Structuring GP Catch-Up and Waterfall Provisions: Legal Best Practices for Private Funds

Designing a fund's economic structure is one of the most important components of private fund formation. Among the most negotiated elements are the General Partner (GP) catch-up and waterfall provisions—mechanisms that govern how profits are distributed between the Limited Partners (LPs) and the GP. These provisions directly affect fund economics, investor alignment, and long-term fund performance.

This article outlines legal best practices for structuring GP catch-up and waterfall terms, with a focus on clarity, compliance, and institutional expectations.

What Is a GP Catch-Up Provision?

A GP catch-up is a tier in the fund distribution waterfall that allows the GP to "catch up" on profits after LPs have received their preferred return (usually 8%). It is designed to bring the GP's overall share of profits (typically 20% carry) into alignment with agreed-upon fund economics.

Example: After LPs receive an 8% preferred return, 100% of subsequent profits go to the GP until the GP has received 20% of total profits, after which the remaining distributions are split 80/20.

What Is a Waterfall Structure?

A waterfall structure defines the order in which investment proceeds are distributed among LPs and the GP. Common models include:

  • European Waterfall: LPs receive all contributed capital and preferred return before the GP earns carry

  • American Waterfall: Carry is distributed deal-by-deal, which may accelerate GP compensation

Key Legal and Structural Considerations

1. Preferred Return (Hurdle Rate)

  • Standard hurdle: 8% IRR or annualized return

  • Must be clearly defined: cumulative, compounded, or simple?

  • Confirm whether it is calculated on contributed capital or invested capital

2. Catch-Up Mechanics

  • Percentage of distributions allocated to GP during catch-up (typically 100%)

  • Duration of the catch-up period (until GP reaches 20% of total profits)

  • Whether catch-up is deal-by-deal or fund-level

3. Carry Vesting and Clawback Provisions

  • Implement vesting schedules for GPs to align long-term incentives

  • Include clawback mechanisms to ensure LPs are not over-distributed in early years

4. Transparency and LP Disclosure

  • Clearly disclose waterfall mechanics in the Limited Partnership Agreement (LPA) and PPM

  • Model cash flow scenarios in LP presentations

  • Consider including illustrative examples of the waterfall in side letters

Institutional Best Practices

  • Use Whole-Fund Accounting: Favored by institutional LPs for fairness

  • Minimize Early Carry Overpayment: Use escrow or clawback to protect LP interests

  • Align Fees and Carry: Fee offsets and waivers should be consistent with waterfall tiers

Regulatory and Tax Considerations

  • SEC Scrutiny: Ensure waterfall disclosures meet fiduciary and anti-fraud standards

  • Tax Allocations: Match economic allocations with tax reporting to avoid IRS scrutiny

  • 409A and 83(b) Elections: Relevant for GP ownership and carry vehicle structuring

Avoiding Common Pitfalls

  • Ambiguity in waterfall definitions or math

  • Inadequate modeling of fund-level vs. deal-level outcomes

  • Failure to update LPs on realized distributions vs. expected performance

Design with Precision, Align with Transparency

GP catch-up and waterfall structures play a pivotal role in shaping fund economics and investor alignment. Fund managers must ensure these provisions are legally sound, clearly documented, and consistently applied.

For legal support in structuring or revising waterfall provisions, drafting LP agreements, or modeling GP economics, contact our private funds legal team at 786.461.1617 to schedule a consultation and optimize your fund's economic architecture.

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Using Side Letters Strategically: Legal Best Practices for Private Fund Managers