Currently studying with Schweser. I was wondering if anyone could elaborate on what the catch-up is for private equity waterfalls?

For instance there was an example to calculate profit for LP but I wouldn’t have proceeded in that way.

LP contributes 20mm to investment, hurdle rate 7% catch up is full, carry split is 80/20 LP/GP. if investment is sold for 30mm, how much will the LP net in profit?

Answer is LP will first receive 1.4mm (20mm * 7%) that makes sense

while the GP will receive 350,000 per the 80/20 split --> this is the part I do not get.

Of the remaining 8.25mm profit, the LP will receive 80% and the GP will receive 2mm.

Why can’t we simply do calculation of hurdle rate 7% of initial 20mm. Then take what is left of profits and split it 80/20?

IMO, the book and Schweser did a piss-poor job of explaining this, or they made it harder than necessary. Just remember, each tranch of spilt needs to be 80/20. Even on the 7% prefer return, LP get that 7% preferred return, then 80/20 also needs to be achieved. So, you work back to see what 80/20 will get the LP 1.4MM…that turn out be to 1.75M for the total, so 0.35M is the GP spilt.

If the answer for the LP made sense then the answer for the GP would also make sense.

Let’s look at the hurdle rate here.

The LP requires a minimum return of 7% before carried interest is considered, therefore the GP need to generate a breakeven return of 8.75% (7%/0.8 i.e 7% before carried interest) to be fully caught up.

Therefore returning 1.75% (8.75%-7.00%) on a relative basis or 350,000 (20mm*1.75%) on an absolute basis.

The way the book describes it, there is the LP pref return and the GP catch-up, and then the residual amounts. Since the catch-up is full and the hurdle has been met, think of it this way:

Total LP investment x hurdle rate / LP share = $20M x 7% / 0.8 = $1.75M, or “$1.4M is 80% of what?” This is the LP pref return.

$1.75M x 20% GP share = $350k. This is the GP catch-up return.

$10M - $1.75M = $8.25M. This is the residual return.

$8.25M x 80% LP share = $6.6M = LP residual share, $8.25M x 20% GP share = $1.65M = GP residual share

LP total return = $1.4M + $6.6M = $8M, or 80% of total profit

GP total return = $350k + $1.65M = $2M, or 20% total profit