# Private Equity Fund Economics Concept Card: [Your fund, case or course] > A concept card for the economics of a private equity fund as the limited partners (LPs) and the general partner (GP) > experience them: commitments and capital calls, management fees and their base, the distribution waterfall > (return of capital, preferred return, GP catch-up, carried interest), European (whole-fund) versus American > (deal-by-deal) waterfalls and the clawback, and the performance measures LPs read (net IRR, TVPI, DPI, RVPI, the > J-curve, the gross-to-net spread and the public market equivalent). It is for second-year MBA students in a private > equity elective, candidates recruiting for buyout, growth or fund-of-funds roles, and anyone who will sit on the LP > side of a fund. It builds on mba/mba-paper-lbo, which shows how one deal earns its return; this card shows how a > portfolio of such deals becomes the net return an LP actually receives. Worked example A follows a fictional > USD 500m buyout fund ("Fund I") through ten years with a computed waterfall; Worked example B is half solved and > Exercise C is left for you, with a separate answer key. Source basis: Sahlman (1990), Gompers and Lerner (1999), > Kaplan and Schoar (2005), Metrick and Yasuda (2010), Harris, Jenkinson and Kaplan (2014), ILPA Principles 3.0 (2019) > and the ILPA Reporting and Performance Templates (2025), written up in original words. Replace every [bracketed] > value and every row marked *Example*. This is a learning aid, not investment, legal, tax or accounting advice: the > limited partnership agreement (LPA) of each fund governs, and its terms differ from fund to fund. ## Document control | Field | Value | |---|---| | Course, case or fund | [Private equity elective, session 3 / Fund name and vintage] | | Learner or analyst | [Your name] | | Fund terms modelled | [Fee rate and base, hurdle, catch-up, carry, waterfall type, clawback] | | Source of terms | [LPA section numbers / private placement memorandum / case exhibit] | | Spreadsheet used | [Excel / Google Sheets / LibreOffice Calc] | | Reviewed by | [Study partner, tutor or LP-side mentor] | | Version | [0.1] | | Last updated | YYYY-MM-DD | ## Contents - [When to use it](#when-to-use-it) - [The idea in plain language](#the-idea-in-plain-language) - [Formulas and notation](#formulas-and-notation) - [Assumptions and limits](#assumptions-and-limits) - [How LPs and GPs use fund economics](#how-lps-and-gps-use-fund-economics) - [Reporting standards (dated facts)](#reporting-standards-dated-facts) - [Worked example A (fully solved): Fund I over ten years](#worked-example-a-fully-solved-fund-i-over-ten-years) - [Worked example B (half solved): deal-by-deal carry and the clawback](#worked-example-b-half-solved-deal-by-deal-carry-and-the-clawback) - [Exercise C (unsolved): Fund III against a public index](#exercise-c-unsolved-fund-iii-against-a-public-index) - [Waterfall diagram](#waterfall-diagram) - [Connections to other cards](#connections-to-other-cards) - [Common mistakes and misconceptions](#common-mistakes-and-misconceptions) - [Self-test questions](#self-test-questions) - [My notes and next steps](#my-notes-and-next-steps) - [Sources and further reading](#sources-and-further-reading) - [Answer key](#answer-key) - [Revision history](#revision-history) ## When to use it **One-sentence rule:** a fund's gross return is what the deals earn; the LP's net return is what is left after management fees, fund expenses and carried interest have been taken out in the order the waterfall sets, and the gap between the two (the gross-to-net spread) is the price of access to the manager. | Use this card when | Use another card when | |---|---| | You must explain to an investment committee what an LP will actually receive from a fund | You must value or return-test one buyout (mba/mba-paper-lbo, mba/mba-lbo-model-card) | | You compare two fund offerings with different fee bases, hurdles or waterfall types | You plan operating improvements in a portfolio company (mba/mba-pe-value-creation-card) | | You read an LP quarterly report and need to interpret TVPI, DPI, RVPI and net IRR | You build a venture portfolio and choose reserves (mba/mba-vc-portfolio-construction-card) | | You judge whether a fund beat public markets after fees (public market equivalent) | You evaluate a listed fund manager with daily prices (mba/mba-performance-evaluation-card) | | You prepare for a fund-of-funds, secondaries or investor-relations interview | You need the CAPM cost of capital for a project (mba/mba-capm-wacc-card) | ## The idea in plain language A private equity fund is usually a **limited partnership** with a fixed life, often about ten years plus extensions. Investors (pension plans, endowments, insurers, sovereign funds, family offices) become **limited partners**: they **commit** an amount but do not hand it over at once. The **general partner**, the manager, **calls** capital when it finds deals and to pay fees, typically during an **investment period** of about five years. When a portfolio company is sold, the proceeds are **distributed**. The LP therefore holds three things at any time: cash already paid in, cash already received, and a share of the remaining **net asset value (NAV)** of unsold companies. Sahlman (1990) described this structure for venture capital, and the same design governs buyout funds. The GP is paid in two ways: - **Management fee.** A percentage of a fee base, paid whatever the performance. A common pattern is a rate on **committed** capital during the investment period and a lower rate on **invested** (or net invested) capital afterwards. Fees are usually paid from capital calls, so they reduce the money that reaches companies. - **Carried interest ("carry").** A share of the fund's profits, commonly 20%, usually paid only after LPs have received back their contributed capital plus a **preferred return** (the "hurdle", commonly 8% a year compounded). A **catch-up** tier then gives the GP a large share (often 100%) of the next distributions until the GP has its full carry share of all profits so far; after that, profits are split, for example 80/20. The order of these payments is the **distribution waterfall**. In a **European** (whole-fund) waterfall the GP earns carry only after the LPs have received all contributed capital and the preferred return across the whole fund. In an **American** (deal-by-deal) waterfall the GP can earn carry on each realised deal as it is sold, which pays the GP earlier; if later deals lose money, the GP may have been overpaid and a **clawback** obliges it to return the excess, usually at the end of the fund and often net of taxes the GP paid. Gompers and Lerner (1999) and Metrick and Yasuda (2010) show that fee and carry terms vary systematically across funds and that a large part of expected GP revenue comes from fixed fees rather than carry. LPs judge results with multiples and rates: **DPI** (cash returned per dollar paid in), **RVPI** (remaining value per dollar paid in), **TVPI** (the sum), and **net IRR**. Because early years contain fees and new investments but few exits, cumulative net cash flow first falls and then rises: the **J-curve**. Kaplan and Schoar (2005) proposed the **public market equivalent (PME)** ratio now usually called the KS-PME, which compares a fund's cash flows with an equal-timed investment in a public index. Harris, Jenkinson and Kaplan (2014) use it, with data from many funds, to show how buyout and venture returns compare with public markets over time. ## Formulas and notation $$ DPI = \frac{\sum_t D_t}{PIC} \qquad RVPI = \frac{NAV_T}{PIC} \qquad TVPI = DPI + RVPI = \frac{\sum_t D_t + NAV_T}{PIC} $$ $$ \text{Net IRR is the rate } y \text{ that solves } \sum_{t=0}^{T} \frac{D_t - C_t}{(1+y)^t} + \frac{NAV_T}{(1+y)^T} = 0 $$ $$ \text{KS-PME} = \frac{\sum_t D_t \, \frac{I_T}{I_t} + NAV_T}{\sum_t C_t \, \frac{I_T}{I_t}} $$ $$ \text{Preferred return balance: } B_t = B_{t-1}(1+h) + C_t - L^{(1,2)}_t \qquad \text{Full catch-up target: } G^{*} = \frac{c}{1-c} \times P^{LP} $$ $$ \text{Carry with full catch-up, fund in profit beyond the catch-up: } G = c \times \left( \sum_t D^{gross}_t - PIC \right) $$ | Symbol | Meaning | Unit | |---|---|---| | $C_t$ | Capital called from LPs at date $t$ (investments, fees, expenses) | Currency | | $D_t$ | Distributions to LPs at date $t$, net of carry | Currency | | $D^{gross}_t$ | Proceeds available for distribution before the waterfall | Currency | | $PIC$ | Paid-in capital, $\sum_t C_t$ | Currency | | $NAV_T$ | Net asset value of the LPs' interest at the measurement date, net of accrued carry | Currency | | $I_t$ | Level of the public index at date $t$ (total return) | Index points | | $h$ | Preferred return (hurdle) rate, per year, compounded | Rate | | $c$ | Carried interest share of profits | Ratio, for example 0.20 | | $B_t$ | Unreturned capital plus accrued preferred return owed to LPs | Currency | | $L^{(1,2)}_t$ | Distributions to LPs in tiers 1 and 2 (return of capital and preferred return) | Currency | | $P^{LP}$ | Cumulative LP distributions less cumulative contributions (LP profit so far) | Currency | | $G$, $G^{*}$ | GP carried interest paid, and the catch-up target | Currency | The catch-up target follows from the definition: the GP should have $c$ of total profit, so $G = c(P^{LP} + G)$, which gives $G = \frac{c}{1-c} P^{LP}$; with $c = 0.20$ that is one quarter of LP profit. The last formula holds once the catch-up is complete; before that the GP holds less than $c$ of profit. ## Assumptions and limits 1. **Terms are contractual.** The fee base, hurdle, catch-up percentage, carry rate, offsets of transaction fees against management fees, recycling and clawback terms are set in each LPA and its side letters. The 2%, 8% and 20% used here are common illustrative values, not a standard. 2. **Annual timing.** The examples place every flow at year end. Real funds call and distribute on specific dates, so use `XIRR` with dates for real analysis; annual spacing biases IRR when flows bunch within a year. 3. **NAV is an estimate.** Interim TVPI and IRR depend on GP valuations of unsold companies under fair value accounting. They can lag public markets and are smoothed; DPI is the only measure that is fully cash. 4. **IRR depends on timing tricks.** Subscription credit lines (short-term borrowing by the fund before calling LP capital) delay calls, which raises IRR without raising the multiple. Compare funds on both IRR and TVPI, and ask for IRR without the facility. 5. **Gross and net are defined differently by different managers.** Some gross figures exclude fund expenses, some add back fees only. Always read the definitions. 6. **The GP commitment** (often 1% to 5% of the fund) is usually not subject to fees or carry. The examples treat the whole fund as LP capital to keep the arithmetic short. 7. **PME assumes the index is the right benchmark.** KS-PME implicitly assumes a beta of one against the chosen index; a buyout fund with leveraged small companies is riskier than a large-cap index (Sorensen and Jagannathan 2015). ## How LPs and GPs use fund economics **LPs** use these numbers in three moments. In **due diligence** they model the fund's terms on a set of gross deal returns to see the expected net return and the share of value going to the GP; Metrick and Yasuda (2010) model expected fee and carry revenue in this way. In **negotiation** they push on the fee base after the investment period, the hurdle, the catch-up, fee offsets and the clawback guarantee, and they use the ILPA Principles as a reference point. In **monitoring** they read quarterly reports (see finance/lp-quarterly-report), compare DPI, TVPI and net IRR with peer funds of the same vintage year, and compute PME against a relevant index. **GPs** use the same arithmetic to set a fund size the team can deploy in the investment period, to forecast fee income that pays salaries and to show prospective LPs the gross-to-net spread at different gross returns. A sensible GP model shows what happens if exits are delayed by two years, because fees continue while the preferred return keeps compounding and the carry moves further away. **Investment committees** typically want one paragraph: the expected net multiple and IRR at a base-case gross return, the fee drag in percentage points of IRR, the waterfall type and clawback protection, and the PME against the index the plan sponsor uses. Worked example A ends with that paragraph. ## Reporting standards (dated facts) - **ILPA Principles.** As of October 2026 the current version is **ILPA Principles 3.0**, published by the Institutional Limited Partners Association in June 2019 and organised around alignment of interest, governance and transparency (checked 2026-10-28, https://ilpa.org/industry-guidance/principles-best-practices/ilpa-principles/). - **ILPA Reporting Template and Performance Template.** ILPA released an updated Reporting Template and a new Performance Template in January 2025. ILPA's Templates FAQ (version 1.1, April 2025) recommends that the updated Reporting Template should first be delivered for the quarter ending 31 March 2026, for funds still in their investment period in Q1 2026 or starting on or after 1 January 2026; the Performance Template applies to funds commencing operations on or after 1 January 2026, with data captured from Q1 2026 and first delivery in Q1 2027. These dates are ILPA recommendations, not legal requirements (checked 2026-10-28, https://ilpa.org/industry-guidance/templates-standards-model-documents/updated-ilpa-templates-hub/). - **What the Performance Template shows.** Two methods are offered: a **granular** method for managers that classify each capital call by use, and a **gross-up** method that starts from aggregate calls adjusted for fees, expenses and carry. Net fund-level metrics are required and gross fund-level metrics optional, and fund-level metrics are shown **with and without** the effect of fund-level subscription facilities (ILPA Templates FAQ v1.1, 2025). Check the current FAQ and templates on ilpa.org before you rely on these details. - **Regulation.** Disclosure rules for private fund managers differ by jurisdiction and change; ILPA's FAQ notes that the US SEC private fund adviser rule it had planned around was vacated. This card gives no regulatory advice: check with counsel and the regulator's own pages. ## Worked example A (fully solved): Fund I over ten years **Situation (fictional).** Fund I is a USD 500m buyout fund (an illustration for this card, not the USD 1,500m Fund I of the mba/mba-private-equity-guide mini-case) with a ten-year life. Terms: management fee 2.0% a year on commitments in years 1 to 5 (the investment period), then 1.5% a year on the cost of unrealised investments at the start of each year; fees are paid from capital calls; preferred return 8% a year compounded on all contributed capital; 100% GP catch-up; carry 20%; European (whole-fund) waterfall. All flows occur at year end. The GP invests USD 400m in years 1 to 4 and realises it in years 4 to 10. **Step 1: calls, fees and gross proceeds (USD m).** | *Example* year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | Total | |---|---|---|---|---|---|---|---|---|---|---|---| | Investments at cost | 100.00 | 120.00 | 110.00 | 70.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 400.00 | | Management fee | 10.00 | 10.00 | 10.00 | 10.00 | 10.00 | 4.95 | 3.60 | 2.10 | 0.90 | 0.30 | 61.85 | | Capital called | 110.00 | 130.00 | 120.00 | 80.00 | 10.00 | 4.95 | 3.60 | 2.10 | 0.90 | 0.30 | 461.85 | | Cost realised | 0.00 | 0.00 | 0.00 | 20.00 | 50.00 | 90.00 | 100.00 | 80.00 | 40.00 | 20.00 | 400.00 | | Gross proceeds | 0.00 | 0.00 | 0.00 | 30.00 | 90.00 | 180.00 | 220.00 | 200.00 | 110.00 | 50.00 | 880.00 | The year 6 fee is 1.5% of the USD 330m of cost still unrealised at the start of year 6 (`=1.5%*(400-20-50)`). Lifetime fees are USD 61.85m, **12.37% of commitments** (`=61.85/500`), and USD 38.15m of commitments is never called. Gross deal returns: MOIC 2.20x (`=880/400`) and gross IRR **18.39%** (`=IRR` on investments and proceeds by year: -100, -120, -110, -40, 90, 180, 220, 200, 110, 50). **Step 2: the waterfall (USD m).** The balance $B_t$ owed to LPs grows at 8% on its opening value, adds each call and falls with each tier 1 and 2 distribution. Excel for year 2: `=B1*(1+8%)+C2-L2`, where C2 is the call and L2 the tier 1 and 2 distribution. | *Example* year | Balance owed after distribution | Tiers 1 and 2 to LPs | Catch-up to GP | 80% to LPs | 20% to GP | |---|---|---|---|---|---| | 4 | 469.80 | 30.00 | 0.00 | 0.00 | 0.00 | | 5 | 427.38 | 90.00 | 0.00 | 0.00 | 0.00 | | 6 | 286.53 | 180.00 | 0.00 | 0.00 | 0.00 | | 7 | 93.05 | 220.00 | 0.00 | 0.00 | 0.00 | | 8 | 0.00 | 102.59 | 40.49 | 45.54 | 11.38 | | 9 | 0.00 | 0.90 | 0.00 | 87.28 | 21.82 | | 10 | 0.00 | 0.30 | 0.00 | 39.76 | 9.94 | Year 8 is the turning point. The balance before the distribution is $93.05 \times 1.08 + 2.10 = 102.59$. The first 102.59 clears it. Up to that point LPs have received USD 622.59m of tier 1 and 2 cash against USD 460.65m contributed by the end of year 8, so their preferred return is USD 161.94m. The catch-up gives the GP one quarter of that, $161.94 / 4 = 40.49$, which is exactly 20% of the total profit distributed so far. The remaining 56.92 of year 8 is split 80/20. In years 9 and 10 the small fee calls are returned first, then the rest is split 80/20. **Step 3: LP and GP cash flows and metrics.** | *Example* year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |---|---|---|---|---|---|---|---|---|---|---| | Distributions to LPs | 0.00 | 0.00 | 0.00 | 30.00 | 90.00 | 180.00 | 220.00 | 148.13 | 88.18 | 40.06 | | Carry to GP | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 51.87 | 21.82 | 9.94 | | Net LP cash flow | -110.00 | -130.00 | -120.00 | -50.00 | 80.00 | 175.05 | 216.40 | 146.03 | 87.28 | 39.76 | | Cumulative net LP cash flow | -110.00 | -240.00 | -360.00 | -410.00 | -330.00 | -154.95 | 61.45 | 207.48 | 294.76 | 334.52 | Lay the first three rows above out as rows 2 to 4 of a sheet (years 1 to 10 in columns B to K). | *Example* measure | Result | Excel formula | Reading | |---|---|---|---| | LP distributions | USD 796.37m | `=SUM(B2:K2)` | What LPs receive in total | | Carried interest | USD 83.63m | `=SUM(B3:K3)` | Exactly 20% of the USD 418.15m profit (`=880-461.85`) | | Net TVPI = DPI at the end | 1.72x | `=796.37/461.85` | Fund fully realised, so RVPI is zero | | Net IRR | 13.17% | `=IRR(B4:K4)` | Against a gross IRR of 18.39% | | Gross-to-net spread | 5.22 points of IRR, 0.48x of multiple | `=18.39%-13.17%` and `=2.20-1.72` | Fees (called on top of invested capital) and carry | | Break-even year (cumulative cash turns positive) | Year 7 | first positive cell in the cumulative row | The bottom of the J-curve is year 4 at USD -410.00m | **Step 4: interim metrics on a liquidation basis.** Each year the GP reports NAV and the LP interest is shown net of the carry that would be due if the NAV were realised at that value (accrued carry). The GP's gross NAV marks are the unrealised cost times an illustrative mark-up: USD 95.00m, 220.00m, 363.00m, 456.00m, 445.50m, 360.00m, 238.00m, 114.00m, 44.00m and 0 in years 1 to 10. The table runs the same waterfall with the gross NAV added as a hypothetical final distribution; net NAV is what the LPs would receive from it. | *Example* year | Paid-in | Distributed to LPs | Net NAV | DPI | RVPI | TVPI | Net IRR since inception | |---|---|---|---|---|---|---|---| | 2 | 240.00 | 0.00 | 220.00 | 0.00 | 0.92 | 0.92 | -18.2% | | 3 | 360.00 | 0.00 | 363.00 | 0.00 | 1.01 | 1.01 | 0.9% | | 4 | 440.00 | 30.00 | 456.00 | 0.07 | 1.04 | 1.10 | 6.2% | | 5 | 450.00 | 120.00 | 427.38 | 0.27 | 0.95 | 1.22 | 8.0% | | 6 | 454.95 | 300.00 | 318.99 | 0.66 | 0.70 | 1.36 | 9.7% | | 7 | 458.55 | 520.00 | 178.11 | 1.13 | 0.39 | 1.52 | 11.5% | | 8 | 460.65 | 668.13 | 91.20 | 1.45 | 0.20 | 1.65 | 12.7% | | 9 | 461.55 | 756.31 | 35.20 | 1.64 | 0.08 | 1.71 | 13.2% | | 10 | 461.85 | 796.37 | 0.00 | 1.72 | 0.00 | 1.72 | 13.2% | Two lessons. First, in year 5 the gross NAV is USD 445.50m but the LPs' net NAV is USD 427.38m, because USD 18.12m of carry has accrued on paper. Second, interim IRR rises steadily while DPI stays low for years: an LP that needs cash should watch DPI, not only TVPI. ```vega-lite { "$schema": "https://vega.github.io/schema/vega-lite/v5.json", "description": "J-curve of Fund I: cumulative net LP cash flow by year (fictional data, USD m)", "width": 420, "height": 220, "data": {"values": [ {"year": 1, "cum": -110.0}, {"year": 2, "cum": -240.0}, {"year": 3, "cum": -360.0}, {"year": 4, "cum": -410.0}, {"year": 5, "cum": -330.0}, {"year": 6, "cum": -154.95}, {"year": 7, "cum": 61.45}, {"year": 8, "cum": 207.48}, {"year": 9, "cum": 294.76}, {"year": 10, "cum": 334.52} ]}, "layer": [ {"mark": {"type": "line", "point": true}, "encoding": { "x": {"field": "year", "type": "quantitative", "title": "Fund year", "scale": {"domain": [1, 10]}}, "y": {"field": "cum", "type": "quantitative", "title": "Cumulative net LP cash flow (USD m)"} }}, {"data": {"values": [{"y": 0}]}, "mark": {"type": "rule", "strokeDash": [4, 4]}, "encoding": {"y": {"field": "y", "type": "quantitative"}}} ] } ``` **Paragraph for the investment committee.** "On a base case of 2.2x gross deal returns, Fund I would return about 1.72x and a 13.2% net IRR to LPs. Fees cost about 12.4% of commitments over the life, and the total gross-to-net spread is about 5.2 points of IRR. The European waterfall pays no carry until LPs have their capital and an 8% compounded return, which in this case happens in year 8. The cash break-even is year 7." ## Worked example B (half solved): deal-by-deal carry and the clawback **Situation (fictional).** Fund II has only two deals, to keep the arithmetic visible. Each costs USD 50m in year 0. Deal X is sold in year 2 for USD 110m. Deal Y is written down and sold in year 4 for USD 10m. To isolate the timing effect, assume no fees, no hurdle and carry of 20%. Under the **American** waterfall the GP takes carry on each realised deal after the cost of that deal is returned; under the **European** waterfall carry is based on cumulative fund profit. The clawback is settled in year 4. | *Example* item | American, no clawback | American with clawback | European | |---|---|---|---| | Carry paid in year 2 | 12.00 (`=20%*(110-50)`) | 12.00 | [ ] (`=20%*(110-100)`) | | Carry paid (or returned) in year 4 | 0.00 | [ ] | 2.00 | | Total carry over the life | 12.00 | 4.00 | [ ] | | LP cash flows, years 0 to 4 | -100, 0, 98, 0, 10 | -100, 0, 98, 0, [ ] | -100, 0, 108, 0, 8 | | LP TVPI | 1.08x | [ ] | 1.16x | | LP IRR (`=IRR` on the five flows) | 3.59% | 6.68% | [ ] | Questions to answer: 1. Whole-fund profit is USD [ ]m, so the correct carry at 20% is USD 4.00m and the clawback is USD [ ]m. 2. The GP paid 40% tax on the USD 12.00m of year 2 carry, and the LPA caps the clawback at the carry the GP received less the taxes it paid on it. How much of the USD [ ]m excess can LPs recover? [ ] 3. Why is the LP IRR still lower under the American waterfall with a full clawback than under the European one, even though total carry is equal? [ ] ## Exercise C (unsolved): Fund III against a public index **Situation (fictional).** A pension LP holds an interest in Fund III. Its net cash flows (USD m, year end) and the total-return level of the public index it uses as a benchmark are below. NAV at the end of year 5 is USD 35m. | *Example* year | 0 | 1 | 2 | 3 | 4 | 5 | |---|---|---|---|---|---|---| | Capital called | 40 | 30 | 20 | 10 | 0 | 0 | | Distributions to the LP | 0 | 0 | 15 | 30 | 45 | 40 | | Index level | 100 | 112 | 105 | 125 | 138 | 150 | 1. Compute net DPI, RVPI and TVPI at year 5. 2. Compute the net IRR, treating NAV as a final flow in year 5 (Excel formula included). 3. Compute the KS-PME: compound every call and every distribution to year 5 with the factor $I_5 / I_t$, add NAV, and divide. Did the fund beat the index? 4. Compute the "direct alpha": the IRR of the index-compounded net flows. Compare it with the difference between the fund IRR and the annual index return. 5. Name two reasons why a KS-PME above 1 may still overstate the manager's skill. ## Waterfall diagram Each distribution passes through the tiers from the top. A tier receives cash only when the tier above is satisfied. In a European waterfall the tests use cumulative fund totals; in an American waterfall they are applied deal by deal, with the clawback as the final correction. ```mermaid flowchart TD A["Gross proceeds from a realisation"] --> B{"LPs repaid all contributed capital?"} B -->|No| C["Tier 1: 100% to LPs until capital is returned"] B -->|Yes| D{"LPs received the preferred return?"} C --> D D -->|No| E["Tier 2: 100% to LPs until the hurdle is met"] D -->|Yes| F{"GP holds its carry share of profit?"} E --> F F -->|No| G["Tier 3: catch-up to the GP"] F -->|Yes| H["Tier 4: split, for example 80% LPs and 20% GP"] G --> H H --> I{"Fund wound up?"} I -->|No| A I -->|Yes| J["Clawback test: GP returns carry above its share of whole-fund profit"] ``` ## Connections to other cards | Card or template | Connection | |---|---| | mba/mba-paper-lbo | One deal's MOIC and IRR, the gross inputs to the fund | | mba/mba-lbo-model-card | The full deal model behind each gross proceeds number | | mba/mba-pe-value-creation-card | Where gross returns come from inside portfolio companies | | mba/mba-private-equity-guide | The elective roadmap and its mini-case | | mba/mba-vc-portfolio-construction-card | The same fund mechanics for a venture fund with power-law outcomes and reserves | | mba/mba-npv-irr-card | IRR, multiple roots, `XIRR` with dates | | mba/mba-performance-evaluation-card | Benchmarking listed managers: alpha, Sharpe and attribution | | finance/lp-quarterly-report | The LP report where these metrics are presented each quarter | | finance/private-equity-investment-memo, finance/investment-committee-memo | Where fund or deal returns go in a decision memo | ## Common mistakes and misconceptions 1. **Reading gross IRR as the investor's return.** The LP receives net returns; in Worked example A the spread is more than five points of IRR. 2. **Ignoring that fees are paid on commitments.** During the investment period the fee is charged on money that has not yet been invested, so the fee as a percentage of invested capital is much higher in years 1 and 2. 3. **Treating the hurdle as a cap on carry.** With a full catch-up the GP still ends with 20% of all profit; the hurdle changes the timing and protects LPs in weak funds, not the share in good ones. 4. **Comparing funds by IRR alone.** Subscription lines and quick early exits raise IRR without raising the multiple. Compare IRR, TVPI and DPI together, and IRR without the facility when it is reported. 5. **Forgetting accrued carry in NAV.** Net NAV is lower than gross NAV once the fund is above the hurdle on paper. 6. **Assuming American and European waterfalls give the same LP result when total carry is equal.** Timing matters: carry paid early and returned late costs the LP IRR, and the clawback may be limited to after-tax amounts. 7. **Computing PME with the wrong compounding date.** Each flow is compounded to the measurement date with $I_T / I_t$, not discounted to the start. 8. **Treating interim TVPI as realised.** Until DPI is high, a large part of TVPI is a GP estimate. 9. **Comparing funds of different vintage years.** Market conditions at entry and exit dominate; compare with peers of the same vintage and strategy. 10. **Believing carry is the main GP income.** For many funds, expected fee income is a large share of total expected GP revenue (Metrick and Yasuda 2010). ## Self-test questions 1. Define DPI, RVPI and TVPI in one sentence each. Which one is fully in cash? 2. A USD 1,000m fund charges 2% on commitments for five years and then 1.5% on USD 600m of invested capital for five more years. What are lifetime fees, and as a percentage of commitments? 3. An LP has paid in USD 80m, received USD 60m and holds a net NAV of USD 70m. Compute DPI, RVPI and TVPI. 4. Explain in two sentences why a full catch-up means the GP ends with 20% of all profits even with an 8% hurdle. 5. LPs have contributed USD 100m and received USD 108m, which includes an USD 8m preferred return. With a 100% catch-up and 20% carry, how much must the GP receive before the 80/20 split starts? 6. What problem does the clawback solve, and why do LPs care whether it is net of taxes? 7. Why does a subscription credit line raise IRR but not TVPI? 8. In Worked example A, why is the bottom of the J-curve in year 4 but cash break-even only in year 7? 9. A fund reports a KS-PME of 1.15 against a large-cap index. What does that mean, and what would make you doubt it? 10. Interleaving: which card answers each question? (a) The maximum price a buyout fund can pay for one company. (b) Whether a seed fund should keep 50% of capital for follow-ons. (c) Whether a fund's net returns beat a listed index after fees. ## My notes and next steps | Item | My entry | |---|---| | Confidence with the waterfall tiers (1 = lost, 5 = could teach it) | [ ] | | Confidence with DPI, TVPI, net IRR and PME | [ ] | | One real LPA, fund factsheet or case exhibit I will model with this card | [ ] | | Mistakes logged in mba/mba-error-log | [Date and short description] | | Next review date (spacing: +2 days, +1 week, +1 month) | YYYY-MM-DD | | Next card to study | [mba/mba-pe-value-creation-card / mba/mba-vc-portfolio-construction-card] | ## Sources and further reading Primary works: - Sahlman, W. A. (1990). The structure and governance of venture-capital organizations. *Journal of Financial Economics*, 27(2), 473-521. - Gompers, P., and Lerner, J. (1999). An analysis of compensation in the U.S. venture capital partnership. *Journal of Financial Economics*, 51(1), 3-44. - Kaplan, S. N., and Schoar, A. (2005). Private equity performance: returns, persistence, and capital flows. *The Journal of Finance*, 60(4), 1791-1823. - Metrick, A., and Yasuda, A. (2010). The economics of private equity funds. *The Review of Financial Studies*, 23(6), 2303-2341. - Harris, R. S., Jenkinson, T., and Kaplan, S. N. (2014). Private equity performance: what do we know? *The Journal of Finance*, 69(5), 1851-1882. - Sorensen, M., and Jagannathan, R. (2015). The public market equivalent and private equity performance. *Financial Analysts Journal*, 71(4), 43-50. - Gredil, O., Griffiths, B., and Stucke, R. (2014). Benchmarking private equity: the direct alpha method. Working paper, SSRN. Standards and practitioner documents: - Institutional Limited Partners Association. *ILPA Principles 3.0* (June 2019), checked 2026-10-28, https://ilpa.org/industry-guidance/principles-best-practices/ilpa-principles/. - Institutional Limited Partners Association. *ILPA Reporting Template* and *ILPA Performance Template* (2025), and *ILPA Templates FAQs* version 1.1 (April 2025), checked 2026-10-28, https://ilpa.org/industry-guidance/templates-standards-model-documents/updated-ilpa-templates-hub/. Textbooks (further reading, by name only): Metrick and Yasuda, *Venture Capital and the Finance of Innovation*; Talmor and Vasvari, *International Private Equity*; Berk and DeMarzo, *Corporate Finance*. Open resource: the ILPA templates and FAQs are free to download from ilpa.org and show the fields a real report uses. ## Answer key **Worked example B.** European carry in year 2 = USD 2.00m (fund profit so far 10, 20% of it); total European carry = USD 4.00m. With clawback the GP returns 8.00 in year 4, so LP flows are -100, 0, 98, 0, 18; TVPI 1.16x. European LP IRR = 7.22%. (1) Whole-fund profit = $110 + 10 - 100 = 20$; correct carry 4.00; clawback 8.00. (2) The cap is the after-tax carry, $12.00 \times (1 - 0.40) = 7.20$, which is below the 8.00 excess, so LPs recover only 7.20 and lose 0.80 against the European outcome. With a 30% tax rate the cap would be 8.40 and the full 8.00 would come back: the tax cap bites only when the excess is large relative to the carry paid. (3) Under the American waterfall the LPs lend the GP USD 8.00m from year 2 to year 4 at zero interest; the money comes back later, so IRR is lower (6.68% versus 7.22%) even though the multiple is the same. **Exercise C.** (1) Paid-in 100; DPI = 130/100 = 1.30x; RVPI = 35/100 = 0.35x; TVPI = 1.65x. (2) Net flows -40, -30, -5, 20, 45, 75 (year 5 includes NAV 35): net IRR = 17.62% (`=IRR(B4:G4)`). (3) Future value of distributions plus NAV = 181.34; future value of calls = 140.75 (for example, the year 0 call becomes $40 \times 150/100 = 60$); KS-PME = 181.34 / 140.75 = 1.288, so the fund beat the index by about 29% in terminal wealth. Excel, with calls in B2:G2, distributions in B3:G3, net flows in B4:G4 and the index in B5:G5: `=(SUMPRODUCT(B3:G3,$G$5/B5:G5)+35)/SUMPRODUCT(B2:G2,$G$5/B5:G5)`. (4) Direct alpha = IRR of the compounded net flows = 8.74% a year (8.38% in continuous terms, `=LN(1+8.74%)`); the index returned 8.45% a year (`=(150/100)^(1/5)-1`), and $17.62\% - 8.45\% = 9.17\%$, so the simple difference overstates the excess because it ignores the timing of the flows. (5) The index may be the wrong benchmark (KS-PME assumes a beta of one, and buyouts use leverage on smaller companies), and NAV of 35 is an unrealised GP estimate. **Self-test.** 1. DPI is cash distributed per unit paid in; RVPI is remaining net value per unit paid in; TVPI is their sum. DPI is fully in cash. 2. $5 \times 20 + 5 \times 0.015 \times 600 = 100 + 45 = 145$, that is USD 145m, 14.5% of commitments. 3. DPI = 60/80 = 0.75x; RVPI = 70/80 = 0.875x; TVPI = 130/80 = 1.625x. 4. The catch-up tier gives the GP 100% of distributions after the hurdle until the GP holds 20% of all profit paid so far, including the preferred return; every later amount is split 80/20, so the 20% share is kept. 5. USD 2.00m: profit so far is 8 to LPs; the GP needs $8 / 4 = 2$ so that it holds 20% of the 10 of total profit. 6. It corrects over-payment of carry when early deals succeed and later ones fail. If the GP may keep the tax it paid, LPs recover less than the excess carry. 7. The fund borrows first and calls LP capital later, so the LP's money is outstanding for a shorter time (IRR rises), while the amounts paid in and returned barely change (TVPI is almost the same, slightly lower after line interest). 8. Calls dominate until year 4; distributions exceed calls from year 5, but the cumulative deficit of USD 410m takes until year 7 to recover. 9. A dollar invested in the fund produced 15% more terminal wealth than the same dollars invested in the index on the same dates. Doubts: the index may not match the fund's risk (size, leverage, sector), and NAV may be stale. 10. (a) mba/mba-paper-lbo or mba/mba-lbo-model-card; (b) mba/mba-vc-portfolio-construction-card; (c) this card, with KS-PME or direct alpha. ## Revision history | Version | Date | Author | Change summary | |---|---|---|---| | 0.1 | YYYY-MM-DD | [Your name] | First pass through the card | | 0.2 | YYYY-MM-DD | [Your name] | *Example:* Replaced Fund I terms with the terms of a real LPA from a case | ## Standard and licence note Based on the standard private equity fund structure described in the primary works listed above and on the ILPA Principles 3.0 and ILPA Reporting and Performance Templates as published on ilpa.org, checked in October 2026. The text, examples, numbers and questions are original; no textbook, case or ILPA text is copied, and Fund I, Fund II, Fund III and the pension LP are fictional. The template is independent and not affiliated with or endorsed by ILPA, any fund manager, business school or publisher. Fund terms are set by each limited partnership agreement; check the current ILPA documents and your own fund documents before you rely on any figure. Template licence: MIT.