## **Learning Outcomes**

This article explains private equity and venture capital fund structures and their economic arrangements, including:

- Describing the limited partnership structure, roles of general partners (GPs) and limited partners (LPs), and how capital commitments and fund life cycles are organized.
- Explaining how management fees are calculated on committed versus invested capital, and how these fees affect net returns and incentives.
- Detailing the definition, purpose, and typical level of carried interest, and how it aligns GP compensation with fund performance.
- Analyzing preferred returns and hurdle rates, including how they are specified and how they condition the GP's right to receive carried interest.
- Comparing European (whole-fund) and American (deal-by-deal) waterfall structures, and determining when each structure allows the GP to receive carry.
- Calculating cash flow distributions between LPs and GPs under different waterfall arrangements, using simplified exam-style numerical examples.
- Interpreting the function of clawback provisions and other contractual protections that prevent overpayment of carried interest to the GP.
- Identifying common CFA exam traps related to sequencing of distributions, misinterpreting hurdle rates, and confusing management fees with carried interest.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand how private equity and venture capital funds are structured, managed, and how profits are allocated, with a focus on the following syllabus points:

- Explaining limited partnership structures in private equity and venture capital funds
- Describing different forms of management fees and carried interest
- Explaining how waterfalls determine the cash flow distribution sequence between limited partners and general partners
- Interpreting hurdle rates, preferred returns, and catch-up provisions
- Calculating distributions to limited and general partners under various scenarios

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. In a private equity fund, what is the fundamental difference between the management fee and carried interest?
2. How does a European-style (whole-fund) waterfall differ from an American-style (deal-by-deal) waterfall in carried interest distribution?
3. If a fund has a hurdle rate of 8%, what does this mean for the general partner’s entitlement to carried interest?
4. What is the purpose of a clawback provision in private equity fund terms?

## **Introduction**

Private equity and venture capital investments are typically accessed through closed-end fund vehicles, most commonly organized as limited partnerships. These structures are designed to align incentives between fund managers (general partners) and investors (limited partners) while addressing profit-sharing and risk. Understanding the mechanics of fees and waterfall distribution is essential for analyzing fund performance and interpreting investment returns, as these elements determine how cash flows and profits are divided.

> **Key Term: limited partnership (LP)**
> A common legal structure used by private equity and venture capital funds, consisting of one general partner (GP) and multiple limited partners (LPs). The GP manages the fund and the LPs are passive investors, exposed only to risk up to their committed capital.
>
> **Key Term: general partner (GP)**
> The managing partner in a private equity or venture capital fund, responsible for investment decisions and fund operations. Receives both management fees and carried interest.

## FUND STRUCTURE AND FEE ARRANGEMENTS

Private equity and venture capital funds usually have a fixed term (commonly 10 years, with possible extensions), fundraising capital from institutional and high-net-worth investors as limited partners. The general partner manages fund operations, selection, and oversight of portfolio companies.

### Management Fees

The general partner receives an annual management fee (typically between 1.5% and 2.0%) calculated on committed or invested capital, paid regardless of performance. This fee covers operational expenses and salaries.

> **Key Term: management fee**
> The annual fee paid by limited partners to the general partner, generally expressed as a percentage of committed or invested capital, compensating the GP for operating the fund.

### Carried Interest (Performance Fees)

Carried interest refers to the share of profits above the original invested capital and a specified preferred return (if applicable) that is paid to the general partner as an incentive for generating strong fund performance. Standard carried interest is 20%, though percentages can vary.

The carried interest is subject to a distribution "waterfall," which stipulates the order in which returns are allocated between LPs and GP.

> **Key Term: carried interest**
> The portion of fund profits (commonly 20%) distributed to the general partner, contingent on achieving returns above the invested capital and often a preferred return for the limited partners.

### Preferred Return / Hurdle Rate

Most funds set a preferred return or hurdle rate (e.g., 8%), ensuring that LPs receive a minimum annualized return before the GP becomes eligible for carried interest.

> **Key Term: hurdle rate (preferred return)**
> The minimum annual return that must be distributed to limited partners before the general partner is entitled to any carried interest.

## WATERFALL DISTRIBUTION STRUCTURES

A waterfall defines the sequence of distributions between LPs and the GP. The two main types are European (whole-fund) and American (deal-by-deal).

> **Key Term: waterfall**
> The cash flow distribution order specifying how proceeds are allocated between limited partners and the general partner, including management fee repayments, return of capital, preferred returns, and carried interest.

### European (Whole-Fund) Waterfall

LPs must have all contributed capital returned—and often the hurdle rate met—over the life of the fund before the GP receives any carried interest. This structure reduces the risk of overpayment to the GP before underperforming investments are realized.

### American (Deal-by-Deal) Waterfall

The GP receives carried interest as soon as individual investments generate profits over the hurdle rate, regardless of the performance of other investments. This can result in the GP receiving incentive compensation even if the overall fund return is weak.

> **Key Term: clawback**
> A contractual provision ensuring that if GPs receive more carried interest than entitled to (e.g., due to early profits from successful deals followed by later losses), excess payments must be returned to LPs.

### **Worked Example 1.1**

A venture fund has committed capital of \$100 million, a management fee of 2% per year on committed capital, a hurdle rate of 8%, and a carried interest of 20% on profits above the hurdle. If, after four years, net fund proceeds total \$140 million, what compensation does the GP receive under a European waterfall?

> **Answer:**
> Management fees: \$100 million × 2% × 4 years = \$8 million (paid regardless of fund profit).
>
> First, LPs are repaid their \$100 million capital. Next, LPs receive the 8% preferred return: \$100 million × 8% × 4 years = \$32 million (simplified, ignoring compounding).
>
> Remaining distributable profit: \$140m – \$100m – \$32m = \$8m. GP receives 20% of this carried interest = \$1.6m. LPs receive the remainder (\$6.4m).
>
> Total LP proceeds: \$100m (capital) + \$32m (hurdle) + \$6.4m = \$138.4m.

### **Worked Example 1.2**

A private equity fund uses an American-style waterfall. An early investment yields \$30 million in profit (meeting the hurdle), for which the GP receives 20% carry. Subsequent investments underperform and the fund ends with no cumulative gain. What mechanism ensures LPs are compensated for overpaid carry?

> **Answer:**
> The fund's clawback provision requires the GP to return the excess carried interest to the LPs, so that carry paid to the GP reflects net profits over the life of the fund.

### **Exam Warning**

> A frequent exam mistake is confusing when GPs are entitled to carried interest under different waterfall structures. Remember that a European waterfall requires full capital repayment and the preferred return fund-wide before the GP receives any carry. In contrast, an American waterfall allows the GP to receive carry on each profitable deal as it occurs, which may be subject to later clawback.

## **Summary**

Private equity and venture capital fund structures are designed to create alignment between investors and fund managers. Understanding how management fees, hurdle rates, carried interest, waterfalls, and clawbacks operate is critical for analyzing fund performance and for the CFA exam. European waterfalls delay GP carry until all LP capital and preferred returns are paid, while American waterfalls pay carry per deal. Clawback provisions can protect LPs if the overall fund return is below early deal expectations.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Limited partnership is the primary legal form for private equity and venture capital funds
- Management fees compensate the GP for basic fund operations; charged annually as a percentage of committed or invested capital
- Carried interest incentivizes performance; typically 20% of profits above the hurdle rate
- Hurdle rate or preferred return ensures LPs first receive a minimum return before GP receives carry
- Waterfall provisions govern the sequencing of distributions (European: whole-fund, American: deal-by-deal)
- Clawback provisions ensure GPs repay excess carry if later investments underperform

## **Key Terms and Concepts**

- limited partnership (LP)
- general partner (GP)
- management fee
- carried interest
- hurdle rate (preferred return)
- waterfall
- clawback

Private equity and venture capital - Fund structures fees and waterfalls