One definition in the waterfall, capital contributions or invested capital, decides whether the GP earns carry on the fees it charged. The cost is a fixed sum, and much larger near the hurdle.
Only if the waterfall's first tier returns all capital contributions. When it does, the LPs get back every amount drawn, including management fees and fund expenses, before the GP earns carry. When it returns only invested capital, the GP takes carry on the fees as well: on an illustrative fund with 70 of fees and expenses and 20 per cent carry, that is 14.00 more carry at any outcome above the catch-up, and 58.00 more at 700 of distributions, near the hurdle.
Worked in full in How to Read a Limited Partnership Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The wording is short and easy to miss. "Return of capital contributions" and "return of invested capital" look interchangeable in a term sheet. In the waterfall they define the base for both the first tier and the preferred return, so they decide when carry switches on and how much of the fee load the LPs ever see again.
| Input | Value |
|---|---|
| Commitments | 500 |
| Contributions used for investments | 410 |
| Contributions used for management fees | 60 |
| Contributions used for fund expenses | 10 |
| Total capital contributions | 480 |
| Preferred return (compounding, average five years outstanding) | 8% |
| Carried interest, full catch-up | 20% |
| Total distributions | 900 |
The preferred return is simplified to one figure: the base compounded at 8 per cent for an average of five years, a factor of 0.4693. A real waterfall accrues it contribution by contribution from each call date, as worked in how to calculate the preferred return; the comparison between the two bases does not depend on that refinement.
Tier 1 return of the base → Tier 2 preferred return on the base → Tier 3 100% to the GP until it holds 20% of profit → Tier 4 80/20
Base A, all contributions: 480, preferred return 480 × 0.4693 = 225.3
Base B, invested capital only: 410, preferred return 410 × 0.4693 = 192.4
Above the catch-up, a full catch-up gives the GP 20 per cent of everything distributed in excess of the base, so carry = 20% × (distributions − base).
| Line | Base A: all contributions | Base B: invested only |
|---|---|---|
| Base returned in tier 1 | 480 | 410 |
| Preferred return | 225.3 | 192.4 |
| Hurdle met at distributions of | 705.3 | 602.4 |
| Catch-up complete at | 761.6 | 650.5 |
| Carry: 20% × (900 − base) | 84.00 | 98.00 |
| To the LPs | 816.00 | 802.00 |
| LP net multiple on 480 contributed | 1.700x | 1.671x |
The gap is 14.00, which is 20 per cent of the 70 of fees and expenses, or 2.8 per cent of commitments. On base B the GP's 98.00 is 23.3 per cent of the fund's true profit of 420 over everything the LPs paid in: the headline carry rate applied to a profit that counts the fees as if they were gains.
Extra carry above the catch-up = carry rate × (fees + expenses) = 20% × 70 = 14.00
In Excel, with distributions in B1, the base in B2 and the carry rate in B3, above the catch-up: =B3*(B1-B2). Run it twice, once with each base, and the difference is the price of the definition.
The fix in negotiation is one sentence: the first tier returns, and the preferred return accrues on, aggregate capital contributions for all purposes, including management fees, organisational expenses and partnership expenses. Most institutional LPAs already read this way, which is exactly why the exceptions are missed. When a manager resists, the number to put on the table is the one above: carry rate times the fee and expense load expected over the fund's life, here 14.00 on a 500 fund, before counting what happens near the hurdle.
| Distributions | Multiple of contributions | Carry, base A | Carry, base B | Difference | LP multiple A | LP multiple B |
|---|---|---|---|---|---|---|
| 600 | 1.25x | 0.00 | 0.00 | 0.00 | 1.250x | 1.250x |
| 700 | 1.46x | 0.00 | 58.00 | 58.00 | 1.458x | 1.337x |
| 800 | 1.67x | 64.00 | 78.00 | 14.00 | 1.533x | 1.504x |
| 900 | 1.88x | 84.00 | 98.00 | 14.00 | 1.700x | 1.671x |
| 1,100 | 2.29x | 124.00 | 138.00 | 14.00 | 2.033x | 2.004x |
Once both bases are past the catch-up the cost is a constant 14.00. The damage is concentrated in the middle: at 700 of distributions base A has not cleared its hurdle and pays nothing, while base B is through its catch-up and pays 58.00. A modest fund, exactly the outcome where the hurdle is meant to protect the LPs, is where the definition costs most.
Find the defined term in tier 1 and in the preferred return. If it is invested capital, the GP earns carry on its own fees: here 14.00 at any good outcome and 58.00 at a mediocre one. How to Read a Limited Partnership Agreement reads the waterfall tier by tier with its four running balances, and the free workbook for this case includes a whole-fund waterfall you can run on your own calls and distributions.
In a standard whole-fund (European) waterfall, yes: the first tier returns all capital contributions, including the part used for fees and expenses, and the preferred return accrues on all of it. If the LPA returns only invested capital, the GP earns carry on the fees too: 14.00 more on 70 of fees and expenses at 20 per cent carry in the example.
Read the definition. Capital contributions usually mean every amount drawn, for investments, management fees, organisational and fund expenses. Some waterfalls, especially deal-by-deal ones, return only the cost of realised investments, sometimes with an allocated share of fees. On 480 drawn, of which 410 was invested, the difference in the first tier is 70.
Most around the hurdle. With an 8 per cent preferred return over an average five years, the illustrative fund clears its hurdle at 705.3 of proceeds on all contributions but at 602.4 on invested capital only. At 700 of proceeds the first base pays no carry and the second pays 58.00, cutting the LPs' multiple from 1.458x to 1.337x.
This article is one calculation from How to Read a Limited Partnership Agreement. 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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