The preferred return runs from the capital call, so a line that delays the call shrinks the hurdle. Whether that raises the carry depends on where the fund sits in the waterfall.
Only in a narrow band around the hurdle. The preferred return accrues from the capital call, so a subscription line that delays the call shrinks the hurdle. On an illustrative investment of 100 exited at 140 after four years, bridging the call for a year at 6.5 per cent cuts the preferred return owed from 36.05 to 27.66 and lifts the GP's carry from 3.95 to 5.84. At a 1.60x exit the same line cuts carry from 12.0 to 10.7, because once the hurdle is cleared the interest is simply a cost.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A European waterfall pays investors their capital, then a compound preferred return on that capital, then gives the GP a catch-up until it holds 20 per cent of the profit, then splits the rest 80/20. The pref is measured from the date capital is contributed. A subscription line lets the fund buy the asset with borrowed money and call capital later, so investors contribute a slightly larger amount, the original cost plus interest, for a shorter time. Two things change at once: the profit shrinks by the interest, and the hurdle shrinks by the time. Which one wins decides whether the GP gains.
| Input | Value |
|---|---|
| Investment cost | 100 |
| Holding period | 4 years |
| Exit proceeds, base case | 140 |
| Capital call deferred by the line | 1 year |
| Subscription line all-in rate (illustrative) | 6.5% |
| Preferred return, compound | 8% |
| Carried interest, with full catch-up | 20% |
Without the line. Capital called: 100 for 4 years. Pref = 100 × (1.084 − 1) = 36.05. Profit = 140 − 100 = 40.00. Excess over the pref = 3.95, all of which goes to the GP in the catch-up, since full catch-up needs a profit of 36.05 ÷ 0.8 = 45.06. Carry = 3.95.
With the line. Capital called: 100 × (1 + 6.5%) = 106.50, a year later, for 3 years. Pref = 106.50 × (1.083 − 1) = 27.66. Profit = 140 − 106.50 = 33.50. Excess = 5.84, still inside the catch-up, which now ends at 34.57. Carry = 5.84.
In Excel, for the catch-up band: =MAX(0,MIN(Profit-Pref,Carry*Profit)) with Pref=Called*((1+Hurdle)^Years-1).
At 140 the line raises the carry by 1.89, or 48 per cent. The 8.39 of pref it saves is larger than the 6.50 of interest it costs, and inside the catch-up every saved unit of hurdle passes straight to the GP. Investors end the deal with exactly the same 8.00 per cent IRR either way, because during the catch-up the waterfall pins them to the hurdle, but they hold 27.66 of profit instead of 36.05. The fund's IRR on called capital rises from 8.78 to 9.55 per cent on an asset that earned 8.78.
Move the exit up and the effect reverses. Once the GP is fully caught up in both cases, carry is 20 per cent of profit and the pref no longer matters; the line's only effect is to reduce profit by the interest, and carry falls by 20 per cent of it, 1.30.
| Exit | Gross multiple | Carry, no line | Carry, line | LP IRR, no line | LP IRR, line | LP profit, no line | LP profit, line |
|---|---|---|---|---|---|---|---|
| 130 | 1.30x | 0.00 | 0.00 | 6.78% | 6.87% | 30.00 | 23.50 |
| 135 | 1.35x | 0.00 | 0.84 | 7.79% | 8.00% | 35.00 | 27.66 |
| 140 | 1.40x | 3.95 | 5.84 | 8.00% | 8.00% | 36.05 | 27.66 |
| 145 | 1.45x | 8.95 | 7.70 | 8.00% | 8.84% | 36.05 | 30.80 |
| 150 | 1.50x | 10.00 | 8.70 | 8.78% | 9.88% | 40.00 | 34.80 |
| 160 | 1.60x | 12.00 | 10.70 | 10.30% | 11.92% | 48.00 | 42.80 |
| 180 | 1.80x | 16.00 | 14.70 | 13.16% | 15.78% | 64.00 | 58.80 |
The band in which the line helps the GP runs from an exit of 134.16, where carry first appears with the line, to 143.44, where the line's carry, by then 20 per cent of a smaller profit, falls back to the no-line figure; without the line carry starts at 136.05. Below the band nobody earns carry; above it the GP is worse off, by the full 1.30 from 145.06, where the no-line catch-up ends. Investors are worse off in cash at every exit, by between 5.20 and 8.39, and better off in IRR at every exit except where the catch-up holds them at 8.00 per cent. The IRR effect alone, with no waterfall, is worked in what a subscription line actually does to the IRR.
The incentive is sharpest for a fund that expects to land close to its hurdle. A GP managing a fund heading for a 1.35x to 1.40x gross result has the most to gain from extending its line, and investors in such a fund have the most reason to ask for performance and carry calculated as if capital had been called on the investment date.
Treating the line as neutral for the waterfall because it is neutral for the asset. The asset earned 8.78 per cent in both cases. The waterfall did not see the asset; it saw contributions and distributions, and the line moved both. The reverse mistake is assuming the line always enriches the GP. Above the catch-up it costs the GP a fifth of the interest, which is why the question to ask in diligence is not whether a fund uses a line but where its expected outcome sits against the hurdle. How the pref itself compounds is set out in how to calculate the preferred return in a private equity fund.
Pref = called capital × ((1 + hurdle)years − 1), measured from the call. A line that defers a 100 call by a year at 6.5 per cent saves 8.39 of pref and costs 6.50 of interest: the GP gains 1.89 of carry at a 1.40x exit and loses 1.30 at 1.60x and above. The IRR effect, priced point by point, is in the free workbook for this case.
In most limited partnership agreements the preferred return accrues on contributed capital from the date it is called, not from the date the fund made the investment. A subscription line that bridges a 100 investment for a year means investors contribute 106.50 a year later, and an 8 per cent pref over three years instead of four comes to 27.66 instead of 36.05.
In cash, usually yes, because the interest is a fund expense. On a 100 investment exited at 160, deferring the call one year at 6.5 per cent cuts the LPs' profit from 48.00 to 42.80, even though their IRR rises from 10.30 to 11.92 per cent and the carry they pay falls by 1.30.
Because the line changes the IRR, and in a band near the hurdle it changes the carry, without changing the asset. At a 1.40x gross exit the line lifts the fund's IRR on called capital from 8.78 to 9.55 per cent and the GP's carry by 48 per cent. Reporting both figures separates the financing from the investment result.
This article is one calculation from The Fund Finance Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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