Carry, Preferred returns, Waterfall, Catch-up

Photo by Jamie Street on Unsplash

A refresher:

Carry -

In venture capital, carried interest refers to the share of profits that a general partner (GP) receives as compensation for managing a fund.

Typically, the GP will receive a percentage of the profits, after the investors (limited partners or LPs)

1. have received their original investment and
2. sometimes post a return on their initial investment (the “preferred return”).

Typically, the GP receives 20% of the profits, while the remaining 80% is distributed among the LPs in proportion to their investment in the fund.

Carried interest is an important incentive for GPs to generate high returns for the fund, as it aligns their interests with those of the LPs. It also encourages the GP to work to improve the value of the portfolio companies and to exit investments at the right time to maximize returns for all parties involved.

The specific terms of carried interest will vary depending on the fund’s partnership agreement.

Preferred returns -

A preferred return (also known as a hurdle rate) is the minimum rate of return that limited partners (LPs) expect to receive on their investment before the general partner (GP) is entitled to any carried interest.

For example, if the preferred return is 8%, and the LPs have invested $100 million in the fund, then the fund must generate at least $8 million in profits before the fund manager can receive a share of the profits.

Once the preferred return is distributed to LPs, the GP is then entitled to receive carried interest on any additional profits generated by the fund.

Catch-up -

A “catch up” provision allows a general partner (GP) of a fund to receive a larger share of the fund’s profits once the fund has generated returns that exceed a certain threshold (preferred return / hurdle).

Distribution waterfall (with carry, preferred return and catch-up)

Distribution waterfall is the pecking order in which investment returns are allocated to LPs and GPs.

Simple waterfall model. The year level working is in the excel model below.

The excel model link to the above table is here — http://bit.ly/407Kd4B

Other factors that could impact distribution and payouts:

1. If your carry is deal-by-deal or fund-level carry
2. If you have venture partners who could be LPs as well as participate in carry — a different class of shareholders
3. If you have exit expenses, then the distribution will happen post-accounting for the same
4. Hurdle is simple interest or compound interest
5. Carry can be differential based on a slab of profit return. In that scenario, carry working changes based on multiples of return

Reads

1. If you want to know how to compute different share in catch-up, ie. GP doesn’t get catch up in one shot but again as a split between LP and GP in the profits, here is an article that explains it https://www.eisneramper.com/waterfall-gp-catch-ups-0123/
2. This is a great article to understand different terminologies and how the waterfall differs between US and Europe (though it is from Real estate example, but still holds true for VC funds) — https://origininvestments.com/2017/12/28/what-are-private-equity-waterfalls-clawbacks-catch-up-clauses/
3. As always Investopedia is bang on in the topic — https://www.investopedia.com/terms/d/distribution-waterfall.asp
4. https://eqvista.com/waterfall-analysis/waterfall-analysis-for-vc-investment/
5. Crunchbase article on J curve — https://news.crunchbase.com/venture/inside-the-ups-and-downs-of-the-vc-j-curve/
6. One final piece — https://thoughtfulfinance.com/private-equity-preferred-returns-catch-ups-and-waterfalls/