Using Waterfalls to Allocate an Investment’s Distributable Proceeds: GP Catch-Ups with Examples

In the private equity realm, the waterfall is the method used to allocate an investment’s distributable proceeds between the General Partner (GP) and the Limited Partners (LP). The specific terms of the waterfall are dictated by the Limited Partnership Agreement (LPA), but they generally include:

1. Return of capital
2. Preferred return for Limited Partners
3. GP catch-up
4. Carried interest

Each LPA is different and close examination of the LPA is the only way to determine the specific terms of each component. For example, some LPAs return capital as first priority of distributions while others may pay preferred returns ahead of capital. Therefore, fund managers must make sure that the terms specified in the LPA agrees to their intent.

Understanding General Partner Catch-ups

Interpreting and modeling the waterfall is a complicated process and slight variations of interpretations can result in large differences. By far the most misunderstood component of the waterfall is the GP catch-up. Most GP catch-up provisions are written with self-referencing language, which causes confusion for many fund managers. We’ll go through two common examples of the GP catch-up calculation and point out common pitfalls to avoid.

The GP catch-up provision allocates distributions to the GP once the fund manager returns contributed capital and reaches the preferred return. The provision’s purpose is to incentivize fund managers to create returns in excess of the preferred return. Below we look at two examples of GP catch-up provisions.

Example #1

In an example of the terms of the distribution section of the operating agreement, distributions are made in the following manner:

1. First, to Limited Partners until distributions to such Limited Partner equal the Limited Partner’s capital contributions
2. Second, to Limited Partners until distributions to such Limited Partner equal the preferred return
3. Third, 100% to the General Partner until distributions to the General Partner equals 20% of all distributions made pursuant to Section B and Section C
4. Thereafter, 80% to Limited Partners and 20% to the General Partner

Let’s look at a simple example to illustrate the GP catch-up with the following assumptions:

The Limited Partners contributed $1,000 on January 1, 202X. The distributable proceeds on December 31, 202X is $2,000. The preferred return is 8%. There are no prior distributions since inception. At the time of distribution on December 31, 202X, distributable proceeds will be allocated as follows:

In this example, a common mistake is to calculate the GP catch-up as simply 20% x $80 preferred return, which equates to $16. However, recall that the GP catch-up is 20% of ALL distributions made pursuant to Section B and Section C. Therefore, the $80 preferred distribution in Section B must be grossed up because it only represents 80% of all distributions pursuant to Section B and Section C. The remaining 20% is distributed to the GP as the catch-up. Put another way, Section C is the 20% portion of all distributions excluding return of capital, so Section B is the remaining 80%.

The calculation for the GP’s share in Section C is as follows:

[$80 preferred distribution / (100% - 20% GP catch-up)] x 20% GP catch-up = $20 GP catch-up

Example #2

In another example to illustrate the calculation of GP catch-up, distributions are made in the following manner:

1. First, to Limited Partners until distributions to such Limited Partner equal the Limited Partner’s capital contributions
2. Second, to Limited Partners until distributions to such Limited Partner equal the preferred return
3. Third, 20% to the Limited Partner and 80% to the General Partner until distributions to the General Partner equals 20% of all distributions made pursuant to Section B and Section C
4. Thereafter, 80% to Limited Partners and 20% to the General Partner

Using the same assumptions as Example #1, the distributable proceeds will be allocated as follows as of December 31, 202X:

In this example, Section C allocates distributions to both the LP and the GP. Like example #1, the $80 preferred distribution in Section B must be grossed up. However, Section B now represents 75% of all distributions pursuant to Section B and Section C because the GP catch-up remains 20% but the LPs now have an additional 5% of distributions per Section C.

The calculation for the GP’s share in Section C is as follows:

$80 preferred distribution / [100% - (20% GP catchup / 80% GP share of Section C)] x 20% = $21 GP catch-up

Applying Correct Terms to the Waterfall Calculation

Waterfalls are complex and subject to interpretation, and it is important for fund managers to understand and accurately apply LPA terms to the waterfall calculation. GP catch-ups in particular are commonly miscalculated because it’s easy to misinterpret the GP catch-up section. One common mistake is to simply take the percentage of the preferred return as the GP catch-up. As we’ve seen in the previous examples, this approach does not conform to the actual language in the LPA. Distributions (excluding return of capital) must be grossed up to arrive at the basis for the GP’s catch-up share of total distributions. Fund managers must focus on these nuances to arrive at the proper allocation of net proceeds between the GP and LPs.