On the same ten deals, with the same total profit, the American calculation pays
the general partner earlier and leaves a $9M clawback — sixteen percent of
everything already banked. Whether that $9M is worth $9M depends on facts that have nothing to do
with the waterfall.
European and American waterfalls are not two different economic deals. Run to the end of a
fund's life, on the same cash flows, they can produce the same total carried interest. What differs
is the order of calculation, and therefore the timing — and timing is where the
disputes are.
The two orders
Convention
How carried interest is computed
European (whole-of-fund)
All contributed capital across every investment is returned first, then the preferred
return on it, and only then does the general partner participate. Carry is calculated once,
on the fund.
American (deal-by-deal)
Each realisation runs its own waterfall. Capital and preferred return attributable to that
deal are satisfied, and the general partner takes its share of that deal's profit
immediately.
In a fund where every investment succeeds, the two converge. In a fund where the winners exit
before the losers — which is the normal sequence, because good assets are easier to sell
— the American calculation pays carried interest on gains that later losses will erase.
What that produces on the ten-deal fund
The $500M fund: ten investments of $50M, seven at 1.8x, three at 0.7x, $735M of proceeds and
$235M of profit. Under the American calculation the general partner receives carry as the seven
winners are realised. Then the three losers come in at 0.7x and the fund's total profit turns out
to be lower than the sum of the profits already shared.
The correction is the clawback: $9M, equal to 16 percent
of everything the general partner had already been paid.
Note what the clawback is not. It is not a penalty and not a
dispute. It is the arithmetic working correctly: the deal-by-deal order overpaid, and the provision
exists to unwind the overpayment. The question is only whether the money comes back.
The three reasons a clawback is worth less than its face
1. It is usually after tax
Carried interest is received by individuals who pay tax on it. Most clawback provisions are
therefore capped at the after-tax amount received, on the reasonable ground that the recipients
never had the gross. A $9M gross clawback can be a materially smaller net obligation, and the
limited partners bear the difference.
2. It is owed by whoever received it
The obligation sits with the carry vehicle and, behind it, with individuals — some of whom
may have left the firm, and some of whom will have spent the money years earlier. A joint and
several guarantee among the carry recipients is far stronger than a several-only one, and the
difference is a drafting point in a document most investors read once.
3. It is settled at the end
Clawbacks are typically trued up at the end of the fund's life — often ten years or more
after the payments they reverse. A promise to repay $9M in year twelve, unsecured, from a vehicle
that may by then hold nothing, is not the same asset as $9M.
The mitigants that actually change the answer
Escrow. A share of each carry payment — commonly 20 to 30 percent
— held back until the clawback test can be run. This converts a promise into cash, and
it is the single most effective protection available.
Interim testing. Running the clawback calculation periodically rather than
only at dissolution, so an emerging overpayment is corrected while it is small.
A loss carry-forward. Requiring realised losses to be recovered before
further carry is paid, which prevents most of the overpayment arising in the first place.
Joint and several liability, and a guarantee from the management company.
Both widen the pool of assets standing behind the obligation.
What to compare, if you are comparing terms
The headline carry rate is the least informative number in the fee section. Two funds at
“20 and 8” can differ by hundreds of basis points of net return on the strength of the
calculation order, the preferred return's compounding, and the fee basis after the investment
period.
The measurement that settles it is the gross-to-net bridge: what the assets earned, and what the
investor received, with every deduction between them named. On one worked fund that bridge runs
from 2.15x gross to 1.78x net — roughly 200 basis points of
compound annual return handed over across management fees, fund expenses and carried interest.
Two hundred basis points is more than most allocators will move on any other decision in the
portfolio. It is worth reading the waterfall for.
The workbooks behind this article
Every figure above is a live formula in the companion files for
Private Equity Real Estate. Change one input and the rest of the sheet answers.
They are free, and they need no account and no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
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