The carried interest waterfall
Capital back, then the preferred return, then the GP's catch-up, then 80/20. Who gets which dollar.
- Compound the preferred return and test whether the fund clears it
- Run a European waterfall tier by tier to the GP's carry and the LPs' total
- Find the proceeds at which the GP is fully caught up
- Compare a catch-up with a hard hurdle
The intuition
A restaurant manager is promised 20% of the profits, but only after the owners have had their money back plus a decent return on it. Once they have, the manager gets everything that comes in next until they have caught up to 20% of all the profit so far. From then on, every dollar splits 80/20.
That is a carried interest waterfall. The GP's 20% share of profit (the carry) is not paid off the top; it waits behind the LPs' capital and a preferred return, then a catch-up hands the GP its share of what it waited for.
Tiers in order: capital, pref, catch-up, split. Once the catch-up is complete the GP holds exactly 20% of all profit. The hurdle delays carry; it does not reduce it.
Why it works
- The conventions here: a European, whole-fund waterfall. LPs get all capital back first; then the pref, compounded annually on the whole capital over the stated years; then a catch-up of 100% or 80% to the GP until it holds the carry share of all profit; then the rest splits at the carry rate. Fees are left out.
- The pref (hurdle) is typically 8% a year, compounded: what the LPs could have earned elsewhere. Below it, the GP earns nothing.
- The catch-up tier is sized so that, at its end, the GP has the carry share of everything above capital. With a 100% catch-up it is carry × pref ÷ (1 − carry); with 80% it is larger, carry × pref ÷ (0.8 − carry).
- A hard hurdle has no catch-up: carry applies only to profit above the pref. The catch-up is worth exactly carry × pref to the GP once complete.
- American (deal-by-deal) waterfalls pay carry on each exit as it happens, with a clawback if later losses mean the GP was overpaid. LPs prefer European; GPs prefer the earlier cash of American.
| Profit: 2,000 − 1,000 | 1,000 |
| Pref: 1,000 × (1.08^5 − 1) | 469.3 to LPs |
| Catch-up tier: 20% × 469.3 ÷ 80% | 117.3, all to the GP |
| Rest: 1,000 − 469.3 − 117.3 | 413.3, of which 20% = 82.7 to the GP |
| GP carry: 117.3 + 82.7 | 200.0, exactly 20% of profit |
| Fully caught up at: 1,000 + 469.3 + 117.3 | 1,586.7, or 1.59x |
Hard hurdle instead: 20% × (1,000 − 469.3) = 106.1. The catch-up is worth 93.9 = 20% × 469.3.
The formulas
Compounded on the whole capital.
Just enough for the GP to reach its carry share.
Its slice of the catch-up tier, then 20% of what is left.
Past this, the GP holds exactly the carry rate.
No catch-up: 20% of profit above the pref only.
Worked example
Work down the tiers in order and check at each one whether there is enough profit to fill it.
See it move
Same fund. Change what it returns, the hurdle rate, the years the pref compounds over and the catch-up.
- Raise the fund's multiple. GP carry never falls: nothing until the LPs have their pref, then a steep climb through the catch-up, then exactly the carry rate.
- Raise the hurdle or the years. The pref grows, the multiple needed for a full catch-up rises, and GP carry can only fall or stay the same.
- Switch to an 80% catch-up. A full catch-up needs a higher multiple, and GP carry is lower or the same.
- Push the multiple past the full catch-up point. The gap between the two GP bars is then exactly the carry rate times the pref.
Run it backwards
Same fund, reversed: how much must it return before the GP is fully caught up, holding its full share of profit?
Add the three tiers the GP waits behind or climbs through: the capital, the pref, and the catch-up tier. At that point the GP's catch-up equals the carry rate times everything above capital.
Below it, a GP's carry is very sensitive to the last few dollars of exit value, which is when incentives to stretch a sale are strongest.
Traps
Say it in the interview
“Walk me through a carried interest waterfall.”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Capital, pref, catch-up, then 80/20.
- Pref = capital × ((1 + hurdle)^years − 1).
- Catch-up tier = carry × pref ÷ (catch-up share − carry).
- Fully caught up, the GP holds exactly the carry rate.