Private Equity puzzles, solved step by step

Puzzles: 100
Traced to a firm: 22
Topics: 12
Hard: 30

Showing 1–9 of 9 · filtered from 100Clear filters

007LPs commit 1,000 to a fund. Over its life, fees total 150, so 850 is invested. The investments return 2.0x gross, or 1,700. The GP takes 20% carry on LP profit. What net multiple do the LPs earn?Fund economics numeracyCoreSecondaries and fund of funds
Try it first
Pick the net multiple to LPs.
Show the worked solution
The LPs earn 1.56x net. The 850 invested at 2.0x returns 1,700. LP profit is 1,700 less the 1,000 they paid in, fees included, which is 700. Carry at 20% of 700 is 140, so LPs receive 1,560 on 1,000. Fees cost 0.30x and carry 0.14x, so a 2.0x gross fund delivers 1.56x.
Why do fees and carry need separate treatment?
Think of a farmer who hands a contractor 100 kilos of seed. The contractor keeps 15 kilos as a fee and sows 85, then takes a fifth of whatever extra grain the harvest brings. Fees shrink the base that gets invested, while carry takes a share of the profit after the LPs have their money back. They hit at different points, so they cannot simply be added as percentages, and trying to do it in one step is where most answers go wrong.
So run it in order. Fees of 150 mean only 850 reaches companies. At 2.0x, 850 becomes 1,700. LPs paid in 1,000 in total, fees included, so the profit is 700. Carry at 20% of 700 is 140. The LPs receive 1,700 less 140, which is 1,560, a net multiple of 1.56x.
A fund returning 2.0x on invested capital delivers 1.56x to LPs once 150 of fees cut the invested base to 850, costing 0.30x, and 20% carry on the 700 of profit takes another 0.14x.
How big is the gap between gross and net, really?
Measured as a multiple, fees and carry take 0.44x off 2.0x, just over a fifth. Measured as profit, the gap is far larger: the LPs keep 560 of what would have been 1,000 of gross profit had every rupee been invested at 2.0x, so fees and carry together take 44% of the gain. That framing is why LPs negotiate hard over the fee base and the fee step-down after the investment period. A fee that looks small as an annual percentage of committed capital takes a large share of the profit over a ten-year life.
The relationship
$\text{Net} = \frac{850 \times 2.0 - 0.2\,(1700 - 1000)}{1000} = \frac{1560}{1000} = 1.56x$
850 capital actually invested after fees
0.2 the GP's carried interest share of profit
1700 - 1000 LP profit: proceeds less everything LPs paid in
What it says in wordsNet multiple equals proceeds less carry, divided by everything the LPs paid in.
What has the simple version left out?
Two things worth naming. Most funds pay carry only after LPs earn a hurdleA minimum return, often expressed as an annual rate, that LPs must receive before the GP earns carried interest. and then let the GP catch up; at a 2.0x outcome a full catch-up still leaves the GP with 20% of all profit, so the answer here holds. Timing is the bigger omission: net IRR falls further than net multiple, because fees are paid early and proceeds arrive late. Recycling of proceeds and fee offsets from portfolio companies would also change the figure.
Where candidates lose it
The common answer is 1.60x: take 20% off the 2.0x multiple. It treats carry as a share of everything returned rather than of profit, and it forgets fees entirely.
The quieter error is computing profit as 1,700 less 850. LPs paid in 1,000, fees included, and carry is on what they made over all of it. Say which base you are using before you subtract.
What the interviewer asks next
What gross multiple on invested capital gives LPs 2.0x net?
If fees were 100 instead of 150, what is the net multiple?
Why does net IRR fall further below gross IRR than the multiples suggest?
013A GP moves an asset from its old fund into a continuation vehicle at NAV of 500. The old fund's cost in the asset was 250, and 20% carry crystallises on the sale. How much carry is paid, and what does an LP holding 10% of the old fund receive if it sells rather than rolls?Fund economics numeracyCoreSecondaries and fund of funds
Try it first
How much carry does the GP collect on the transfer?
Show the worked solution
Carry of 50 is paid, and a 10% LP that sells receives 45. The transfer is a sale at 500 against a cost of 250, so the old fund books a profit of 250 and the GP takes 20% of it, 50. The remaining 450 belongs to the old fund's LPs; a 10% holder gets 45 in cash. The GP earns that carry at a price it helped set, which is the conflict LPs examine.
What is a continuation vehicle, in plain terms?
Picture a shopkeeper who manages a shop for a group of owners and is paid a share of the profit when the shop is sold. Instead of selling to an outsider, he sets up a new group, with some new owners and some old ones, and sells the shop to that group. A continuation vehicleA new fund, managed by the same GP, that buys one or more assets from the GP’s older fund so they can be held for longer. is the same GP selling an asset from its old fund to a new fund it also manages, so existing LPs can take cash or roll into the new vehicle. To the old fund the transfer is a sale, so its carry is calculated as though the asset had been sold.
A transfer at NAV of 500 against a cost of 250 books a profit of 250, of which 20%, or 50, is paid to the GP as carry, leaving 450 for old-fund LPs, so a 10% LP that sells receives 45.
Why does the transfer price matter so much?
Because the GP is on both sides of it. A higher price raises the carry the GP collects today; a lower price makes the new vehicle, which the GP also manages and earns carry from, a cheaper purchase. At 450, carry falls to 40 and old LPs get 410; at 550, carry is 60 and they get 490. Each 10 of price moves carry by 2 and the selling LPs by 8. That is why these deals usually rely on a third-party lead buyer setting the price and a fairness opinion, so the number is tested by someone without the conflict.
The relationship
$\text{Carry} = 0.2 \times (500 - 250) = 50 \qquad \text{LPs} = 500 - 50 = 450$
500 the transfer price, equal to NAV
250 the old fund's cost in the asset
0.2 the carried interest share
What it says in wordsCarry is a fifth of the gain over cost, and the LPs share everything else.
What has the simple version left out?
Carry in most funds is calculated across the whole fund, not deal by deal. If the old fund has losses elsewhere, or has not yet returned LP capital and the hurdle, the crystallised carry could be lower or held back in escrow. Transaction costs, a discount to NAV and the GP rolling part of its carry into the new vehicle all change the cash figures. Name those three, then give 50 and 45 as the answer on the question's terms.
Where candidates lose it
The common slip is 20% of the NAV, 100, treating carry as a share of value. Carry is always a share of profit over cost.
The second loss is missing why the question is asked. The arithmetic takes ten seconds; the point is that the GP earns carry on a price it influences, and the interviewer wants to hear you name the conflict and the usual protection against it.
What the interviewer asks next
If the selling LP instead rolls into the continuation vehicle, what does it own?
Why might a GP roll its crystallised carry into the new vehicle?
A buyer offers 92% of NAV. What carry is paid, and what do old LPs receive?

021A secondary buyer pays 85% of NAV for an LP interest with a NAV of 100 and 20 of unfunded commitment. Over three years the NAV realises at 1.3x, and the unfunded 20 is drawn and returns 1.5x. What is the buyer's MOIC?Fund economics numeracyHardSecondaries and fund of funds

Try it first

Commit before you work it: the buyer's multiple is closest to

Show the worked solution

About 1.52x. The buyer pays 85 for the NAV today and 20 more when the unfunded commitment is drawn, 105 in all. It receives 130 when the NAV realises at 1.3x and 30 when the drawn 20 returns 1.5x, 160 in all. 160 over 105 is 1.52x, roughly 15% a year if the money went out at the start and came back at year three. At full NAV the same deal would be 1.33x.

Why does the unfunded commitment belong in the sum at all?

Think of taking over a friend's gym membership halfway through. You pay him something for the months already paid up, but you also inherit the remaining monthly instalments, and in return you get every month of the membership that is left. Buying an LP interest transfers both the assets already in the fund and the obligation to fund the rest of the commitment, so the cheque you write today is only part of what the position costs. Here the buyer pays 85 now and 20 later, and the unfunded commitmentThe part of an LP commitment that the fund has not yet called. The buyer of the interest takes over the obligation to pay it when called. is money the buyer must find whether or not it wants to.

The buyer pays 85 plus 20 drawn, 105, and receives 130 plus 30, 160, so the multiple is 1.52x, compared with 1.33x if it had paid full NAV, and the unfunded 20 appears on both sides of the sum.

What are the numbers, line by line?

Money out: 85% of 100 is 85, plus 20 when it is drawn, so 105. Money in: the existing NAV of 100 grows 1.3x to 130, and the 20 of new capital earns 1.5x, which is 30, so 160. 160 over 105 is 1.52x, and the discount is what lifts it, because at full NAV the cost would be 120 and the multiple only 1.33x. Note that the 15-point discount is 15% of NAV but only 12.5% of the 120 of total exposure. Quoting the discount on NAV alone makes a secondary look cheaper than it is when a lot of the commitment is still to be drawn.

The relationship

\text{MOIC} = \frac{\text{NAV} \times m_1 + U \times m_2}{p \times \text{NAV} + U} = \frac{130 + 30}{85 + 20} \approx 1.52x

NAV	net asset value of the interest at purchase, 100
p	the price paid as a share of NAV, 0.85
U	the unfunded commitment, 20, drawn later
m_1, m_2	the multiples earned on the existing NAV and on the new capital, 1.3 and 1.5

What it says in wordsProceeds from the old assets and the new capital, divided by the price paid plus the capital still to be put in.

What does the simple version leave out?

Timing, mostly. The 20 is drawn after the purchase and the 160 arrives in pieces, so the 15% figure is only a placeholder for an IRR that depends on when each call and distribution lands. A later draw raises the IRR because less money is out for less time, which is one reason secondary buyers like interests with a large unfunded tail: the headline discount applies to a small NAV and the rest of the exposure is priced at cost. Say that out loud, then say what else is missing: the GP's management fee on the commitment, transfer costs and the fact that 1.3x and 1.5x are assumptions, not knowledge.

Where candidates lose it

The common loss is a half-count: including the 20 in the cost but forgetting that it also earns a return, which gives 1.24x, or counting the 30 of proceeds while pretending the 20 never had to be paid, which gives 1.88x. The unfunded commitment is either on both sides or on neither, and on neither is wrong.

The second loss is quoting the discount as a 15% bargain without noting that it applies only to the funded part. On total exposure of 120 it is about 12.5%, and the interviewer wants to hear that distinction.

What the interviewer asks next

If the unfunded 20 is never called, what is the MOIC?
The buyer is offered the same interest at 70% of NAV but the unfunded is 60 rather than 20. Is that a better deal?
Why do secondary buyers often price a young fund at a larger discount than an old one?

030A sponsor funds a buyout with 400 of preference shares compounding at 12% a year and 45 of ordinary shares for 90% of the ordinary. Management pays 5, at the same price per share, for the other 10%. After 5 years the equity is sold for 1,000. What does management receive?Fund economics numeracyHardMid-market buyout fundIndian mid-market PE
Try it first
Roughly what multiple does management make on its 5?
Show the worked solution
Management receives about 29.5, roughly 5.9x its money. The preference compounds to 400 x 1.12^5 = 704.9 and is paid first. That leaves 295.1 for the ordinary shares, and management's 10% is 29.5. The sponsor gets 970.5 on 445, about 2.18x. The structure gears management's small cheque on the ordinary hard.
Why does management do so much better than the sponsor on the same deal?
Imagine two friends buy a flat for Rs 50 lakh. One lends Rs 45 lakh at a fixed rate; both put a little cash in for the ownership. When the flat sells, the loan and its interest are repaid first and whatever is left belongs to the owners. If the price rises, the owners' small stake multiplies; the lender just gets the fixed rate. The preference share is the lender here: it takes a fixed 12% a year first, so all of the upside above that sits on the thin layer of ordinary equity where management's 10% lives. This is called sweet equityOrdinary shares sold to management at the same price as the sponsor, made valuable because most of the sponsor money sits in a senior preference instrument..
The relationship
$\text{Mgmt} = 10\% \times \big(1000 - 400 \times 1.12^5\big) = 10\% \times 295.1 = 29.5$
400 x 1.12^5 the preference with five years of compounding, 704.9
1000 exit equity
10% management's share of the ordinary equity
What it says in wordsManagement gets its share of whatever exit equity is left after the compounded preference.
Of 1,000 of exit equity the compounded preference takes 704.9 and the ordinary shares split 295.1, so management's 10% is 29.5, about 5.9x its 5; below 705 of exit equity management gets nothing.
What happens to management if the deal goes less well?
Run it at different exits. Because the preference keeps compounding whether the business grows or not, management's payout swings from nothing to many times its money over a narrow range of exit values. The table shows management's cheque and multiple at four exit values.
Exit equity Left for ordinary Management gets Multiple on 5
700 0.0 0.0 0.0x
800 95.1 9.5 1.9x
1,000 295.1 29.5 5.9x
1,200 495.1 49.5 9.9x
A 30% fall in exit equity, from 1,000 to 700, takes management from 5.9x its money to nothing, while the sponsor still recovers most of its cheque.
Sponsors measure this with the envy ratioThe price per 1% of ordinary equity paid by the sponsor, counting all its money, divided by the price per 1% paid by management.. The sponsor pays 445 for 90%, about 4.94 per point; management pays 5 for 10%, 0.5 per point, an envy ratio of about 9.9x. The limitation: the sums assume no leaver clauses, ratchets or management loan notes, all of which change who gets what in a real deal.
Where candidates lose it
The common loss is giving management 10% of the whole 1,000, which is 100, or 20x its money. That forgets that the preference sits ahead of the ordinary and has been compounding for five years.
The second loss is compounding the preference with simple interest: 400 plus 5 years of 48 is 640, not 704.9. That error hands management an extra 6.5 and makes the structure look safer than it is.
What the interviewer asks next
At what exit equity does management make 3x its money?
If the preference rate were 8% instead of 12%, how much would management get at 1,000?
Why do sponsors want the envy ratio high, and what stops them pushing it further?
038A fund draws 1,000 at once and returns 1,500 in a single distribution after 5 years. The waterfall has an 8% compounding preferred return, a full GP catch-up and 20% carry. How much does the GP receive, and what share of the fund's profit is that?Fund economics numeracyHardSecondaries and fund of funds
Try it first
Profit is 500. How much carry does the GP get?
Show the worked solution
The GP receives about 30.7, all of it from the catch-up, which is 6.1% of the profit. LPs first get their 1,000 back, then the 8% compounding preferred return: 1,000 x (1.08^5 - 1) = 469.3. That leaves 30.7. A full catch-up sends 100% of the next distributions to the GP until it holds 20% of profit, which would take 117.3, so the money runs out inside that tier.
What order does the money flow in?
Think of a restaurant partnership where the investor gets her money back first, then an 8% a year return on it, and only then does the chef share in the profit. A waterfall pays in tiers: capital back, then the preferred returnThe minimum return LPs receive before the GP shares in profit, often 8% a year, here compounding., then the GP's catch-up, then the 80/20 split, and each tier must fill before the next one starts. Here capital takes 1,000, the preferred return takes 469.3, and only 30.7 is left to flow further.
The relationship
$\text{Pref} = 1000\,(1.08^5 - 1) = 469.3 \qquad \text{Full catch-up} = \frac{0.2}{0.8}\times 469.3 = 117.3$
1.08^5 - 1 five years of 8% compounding, 46.9%
0.2 / 0.8 the catch-up needed for the GP to hold 20% of the profit paid so far
What it says in wordsThe catch-up tier is a quarter of the preferred return, because the GP must end with one part to the LPs' four.
Of 1,500 returned, 1,000 repays capital and 469.3 pays the preferred return, so only 30.7 reaches the GP catch-up, which needs 117.3 to fill; the GP's share of profit is 6.1% here and reaches the full 20% only at 1,587.
Why does the GP's share jump so fast just above the hurdle?
Because inside the catch-up tier every extra unit goes to the GP. Between 1,469 and 1,587 of proceeds, each additional 1 of exit value adds 1 to carry, so the GP's share climbs from zero to 20% across a band of only 117. Above 1,587 the split settles at 80/20 and stays there.
This is why secondaries buyers and LPs model carry near the hurdle so carefully. A fund sitting just above its hurdle has a GP with a strong incentive to push value up through that band, and a buyer of the LP interest must remember that much of the next gain goes to the GP. The limitation: real waterfalls run on dated cash flows, often deal by deal, with clawbacks; a single drawdown and exit is the clean case.
Where candidates lose it
The common loss is answering 100, 20% of the 500 profit, as if carry were a flat share. Near the hurdle the catch-up tier decides the answer, and here it is barely filled.
The second loss is using a simple 8% a year, 400 over five years, instead of compounding. That leaves 100 for the catch-up, and the GP's share comes out at 20%, not 6.1%. Ask whether the hurdle compounds before you start.
What the interviewer asks next
What would the GP receive with a 50% catch-up instead of a full one?
At what total proceeds does the GP first receive anything?
How does a deal-by-deal waterfall change the GP's carry on the same fund?
070A Rs 1,000 crore fund charges a 2% management fee on commitments for its first five years, then 1.5% on invested capital of Rs 800 crore for the next five. What are total management fees over the fund's life?Fund economics numeracyWarm upSecondaries and fund of funds
Try it first
Total management fees over ten years?
Show the worked solution
Rs 160 crore, or 16% of commitments. In years one to five the fee is 2% of Rs 1,000 crore, Rs 20 crore a year, Rs 100 crore in all. In years six to ten it is 1.5% of the Rs 800 crore invested, Rs 12 crore a year, Rs 60 crore in all. The early fees are charged on the full commitment, whether or not the money has been invested yet.
Why does the base change halfway through?
Think of a gym that charges full membership from the day you sign, even before you start going, and then a lower fee once you only use part of the facilities. During the investment period, fees are charged on what investors have promised, because the manager is busy finding deals; afterwards they usually drop to what is actually invested, because the job shifts to managing what was bought. The rates and bases differ from fund to fund, so read the agreement rather than assuming.
The fund charges Rs 20 crore a year for five years on Rs 1,000 crore of commitments and Rs 12 crore a year for five more on Rs 800 crore invested, a total of Rs 160 crore, 16% of commitments.
The relationship
$F = 5 \times 2\% \times 1{,}000 + 5 \times 1.5\% \times 800 = 100 + 60 = 160$
2% x 1,000 the annual fee on commitments in years 1 to 5
1.5% x 800 the annual fee on invested capital in years 6 to 10
What it says in wordsAdd the fees of each phase: rate times base times the years it applies.
Why does an investor in the fund care about this number?
Because fees come out of the investors' money before any profit is shared. Rs 160 crore of fees on Rs 1,000 crore of commitments means the investments must earn back 16% before the investors are even whole on what they put in. The early fees bite hardest: if only Rs 200 crore were invested in year one, an illustrative figure, the Rs 20 crore fee would be 10% of the money actually at work. That is why investors care about the fee base as much as the rate.
Where candidates lose it
The common slip is applying 2% to the full Rs 1,000 crore for all ten years and answering Rs 200 crore. The question gives a step-down in both rate and base; using it is the whole point.
The second is computing the second phase as 1.5% of 1,000. After the investment period the base is the Rs 800 crore invested, not the original promise.
What the interviewer asks next
If the fund also charges 20% carry over an 8% hurdle, what else must you know to estimate total cost?
How would fee offsets from portfolio company charges change the total?
Why do investors push for fees on invested rather than committed capital?
072An investor in a fund has paid in 800, received distributions of 600, and still holds a net asset value of 700. What are the DPI, RVPI and TVPI, and which of them is cash?Fund economics numeracyWarm upSecondaries and fund of funds
Try it first
Which ratio tells you how much cash the investor has actually got back?
Show the worked solution
DPI is 0.75x, RVPI is 0.875x and TVPI is 1.625x; only DPI is cash. All three divide by the 800 paid in. DPI counts the 600 distributed, RVPI the 700 still held at estimated value, and TVPI adds them, 1,300 over 800. On paper the fund is well ahead, but in cash the investor has 600 back on 800 and is still short of break-even.
What does each ratio measure?
Imagine lending a friend Rs 800 to start a business. She has paid you back Rs 600 and says your share of the shop is worth Rs 700 more. Rs 600 is in your wallet; Rs 700 is her estimate. DPI counts the cash back, RVPI counts the estimated value still held, and TVPI adds the two, all measured against the money paid in. In fund language: distributions to paid-in, residual value to paid-in, total value to paid-in.
Against 800 paid in, the investor has 600 back in cash and 700 still held as net asset value, so DPI is 0.75x, RVPI is 0.875x and TVPI is 1.625x, and only the DPI part is money in the bank.
The relationship
$\text{TVPI} = \text{DPI} + \text{RVPI} = \frac{600}{800} + \frac{700}{800} = 0.75 + 0.875 = 1.625\times$
DPI distributions over paid-in capital
RVPI residual value, the NAV, over paid-in capital
TVPI total value over paid-in capital
What it says in wordsTotal value to paid-in is the cash already returned plus the value still held, each divided by the money paid in.
Why does the difference between DPI and TVPI matter so much?
Because NAV is a valuation made by the manager, and it only becomes cash when the holdings are sold. A fund with a high TVPI and a low DPI is telling you it is worth a lot on paper, and investors have learnt to ask how much of that has actually come home. Here more than half the reported value, 700 of 1,300, is still an estimate. A buyer of this fund stake on the secondary market would price that 700 at whatever discount it thinks the estimate deserves, which is exactly why the split matters.
Where candidates lose it
The common slip is quoting TVPI as the return, 1.625x, and saying the investor has made 62.5%. That mixes cash with an estimate.
The second is dividing by commitments instead of paid-in capital, or adding NAV to paid-in. All three ratios share one denominator, the money actually called and paid.
What the interviewer asks next
What would DPI be if the fund sold the remaining holdings at a 20% discount to NAV?
Why might two funds with the same TVPI have very different IRRs?
A secondary buyer offers 90% of NAV. What is the seller's TVPI after the sale?
084A fund of 1,000 is drawn in full on day one and returns 1,800 in a single distribution after 5 years. The hurdle is 8% compounding, with a full catch-up and 20% carry. How much carry does the manager receive?Fund economics numeracyCoreSecondaries and fund of fundsLarge-cap buyout fund
Try it first
Before working the tiers: how much carry?
Show the worked solution
The manager receives 160 of carry. Investors first get 1,000 of capital and 469.3 of preferred return, 8% compounded for five years. The manager then takes 100% of the next 117.3 as catch-up. The last 213.3 splits 80/20. Manager's total: 117.3 plus 42.7, which is 160, exactly 20% of the 800 profit.
What order does the money flow in?
A distribution waterfallThe agreed order in which a fund pays out cash: capital back, then the preferred return, then catch-up, then the profit split. pays tier by tier, like a row of glasses being filled in turn: the next glass gets nothing until the one before is full. Capital comes back first, then the hurdle, then the catch-up, and only then the 80/20 split. Compounding 1,000 at 8% for five years gives 1,469.3, so the preferred return is 469.3.
Of the 1,800 returned, 1,000 repays capital and 469.3 pays the 8% compound hurdle to investors, the manager takes the next 117.3 as catch-up, and the last 213.3 splits 80/20, leaving the manager 160, exactly 20% of the 800 profit.
How big is the catch-up, and why does it end at 20% of all profit?
The catch-up runs until the manager holds 20% of everything distributed above capital. Investors already hold 469.3 of profit, so the manager needs c where c equals 20% of 469.3 plus c. That solves to a quarter of the preferred return, 117.3, after which every rupee splits 80/20 and the manager's share of total profit stays at exactly 20%. There was enough money to finish the catch-up, so the answer is simply 20% of 800.
The relationship
$c = \frac{0.20}{0.80} \times 469.3 = 117.3 \qquad \text{carry} = 117.3 + 0.20 \times 213.3 = 160$
469.3 preferred return, 1,000 x 1.08^5 less 1,000
117.3 catch-up, a quarter of the preferred return
213.3 what remains for the 80/20 split
What it says in wordsThe catch-up brings the manager level at 20% of profit so far; the split keeps it there.
Say the shortcut, then show the tiers as proof. If the fund had returned only 1,500, the catch-up would not complete: after the hurdle only 30.7 would be left, all of it to the manager, and carry would fall well short of 20% of the 500 profit.
Where candidates lose it
Candidates treat the hurdle as a deduction and pay carry only on profit above it: 20% of 330.7, about 66. A hurdle with a full catch-up is a gate; once the fund clears it with room to spare, the manager is made whole to 20% of all profit.
The other slip is using a simple 8% a year, 400, instead of compounding. That understates the hurdle by 69.3 and puts the catch-up in the wrong place.
What the interviewer asks next
What is the carry if the fund returns 1,500 instead of 1,800?
How does a 50% catch-up instead of a full one change the answer at 1,800?
Why do investors care whether the hurdle compounds or is simple?
089A fund makes two deals of 100 each. Deal A returns 300 in year 2. Deal B returns nothing and is written off in year 4. Carry is 20% with no hurdle. How much carry is paid under a deal-by-deal waterfall, and under a whole-fund waterfall?Fund economics numeracyHardSecondaries and fund of funds
Try it first
Under deal-by-deal, how much carry does the manager hold at the end of year 2?
Show the worked solution
Both end at 20 of carry, but deal-by-deal pays 40 in year 2 and needs a 20 clawback in year 4. Deal-by-deal pays 20% of A's 200 profit as soon as A exits. When B is written off, fund profit is only 100, so the manager owes 20 back. Whole-fund returns all 200 of capital first, then pays 20% of the 100 profit: 20, with nothing to settle.
What is the difference between the two waterfalls?
Picture a salesperson paid commission on each sale as it closes, against one paid at year end on the year's net result. The first gets paid for the good deals before the bad ones show up. A deal-by-deal waterfall pays carry on each exit as it happens; a whole-fund waterfallA distribution order in which investors get back all contributed capital across the fund, plus any hurdle, before the manager receives any carry. pays carry only after investors have their capital back across the entire fund. The final entitlement is the same here; the timing is not.
Under deal-by-deal the manager takes 40 when deal A exits in year 2 and must hand back 20 when deal B is written off in year 4; under whole-fund the 300 first repays all 200 of capital, then pays the manager 20 of the 100 profit, with nothing to settle.
Why does the clawback matter so much to investors?
The clawbackA promise by the manager to return carry it was paid early if the fund as a whole ends up earning less than the carry assumed. is only as good as the manager's ability to pay. By year 4 the 40 has been distributed to individual partners and often taxed, so recovering 20 can mean chasing people, not a fund account. That is why investors negotiate escrows that hold back part of early carry, or prefer whole-fund terms altogether. The manager, meanwhile, has had an extra 20 for two years for free.
Waterfall Year 2 Year 4 Final carry
Deal by deal +40 -20 clawback 20
Whole fund +20 0 20
Both waterfalls end with the manager holding 20 of carry, 20% of the fund's 100 profit, but deal-by-deal pays 40 two years early and recovers 20 through a clawback.
One honest caveat: whole-fund here still pays in year 2, because the 300 from A is enough to return both deals' capital. Had A returned only 200, the fund would have made no profit and whole-fund would never have paid carry, while deal-by-deal would have paid 20 on A's 100 of profit and then had to claw all of it back.
Where candidates lose it
The common slip is saying both waterfalls pay 20 and stopping. The interviewer wants the timing and the clawback, because that is where investors lose money in practice.
The other is ignoring B under deal-by-deal and leaving the carry at 40. Under either structure the manager is finally entitled to 20% of the fund's profit, not of the winners.
What the interviewer asks next
Add an 8% hurdle. How does each waterfall change?
Why do most buyout funds outside the United States use the whole-fund model?
How would an escrow of 30% of carry have changed the clawback problem here?

400 x 1.12^5	the preference with five years of compounding, 704.9
1000	exit equity
10%	management's share of the ordinary equity

Exit equity	Left for ordinary	Management gets	Multiple on 5
700	0.0	0.0	0.0x
800	95.1	9.5	1.9x
1,000	295.1	29.5	5.9x
1,200	495.1	49.5	9.9x

1.08^5 - 1	five years of 8% compounding, 46.9%
0.2 / 0.8	the catch-up needed for the GP to hold 20% of the profit paid so far

469.3	preferred return, 1,000 x 1.08^5 less 1,000
117.3	catch-up, a quarter of the preferred return
213.3	what remains for the 80/20 split

Try it first

Why do fees and carry need separate treatment?

How big is the gap between gross and net, really?

What has the simple version left out?

Where candidates lose it

What the interviewer asks next

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What is a continuation vehicle, in plain terms?

Why does the transfer price matter so much?

What has the simple version left out?

Where candidates lose it

What the interviewer asks next

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Why does the unfunded commitment belong in the sum at all?

What are the numbers, line by line?

What does the simple version leave out?

Where candidates lose it

What the interviewer asks next

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Why does management do so much better than the sponsor on the same deal?

What happens to management if the deal goes less well?

Where candidates lose it

What the interviewer asks next

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What order does the money flow in?

Why does the GP's share jump so fast just above the hurdle?

Where candidates lose it

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Why does the base change halfway through?

Why does an investor in the fund care about this number?

Where candidates lose it

What the interviewer asks next

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What does each ratio measure?

Why does the difference between DPI and TVPI matter so much?

Where candidates lose it

What the interviewer asks next

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What order does the money flow in?

How big is the catch-up, and why does it end at 20% of all profit?

Where candidates lose it

What the interviewer asks next

Try it first

What is the difference between the two waterfalls?

Why does the clawback matter so much to investors?

Where candidates lose it

What the interviewer asks next