The distribution notice, the capital account and the statement of operations describe the same cash in three vocabularies.
Because the label comes from the waterfall, not from the deal. Under a whole-fund waterfall every distribution is applied first to returning all capital contributed, so an exit that sold a $30.0m investment for $54.0m books a $24.0m realised gain in the statement of operations, yet the distribution notice shows the full $54.0m as return of capital while the fund has $150.0m of contributions outstanding. The gain is real; it is simply not yet "profit" in the waterfall's sense.
Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Limited partners meet the same cash in three documents that describe it three ways: the distribution notice, the capital account statement and the fund's audited financial statements. They do not contradict each other. Each answers a different question, and reading one with the vocabulary of another is how investors come to believe a successful exit lost money, or that a fund is in profit when it is not.
| Input | Value |
|---|---|
| Commitments | 200.0 |
| Contributed to date (investments 135.0, fees and expenses 15.0) | 150.0 |
| Cost of the investment sold | 30.0 |
| Carrying value at the last quarter end | 46.0 |
| Net sale proceeds, distributed in full | 54.0 |
| Preferred return owed, held fixed for comparison | 25.0 |
| Carried interest, with a full catch-up | 20% |
| Our investor's share of the fund | 10% |
Realised gain = proceeds − cost = 54.0 − 30.0 = 24.0, a 1.80x exit. The $16.0m of unrealised gain recognised in earlier quarters reverses in the same period, so the exit adds only 54.0 − 46.0 = 8.0 to net assets this quarter. That split is worked in realised vs unrealised gain on a fund exit.
Tier 1 returns contributed capital first. Unreturned capital is 150.0, larger than 54.0, so all 54.0 is return of capital and unreturned capital falls to 96.0. Tiers 2 to 4 (preferred return, catch-up, 80/20 split) receive nothing.
Investor X is allocated 10 per cent of the gain, 2.40, less 1.60 of reversed unrealised gain, and is debited the 5.40 distribution. Its account moves from 16.2 to 11.6. Its unreturned capital moves from 15.0 to 9.60.
Distributions in the fund's statement of changes in net assets are usually a single line, with no split at all. The split into return of capital and profit lives in the notice and in the capital account's memorandum columns, and it is a statement about cumulative cash, not about any one investment.
Run the same $54.0m distribution, from the same $24.0m gain, through the waterfall at four different points in the fund's life.
| Already distributed | Return of capital | Preferred return | GP catch-up | LP 80% | GP 20% | Cumulative ÷ contributed |
|---|---|---|---|---|---|---|
| 0.0 | 54.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.36 |
| 100.0 | 50.00 | 4.00 | 0.00 | 0.00 | 0.00 | 1.03 |
| 140.0 | 10.00 | 25.00 | 6.25 | 10.20 | 2.55 | 1.29 |
| 175.0 | 0.00 | 0.00 | 6.25 | 38.20 | 9.55 | 1.53 |
The realised gain in the financial statements is 24.0 in every row. What the limited partners are told they received ranges from pure return of capital to 38.20 of profit, and the general partner's share from nothing to 15.80. For investor X the first row is 5.40 of capital and no profit; the third is 1.00 of capital and 3.52 of preferred return and profit.
Catch-up arithmetic. With a full catch-up, the GP receives 100 per cent after the preferred return until it holds 20 per cent of everything above capital: 25.0 × 0.20 ÷ 0.80 = 6.25.
When a notice calls a distribution return of capital, check the statement of operations for the realised gain and the capital account for the allocation: the three should reconcile to the same cash. Unreturned capital, not the label on any one exit, tells you how close the fund is to carry. The full reporting pack, with its reconciliations live, is in the free workbook for this book, and the capital account tie-out in how to reconcile a capital account statement.
In a US partnership the tax follows allocations, not labels: the investor is taxed on its share of the realised gain, 2.40 in the illustrative case, whether or not cash is paid, and a cash distribution is generally taxable only to the extent it exceeds the investor's basis. The waterfall label on the notice does not decide the tax treatment.
No. In the illustrative fund an investment bought for $30.0m and sold for $54.0m, a 1.80x exit, produces a distribution labelled entirely return of capital, because the whole-fund waterfall first returns all $150.0m contributed, fees and expenses included.
Once cumulative distributions exceed contributions and the preferred return. With $150.0m contributed and a $25.0m preferred return owed, a $54.0m distribution made after $140.0m has been paid splits into 10.00 of capital, 25.00 of preferred return, 6.25 of GP catch-up and 12.75 shared 80/20.
This article is one calculation from How to Read a Private Fund's Financial Statements. 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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: private equity and private markets → · All 1682 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.