How does a private equity fund structure work? I'm confused by the GP/LP relationship and the fee waterfall.

Private equity fund structure follows a limited partnership model with distinct roles and an incentive-aligned fee structure. Let's break it down systematically.

The Players:

• General Partner (GP): The PE firm that manages the fund. Makes investment decisions, runs due diligence, sits on portfolio company boards. Typically commits 1-5% of fund capital.
• Limited Partners (LPs): Institutional investors (pensions, endowments, sovereign wealth funds) that provide 95-99% of capital. They have limited liability and no management control.

Fee Structure:

1. Management Fee: Typically 2% per year on committed capital during the investment period (first 5 years), then 2% on invested capital (remaining years). This covers salaries, office, travel.

1. Carried Interest ("Carry"): Typically 20% of profits above a hurdle rate. This is the GP's performance incentive.

1. Hurdle Rate (Preferred Return): Usually 8% per year. LPs must earn this return before the GP receives any carry.

The Distribution Waterfall (European vs. American):

European (Whole-Fund) Waterfall:

1. Return all contributed capital to LPs
2. Pay LPs the preferred return (8%) on all capital
3. GP catch-up: GP receives carry until they've received 20% of total profits
4. Remaining profits split 80/20 (LP/GP)

American (Deal-by-Deal) Waterfall:

• Same structure but applied to each deal individually
• GP receives carry earlier (after each successful deal)
• Riskier for LPs: early profitable deals generate carry, but later losses can't claw it back easily

Worked Example:

Summit Peak Fund III: $500M committed, 8% hurdle, 20% carry, European waterfall.

After 7 years, total distributions = $850M.

• Capital returned to LPs: $500M
• Total profit: $350M
• Preferred return: $500M x 8% x 7 years = $280M (simplified; actual is compounded)
• Since $350M > $280M, the hurdle is met
• GP catch-up until GP has 20% of total profit
• GP carry = 20% x $350M = $70M
• LP total: $500M + $280M = $780M (net of carry)

Clawback Provision:

If the GP receives carry on early deals but the fund overall underperforms the hurdle, the GP must return excess carry. This protects LPs in American-style waterfalls.

Exam Tip: Know the difference between European and American waterfalls and which is more LP-friendly (European, because carry is calculated on the whole fund, not deal-by-deal).

Explore PE fund economics in our CFA Level II Alternative Investments course.