Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our Legal Lingo series, which we've introduced to help break down this jargon, is an explanation of what is meant by the private equity "waterfall".
The waterfall in a limited partnership agreement (LPA) describes how a fund’s profits are distributed among investors and the sponsor. In essence, it’s the economic blueprint – determining who gets paid, when, and how much as investments generate returns.
A well-crafted waterfall balances two goals: ensuring investors first recover their capital (and earn a “preferred return” (see below)) before the sponsor participates, while also rewarding the sponsor for strong performance by entitling them to a good share of the profits.
Typical Structure
While details vary across funds and strategies, a standard private equity fund waterfall follows four main tiers:
1. Return of Capital: Distributions first go to limited partners (LPs) until they have received back the capital they have paid into the fund – either on an all-capital-first (the typical formulation for EU funds) or deal-by-deal (the typical formulation for US funds) basis.
2. Preferred Return (the “Soft Hurdle”): LPs next receive a fixed rate of return on their contributed capital, typically around 8% per annum. The hurdle represents the minimum return the fund must achieve before the sponsor becomes entitled to carried interest.
3. Catch-Up: Once the preferred return has been satisfied, profits often flow primarily to the GP until they “catch up” to the agreed carried interest split (commonly 20%). The catch-up ensures the GP’s share of total profits aligns with the agreed carry percentage. A catch-up limb is the reason why the preferred return is referred to as a soft hurdle.
4. Carried Interest (the “Carry”): Thereafter, remaining profits are shared between LPs and the GP in the agreed ratio (e.g., 80/20). This final tier rewards the GP for the profits earned by the fund (following satisfaction of the soft hurdle).
Worked Example (Simplified) – Visualising the Flow
Suppose a fund invests £100 million. At exit, the portfolio company generates £160 million – a £60 million profit. The waterfall might run as follows:
| Tier | Distribution | Description |
| A. Return of capital to LPs | £100 million | LPs recover their contributed capital first. |
| B. Preferred return to LPs (8%) | £8 million | LPs receive an 8% preferred return on capital. |
| C. GP catch-up (100%) | £2 million | GP receives 100% of proceeds until it has received 20% of all profits earned by the fund (i.e., the amounts earned in A. and B.). |
| D. Carried Interest (20%) | £50 million | Split: £40 million to LPs, £10 million to GP. |
Result:
LPs receive £148 million (1.48x multiple; ~9.6% IRR).
Sponsor receives £12 million carry in total (catch-up + carry).
Clawback Protections
Because carry is often distributed before all the fund’s investments have been realised, most LPAs include clawback protections to ensure the sponsor does not ultimately receive more than its contractual entitlement once the fund has disposed of all investments and is wound up.
Typically, the sponsor (and/or the actual beneficiaries of the carry) agrees to return any excess carry if subsequent losses or write-downs mean that investors have not, in the end, received their full capital and profits in the ratio agreed under the waterfall. To give this protection practical effect:
Clawback calculations are usually tested at the end of the fund’s life or, for deal-by-deal funds, on an interim basis.
Escrow or holdback arrangements may require a portion (often 20–30%) of carried interest distributions to be retained until final reconciliation. This is typically more common for deal-by-deal funds where the risk of overpayment of carry is higher.
Joint and several guarantees from carry recipients are sometimes negotiated to ensure repayment obligations can be enforced.
These provisions help preserve the intended economics of the waterfall and maintain investor confidence that the carry payments align with the contractual profit split between the sponsor and LPs.
Subscribe to Ropes & Gray Viewpoints by topic here.
Stay Up To Date with Ropes & Gray
Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Stay in the loop with all things Ropes & Gray, and find out more about our people, culture, initiatives and everything that’s happening.
We regularly notify our clients and contacts of significant legal developments, news, webinars and teleconferences that affect their industries.