What Is a Catch Up in Private Equity?
Understand a crucial phase in private equity profit distribution, detailing how fund managers receive their share after investors meet specific return thresholds.
Private equity involves investments in companies not traded on public stock exchanges. General Partners (GPs) pool capital from Limited Partners (LPs) to manage these funds. GPs actively engage with portfolio companies to enhance their value, aiming to sell them for a profit and generate substantial returns for LPs.
Understanding Carried Interest
Carried interest is a fundamental component of General Partner compensation in private equity. It represents the share of profits GPs receive from a fund’s investments, distinct from any capital they personally contributed. This profit share acts as a performance-based incentive, aligning the financial interests of fund managers with Limited Partners. Carried interest is typically a percentage of profits generated above a threshold, commonly 20% of the fund’s gains.
Key Terms in Fund Distributions
The “preferred return,” also known as a “hurdle rate,” is a minimum rate of return that Limited Partners must achieve on their invested capital. General Partners cannot receive their carried interest until this threshold is met, protecting investors. A common preferred return rate typically falls within the range of 7% to 8% annually.
“Return of capital” refers to the initial repayment of the Limited Partners’ invested principal. LPs receive their original investment back before any profits are distributed to the General Partners. “Capital calls” are requests made by the GP to LPs for portions of their committed capital as investment opportunities arise. “Distributions” are the payouts of capital and profits from the fund back to the investors.
How the Catch-Up Mechanism Works
The “catch-up” mechanism is a specific phase within a private equity fund’s profit distribution structure. It allows the General Partner to receive a disproportionately large share of profits after Limited Partners have received their preferred return. This phase ensures the GP “catches up” to their agreed-upon percentage of total profits generated above the preferred return. Without a catch-up, the GP’s share of profits might be diluted.
This mechanism typically kicks in after two initial hurdles are cleared. First, Limited Partners receive 100% of distributions until their initial invested capital is fully returned. Second, LPs then receive 100% of distributions until they have achieved their preferred return.
During the catch-up phase, the General Partner typically receives a very high percentage, often 100%, of subsequent distributions. This continues until the GP’s share of cumulative profits equals their predetermined carried interest percentage, usually 20%, of all profits above the preferred return. For example, if a fund generates $100 million in profits above the preferred return, and the carried interest is 20%, the GP aims to receive $20 million. If, after the preferred return is paid, the GP has only received a smaller portion, the catch-up ensures they receive a larger share of subsequent distributions until their 20% target is met.
Consider a simplified example: LPs invested $100 million, preferred return is 8%. If the fund generates $120 million in total profit, LPs first receive their $100 million capital back. Then, they receive $8 million as their 8% preferred return. This leaves $12 million in profit ($120M – $100M – $8M) for distribution. If carried interest is 20%, the GP’s share is $2.4 million (20% of $12 million). The catch-up mechanism ensures the GP receives this $2.4 million after LPs receive their capital and preferred return.
Placement within Overall Fund Distributions
The catch-up mechanism is an integral part of a private equity fund’s “distribution waterfall,” which dictates the sequential allocation of profits. This tiered system ensures an orderly distribution of investment returns.
The first stage in this waterfall is the “return of capital,” where Limited Partners receive 100% of distributions until their initial invested capital is fully repaid. Following this, the “preferred return” stage ensures LPs continue to receive 100% of distributions until they achieve their agreed-upon preferred return.
Once both the capital and preferred return are distributed to LPs, the “GP catch-up” phase begins. During this stage, the General Partner receives a substantial portion, often 100%, of distributions. This continues until the GP has received their full carried interest percentage of total profits generated above the preferred return.
Finally, after the catch-up is complete, remaining profits are typically split. This often means 80% goes to Limited Partners and 20% to General Partners.