Catch-Up Provision

What is catch up in private equity?

Catch-up is the waterfall tier that sends most or all of the next dollars to the manager once investors have received their preferred return, until the manager holds its full carried interest share of total profits. ILPA calls it the period in which the general partner receives the majority or all of the profits.

Why a catch-up exists at all

A catch-up is a repair for a design choice made one tier earlier. Its existence depends entirely on whether the fund uses a soft hurdle or a hard hurdle.

With a hard hurdle, the manager's carry applies only to profits above the preferred return. Nothing needs catching up, because the manager never had a claim on the preferred-return dollars. ILPA's stated preference is exactly this: the carried interest calculation should ideally use a hard hurdle whereby the general partner's carried interest is based only on the portion of profits that exceed the investors' preferred return.

With a soft hurdle, the manager's carry is calculated on total profits including the preferred return, but investors are paid first. That leaves the manager behind on its own percentage as soon as the preferred return is paid, and the catch-up tier closes the gap. Everything practitioners argue about, the catch-up rate in particular, is a consequence of choosing the soft version.

The mechanics, tier by tier

A whole-of-fund waterfall runs in order. ILPA calls the all-contributions-plus-preferred-return-back-first model best practice, and its glossary describes the preferred structure as one that distributes all committed capital back to investors before the general partner begins to accrue carried interest.

• Tier one, return of capital. Every dollar of contributed capital goes back to investors.
• Tier two, preferred return. Investors receive the accrued preferred return, commonly quoted at 8 percent per annum for buyout and credit funds. ILPA defines it as the minimum return to investors to be achieved before a carry is permitted.
• Tier three, catch-up. A stated share of distributions, often 100 percent, goes to the manager until the manager holds its target percentage of cumulative profits.
• Tier four, the split. Everything after that divides at the agreed rate, classically 80 percent to investors and 20 percent to the manager.

The catch-up rate is the percentage of tier three that flows to the manager. At 100 percent the manager takes the whole tier; at 50 percent the tier splits evenly and the catch-up takes twice as long to complete. Perpetual private vehicles use the same grammar with different numbers. TPG Private Equity Opportunities discloses a performance participation allocation of 12.5 percent of total return subject to a 5 percent annual hurdle amount and a high water mark, with a 100 percent catch-up.

A worked example with the arithmetic shown

Assume a hypothetical fund that drew $100,000,000, returned all of it, and has $50,000,000 of profit left to distribute. Assume the preferred return is 8 percent per annum, not compounded, on the full $100,000,000 for three years, so the accrued preferred return is 0.08 times 100,000,000 times 3, which equals $24,000,000. Carried interest is 20 percent with a 100 percent catch-up. All figures are hypothetical.

Tier two pays investors $24,000,000.

Tier three asks how much the manager needs so that it holds 20 percent of cumulative profits distributed. Let that amount be X. Cumulative profits distributed at the end of the tier are 24,000,000 plus X, and the manager holds X, so X equals 0.20 times (24,000,000 plus X). Expand: X equals 4,800,000 plus 0.20X. Subtract: 0.80X equals 4,800,000. Divide: X equals $6,000,000.

Check that. After the catch-up, cumulative profits distributed are 24,000,000 plus 6,000,000, which equals $30,000,000, and the manager holds $6,000,000. Six million divided by thirty million equals 0.20. Correct.

Tier four splits the rest. Remaining profit is 50,000,000 minus 30,000,000, which equals $20,000,000. Eighty percent of that is $16,000,000 to investors and 20 percent is $4,000,000 to the manager.

Totals. The manager receives 6,000,000 plus 4,000,000, which equals $10,000,000, and 10,000,000 divided by 50,000,000 equals 0.20. Investors receive 24,000,000 plus 16,000,000, which equals $40,000,000, and 40,000,000 divided by 50,000,000 equals 0.80. The two add to $50,000,000.

Now run the same fund with a 50 percent catch-up. Let T be the size of tier three. The manager takes half of it, so 0.50T equals 0.20 times (24,000,000 plus T). Expand: 0.50T equals 4,800,000 plus 0.20T, so 0.30T equals 4,800,000 and T equals $16,000,000. The manager receives $8,000,000 and investors receive $8,000,000. Cumulative profits distributed are $40,000,000 and the manager holds $8,000,000, which is 20 percent. The remaining 50,000,000 minus 40,000,000, or $10,000,000, splits into $8,000,000 for investors and $2,000,000 for the manager. The manager's total is again $10,000,000.

So on a fully realized fund the catch-up rate changes only timing. It changes outcomes when profits run out mid-tier. Suppose total profit is $34,000,000 instead of $50,000,000. With a 100 percent catch-up the manager still reaches its full share: it takes $6,000,000 of catch-up, cumulative profits reach $30,000,000, the last $4,000,000 splits into $3,200,000 and $800,000, and the manager's $6,800,000 is 20 percent of $34,000,000. With a 50 percent catch-up only $10,000,000 is available above the preferred return, the manager takes half, or $5,000,000, and 5,000,000 divided by 34,000,000 equals 0.147, so the manager lands at 14.7 percent rather than 20 percent.

For contrast, the hard-hurdle version of the same $50,000,000 fund pays the manager 20 percent of profits above the preferred return: 0.20 times (50,000,000 minus 24,000,000) equals $5,200,000. That is $4,800,000 less than the soft hurdle with a catch-up produces.

Where it shows up in documents

The catch-up is a numbered clause inside the distributions article of the limited partnership agreement, usually the third or fourth subsection of a waterfall that reads as a sequence of "second," "third," "fourth" paragraphs. It is rarely titled "catch-up"; the heading is more often simply "Distributions" or "Distributable Proceeds."

In registered vehicles the same term surfaces in the securities description. TPG Private Equity Opportunities' exhibit describing its registered units states the performance participation allocation, the hurdle amount, the high water mark and the 100 percent catch-up in a single row of a class comparison table, which is the fastest way to read a modern perpetual fund's economics.

Two things to verify wherever you find it.

• Whether the preferred return accrues simple or compounded, and on what base. ILPA asks only that whatever accrual method is used be fully transparent and consistent over the life of the fund, so the convention is genuinely deal-specific.
• Whether carried interest is calculated on net profits after fund-level expenses. ILPA's guidance is that it should be, and on an after-tax basis.

Common mistakes

Believing the catch-up increases the manager's total carry. On a fund that fully realizes, it does not. It accelerates when the manager gets paid, which matters for the manager's cash flow and for clawback exposure, not for the terminal split.

Applying a catch-up to a hard-hurdle fund. If the documents use a hard hurdle there is no catch-up tier, and modeling one overstates the manager's carry by the amount computed above.

Assuming the catch-up rate is the fee. A 100 percent catch-up alongside a 5 percent hurdle and a 12.5 percent allocation is a different economic package from a 100 percent catch-up alongside an 8 percent hurdle and 20 percent carry, and only reading all three numbers together tells you which is richer.

Forgetting that an unfinished catch-up can be reversed. Where carry is paid early, ILPA recommends that accrued carried interest sit in escrow with significant reserves and that clawback amounts be repaid no later than two years after the liability is recognized.

How it relates to adjacent terms

The preferred return is the tier immediately before, and its accrual convention sets the size of the catch-up. A larger accrued preferred return means a larger catch-up, because the manager has more profit to catch up on.

The distribution waterfall is the containing structure, and whether it is European or American whole-of-fund versus deal-by-deal determines when the catch-up is even reachable.

The clawback is the catch-up's safety net. Paying a manager early through a generous catch-up on a fund that later writes down its remaining portfolio is precisely the fact pattern a clawback provision exists to unwind.