up periods. For instance, GPs might receive 10% of the carried interest after an 8% return and 20% after a higher return threshold is met.
Frequently Asked Questions
What is a catch-up period in private equity?
The catch-up period is a phase in private equity profit distribution where general partners (GPs) receive most of the profits until they achieve their agreed-upon carried interest after limited partners (LPs) have received their preferred return.
How do hurdle rates impact profit distribution?
Hurdle rates ensure that LPs receive a minimum return on their investment before GPs earn performance fees. This aligns the interests of both parties in achieving optimal financial outcomes.
What role do clawback clauses play in private equity?
Clawback clauses protect LPs by allowing them to recover money from GPs if the total distributions received during the fund’s life are below the agreed-upon threshold. Learn more about clawback clauses and profit allocation.
Final Thoughts!
The catch-up period is a fundamental component of private equity fund compensation, designed to balance the interests of both investors and fund managers. By ensuring that LPs receive a preferred return before the GPs begin to share in the profits, the structure aligns the incentives of both parties, ultimately aiming to maximize returns for the entire fund. Understanding this mechanism is essential for anyone involved in private equity, from investors evaluating fund terms to managers structuring compensation agreements.
