When the cash flows arising from successful, exited investments are sufficient to repay a fund's invested capital as well as the preferred return it has attracted over time, the GP then becomes entitled to its carried interest stake. This stake is 20 percent of a fund'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 fund's cash flows crest above the preferred return obligation and stop its accrued interest 'clock' from further ticking, the LPs have received 100 percent of the fund's cash returns and gross profits up to then, and the GP none of them.
Because in a typical fund the LPs and the GP have agreed that they will share the gross profits 80/20, respectively, at that point, the fund's mechanics 'look back' and start to redress the balance by directing a disproportionate share of the fund's further cash flows as they arise to the GP. This is called the 'catch-up'. As the fund has now proven it can cover its return-of-capital and preferred return obligations, the GP is allowed to catch up with the LPs in its share of the profits. Mechanically, the cash flows now start to adjust in allocation between GP and LP such that the LPs' gross profit share goes down from 100 percent eventually to the 80 percent that reflects the agreed ultimate split.
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 fund. The GP 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, LPs generally seek a lower percentage and a slower build-up of profits for the GP, to protect themselves from cases where the fund may pay out profits above but not much more than the preferred return. LPs 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 GP.
If, however, a fund's cash flows from exited investments prove sufficiently strong, at some point the catch-up mechanism will lead to the GP receiving 20 percent of all gross profits earned. The mechanism then falls away, and neither the LPs nor the GP receive any excess, disproportionate distributions. Further cash flows (and therefore gross profits) are simply divided 80/20 between the two parties, respectively.
It should be noted that the catch-up was not a feature of the first few generations of private equity funds established in the industry's early days. It was added later by more successful GPs eager to capture their share of the gross profits of a fund, rather than of those profits net of the preferred return paid to LPs. 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 funds in due course. Many LPs 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 funds, the preferred return should be LPs' exclusive, undiluted income stream even on funds producing outstanding performance, well above the preferred return threshold, as a reward for their provision of the capital with which those risks are taken. However, while succeeding in retaining the 8 percent level of the preferred return on most funds (even in the context of a persistent ultra-low interest rate environment), LPs have yet to achieve this desired reversal of course on this term.