When the cash flow arising from successful, exited investments are sufficient to repay a structure's invested capital as well as the preferred return it has attracted over time, the general partner then becomes entitled to its carried interest stake. This stake is 20 percent of a structure's gross profits, that is, all gains after the return of invested capital, implicitly including the preferred return previously paid to LPs. In other words, at the point at which a structure's cash flows crest above the preferred return obligation and stop its accrued interest 'clock' from further ticking, the investors have received 100 percent of the cash returns and gross profits up to then, and the general partner none of them.
Understanding the Mechanics of Catch-Up in Private Equity
Because in a typical structure the investors and the general partner have agreed that they will share the gross profits 80/20, respectively, at that point, the mechanics 'look back' and start to redress the balance by directing a disproportionate share of the further cash flows as they arise to the general partner. This is called the 'catch-up'. As the venture has now proven it can cover its return-of-capital and preferred return obligations, the general partner is allowed to catch up with the investors in its share of the profits. Mechanically, the cash flows now start to adjust in allocation between general partner and investor such that the investors' gross profit share goes down from 100 percent eventually to the 80 percent that reflects the agreed ultimate split.
GP catch-up provisions can significantly impact the distribution of profits in private equity. Understanding these mechanisms is crucial for both general partners and investors to ensure alignment of interests. The speed of the catch-up can be an area of contention and negotiation between a GP and its LPs in coming to terms on a new venture. The general partner would prefer at the point when the preferred return is met that 100 percent of the incremental cash flows go to it until the 80/20 balance of profits is restored.
However, investors generally seek a lower percentage and a slower build-up of profits for the general partner, to protect themselves from cases where the venture may pay out profits above but not much more than the preferred return. Investors would usually regard such performance as inadequate in relation to risks taken, and therefore not meriting a full 20 percent carried interest reward to the general partner.
When Catch-Up Ends and Profit Sharing Stabilizes
If, however, a structure's cash flows from exited investments prove sufficiently strong, at some point the catch-up mechanism will lead to the general partner receiving 20 percent of all gross profits earned. The mechanism then falls away, and neither the investors nor the general partner receives any excess, disproportionate distributions. Further cash flows (and therefore gross profits) are simply divided 80/20 between the two parties, respectively.
The Evolution of Catch-Up Provisions: From Novelty to Standard Practice
It should be noted that the catch-up was not a feature of the first few generations of private equity structures established in the industry's early days. It was added later by more successful general partners eager to capture their share of the gross profits of a structure, rather than of those profits net of the preferred return paid to investors. This evolution reflects the growing sophistication of GP compensation structures. Probably because it was not a 'headline' term, but also because its operation was quite subtle in its impact, the catch-up was rather quietly incorporated as a standard feature across almost all structures in due course.
Many investors would like the history of this term to reverse course, and for it either to be eliminated entirely or watered down materially. They feel that, given the risks taken by most private equity structures, the preferred return should be investors' exclusive, undiluted income stream even on structures producing outstanding performance, well above the preferred return threshold, as a reward for their provision of the funding with which those risks are taken. However, while succeeding in retaining the 8 percent level of the preferred return on most structures (even in the context of a persistent ultra-low interest rate environment), investors have yet to achieve this desired reversal of course on this term.
