How does a NAV coverage test hold back carried interest?

The one-sentence clause in a deal-by-deal waterfall that decides how much of the GP's carry ends up as a clawback promise.

Julian R. Sterling · from How to Read a Limited Partnership Agreement

A NAV coverage test lets the GP take deal-by-deal carry only if, after the distribution, the remaining portfolio is worth a set multiple, often 125 per cent, of the LPs' contributions not yet returned. The carry withheld is the amount that brings the test back into line: withheld = unreturned contributions − NAV ÷ 125%, capped at the carry. On an illustrative 500 fund exiting its first deal, that holds back 10.0 of 14.0 of carry and pays the GP 4.0.

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 →

In a deal-by-deal (American) waterfall the GP is paid as each investment is sold, before the LPs have their whole fund back. The NAV coverage test, also called a value test or fair value test, is the clause that stops the GP being paid on an early winner while the rest of the portfolio is quietly worth less than the money still owed to the LPs. It is one sentence in the distribution section of the LPA, and it decides how much of the carry is at risk of a clawback ten years later.

The assumptions

An illustrative buyout fund, $m, at its first exit.
Input	Value
Commitments	500.0
Investments made	8 × 50.0 = 400.0
Management fees and expenses called	40.0
Total contributions	440.0
Proceeds from the first exit (cost 50.0)	120.0
Fair value of the seven remaining deals	475.0
Carried interest	20%
Coverage required	125%

To keep the focus on the test, assume the deal's own waterfall (return of its cost, the preferred return on it and a full catch-up) leaves the GP 20 per cent of the deal's profit: 20 per cent of 70.0, or 14.0. The mechanics of that catch-up are in how the GP catch-up is solved.

Step 1: what the test compares

Coverage ratio = NAV of remaining investments ÷ unreturned contributions

Unreturned contributions = all capital contributed (investments, fees, expenses) − capital returned

The exit returns the deal's 50.0 of cost, so unreturned contributions fall from 440.0 to 390.0. The ratio is 475.0 ÷ 390.0 = 121.8%, below the 125 per cent the clause requires. The test fails, but only just: the NAV needed is 1.25 × 390.0 = 487.5.

Note what is in the denominator. Fees and expenses are contributions too, so the 40.0 of fees stays in unreturned capital until a later distribution pays it back. A test drafted against the cost of the remaining investments (350.0) is a different, weaker test, as the mistake section shows.

Step 2: how much carry is withheld

Most clauses that use the test do not stop the distribution. They redirect the GP's share to the LPs until the test is met. Every dollar redirected is returned capital, so it lowers the denominator dollar for dollar. The test is met once unreturned contributions are no more than NAV ÷ 1.25.

Withheld = MIN(carry, MAX(0, unreturned − NAV ÷ coverage))

Here: 475.0 ÷ 1.25 = 380.0; 390.0 − 380.0 = 10.0. In Excel, with named cells: =MIN(Carry,MAX(0,Unreturned-NAV/Coverage)), where Carry is the 14.0 the deal waterfall would pay, not the 20 per cent rate.

The first exit with and without the coverage test, $m.
	No test	125% test
Exit proceeds	120.0	120.0
Carry paid to the GP	14.0	4.0
Carry redirected to LPs	0.0	10.0
Paid to LPs	106.0	116.0
Unreturned contributions after	390.0	380.0

After the redirect the ratio is 475.0 ÷ 380.0 = 125.0 per cent exactly. The 10.0 is not forfeited: it has been paid to the LPs as an early return of capital, and a later exit that clears the test pays the GP its catch-up on it.

Step 3: what the test protects

Suppose the seven remaining companies are eventually sold for 380.0, below their 475.0 mark. Total distributions are 500.0 on 440.0 contributed: a fund profit of 60.0. An 8 per cent preferred return on 440.0 for just two years is 73.2, more than the whole profit, so on a whole-fund basis the GP is owed no carry at all. Everything it received must come back through the clawback: 14.0 without the test, 4.0 with it.

The coverage test does not change what the GP earns over the fund's life. It changes how much of the GP's carry sits outside the fund as a promise to repay. Here it cuts that exposure from 14.0 to 4.0, which protects the LPs more than a partial escrow on the 14.0 would. Why an after-tax promise is weaker than it looks is set out in what a clawback actually collateralises.

What if: the coverage level and the NAV

Carry withheld on the 14.0, by required coverage, NAV 475.0.
Coverage	NAV needed	Withheld	Paid to GP
100%	390.0	0.0	14.0
110%	429.0	0.0	14.0
120%	468.0	0.0	14.0
125%	487.5	10.0	4.0
130%	507.0	14.0	0.0
150%	585.0	14.0	0.0

Carry withheld by NAV of the remaining deals, 125% coverage.
NAV	Coverage ratio	Withheld	Paid to GP
400.0	102.6%	14.0	0.0
450.0	115.4%	14.0	0.0
475.0	121.8%	10.0	4.0
487.5	125.0%	0.0	14.0
520.0	133.3%	0.0	14.0

The switch is narrow. Between a NAV of 470.0 and 487.5 the GP's cash on this exit moves from nothing to all 14.0; a mark 1.1 per cent below 475.0 withholds everything. That is why LPs should ask who sets the NAV used in the test, and at what date. A test run on the GP's own quarter-end marks, a quarter stale, is weaker than the percentage suggests.

The common mistakes

Testing against remaining cost. 475.0 ÷ 350.0 = 135.7 per cent: the test passes and the GP takes all 14.0. Leaving fees and expenses out of the denominator is worth 10.0 to the GP on the first exit alone.
Escrow instead of redirect. If the clause escrows the carry rather than paying it to the LPs, the escrowed cash does not reduce unreturned contributions. The ratio stays at 121.8 per cent and all 14.0 is held, but the LPs receive none of it until the test clears or the fund ends.
Treating the test as a substitute for a clawback. It limits the overpayment at each exit. It does not true up the end of the fund, as the clawback mechanics in European versus American waterfall show.

Takeaway

Read the denominator before the percentage: unreturned contributions including fees, not remaining cost. Then compute the withheld carry as unreturned minus NAV over the coverage, capped at the carry: 10.0 of 14.0 here. How to Read a Limited Partnership Agreement works the waterfall and the clawback clause by clause, and the free workbook for this case carries a blank fee and waterfall model for your own fund.

Questions readers ask

What is a NAV coverage test in a private equity fund?

A condition in a deal-by-deal waterfall: the GP takes carry on an exit only if the remaining portfolio's fair value is at least a set multiple, commonly 110 to 125 per cent, of LP contributions not yet returned. In the illustrative case a 475.0 NAV against 390.0 unreturned is 121.8 per cent, so part of the carry is withheld.

Is carry withheld under a coverage test lost by the GP?

No. Under the usual redirect drafting it is paid to the LPs as an early return of capital, which lowers unreturned contributions. When a later exit clears the test, the catch-up pays the GP back. Here 10.0 is redirected, leaving 380.0 unreturned and the ratio at exactly 125.0 per cent.

Does a coverage test replace the clawback?

No. It limits overpayment at each exit; the clawback still trues up the whole fund at the end. If the remaining deals sell for 380.0, fund profit is 60.0, below a two-year 8 per cent preferred return of 73.2, so all carry paid must come back: 14.0 without the test, 4.0 with it.

Read the whole case

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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Also on this site

European versus American waterfall: what the clawback is really worthThe American order pays the GP early and leaves a $9M clawback, 16% of what was banked. What it is worth depends on who owes it.
How is the GP clawback calculated at the end of a fund?Carry paid deal by deal less carry due on the whole fund: $21.00m paid against $13.09m due is a $7.91m clawback, not the $2.00m a 20% shortcut gives.
What a clawback actually collateralisesA 24 million clawback recovers 13.20 net of tax, of which 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
How the GP catch-up is actually solvedThe catch-up is an equation, not a number: C / (pref + C) = carry rate. Worked on a $160m distribution, at three carry rates.
At what multiple does a private equity fund start paying carry?When the gross IRR reaches the hurdle. On an illustrative fund, an 8 per cent hurdle bites at 1.48x and the full catch-up completes at 1.57x.
Full vs 80 per cent catch-up: how much carry does the GP lose?Only inside a narrow band. With 30 of pref and 20% carry, a full catch-up ends at 137.5 and an 80% one at 140.0; the most the GP loses is 1.50, then nothing.

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