The Basics of Private Equity Funds

Private equity (PE) refers to illiquid investments or securities that are not publicly traded on an exchange.
The investments can take many forms: venture capital (VC) (seed and early stage); mezzanine or distressed
debt; leveraged buyouts; timber, oil, and gas properties; and real estate. The typical PE firm is organized as a
limited partnership. The general partners (GPs) of the firm organize a fund and seek capital from the limited
partners (LPs). A limited partnership agreement (LPA) defines the terms of the relationship between the GPs
and LPs. The structure and compensation arrangements used by PE firms are highly standardized and a working
knowledge of frequently employed terms and arrangements of LPAs is important to understanding the division
of the profits and the drivers of returns in the industry.1 This note describes some of the basic features of LPAs
with a particular focus on the basic terminology and compensation practices that relate to GPs and LPs.

The Basics

GPs invest in deals that they believe offer an opportunity to earn high risk-adjusted returns. To achieve
this objective, they must find and evaluate deals and, when necessary, provide managerial and operational
support to their investee companies. For the most part, GPs provide only a small portion of the funding for
their investments (frequently 1% of the capital) and therefore they organize a fund and seek capital from LPs
to fund their investments. Because of the high risk and illiquid nature of the assets, investors in PE funds are
typically restricted to accredited investors.2 LPs include, among others, pensions and insurance companies,
endowments, and high-net-worth individuals. GPs retain virtually all the important decision-making authority
in a fund and, by comparison, LPs are usually passive investors with little say in the fund’s direction.

A typical PE fund has a finite life, usually 10 to 12 years, which cannot be extended beyond a predetermined
ending date unless the LPs agree to it. Assuming a 10-year fund life, the first 5 years are referred to as the
investment period. During the investment period, GPs are expected to put the lion’s share of the LPs’ funds to
work. Depending on the size and nature of the PE fund, a GP can invest in 10 (or more) portfolio companies
during this period. GPs typically reserve some amount of funds to make follow-on investments or cover losses
that might arise from these investments. The period from years 6 to 10 is referred to as the harvest period, during
which time GPs look to exit their investments by either selling them to a strategic or corporate buyer or to
another PE firm, or by taking the company public through an IPO. Since there is no public market for the
investments, exits are the means by which GPs realize cash from (i.e., monetize or liquidate) the investments.
If GPs exit the investments at reasonable returns, they will typically raise another fund sometime during the
harvest period and begin the investment process all over again.

For their efforts, GPs receive two forms of compensation from LPs: management fees and carried interest.3
Management fees are assessed annually (and paid quarterly) as a small percentage (1% to 3%) of an agreed-
upon capital base that is negotiated between LPs and GPs. Management fees are used to pay the fund’s
operating expenses that are associated with finding new investments (e.g., GPs’ salaries, rent, and travel).
Because fees are paid up front on an agreed-upon capital basis, they do not vary with fund performance. Most
often, management fees are paid on committed capital because at the beginning of the fund’s life, the workload
mainly relates to the GPs’ search for potential investments, and the cost of this search depends on the aggregate
size of the fund commitments rather than on the amount of capital invested to this point.4

Carried interest is a profit-sharing arrangement that serves to align GP and LP interests.5 Carried interest
represents the share of profits generated by the fund that accrues to the GPs. The 80%/20% carry structure is
a typical compensation structure in which 80% of the profits is paid to the LPs and 20% is paid to the GPs.
Profits arise as GPs exit investments and cash or stock (if the exit has occurred via an IPO) is received for the
portfolio company. As exits arise, some or all of the proceeds are typically distributed to the LPs. Because
normally GPs do not receive any carried interest until LPs have been paid back the entirety of their capital
contributed to the fund, the point of GP profit participation is called the make-whole provision. Profit in a PE
fund is therefore similar to a capital gain, in which the excess of exit proceeds over funds invested is the gain
or profit on a deal. Most frequently, the make-whole provision calls for the funds received from exits to be
pooled and distributed according to a waterfall agreement that defines the priority of payments between GPs
and LPs. In a later section of this note, we consider frequently used alternatives for how fees and carry can be
negotiated in an LPA.

The definitions of capital

Let’s look at the basic terminology and timing associated with the flow of funds through a PE fund. We
begin with definitions of the four Cs—four kinds of capital—that frequently arise in this context.

Committed capital: The maximum pledge of capital by LPs to a PE fund.

Contributed capital: The amount of capital called by the GPs as investments are identified and funding is
needed for them. It is also known as a capital call, takedown, or drawdown. Committed capital is typically not drawn
all at once and therefore LPs are legally obligated to respond to notice of a call and typically have 10 days to
two weeks to advance their funds to the GPs.

Invested capital: Contributed capital less management fees. Because management fees go to pay the GPs’
salaries and other expenses, those monies accrue to the GP and are not invested in portfolio companies.
Invested capital is the amount of capital that is actually invested by the fund that can grow and produce returns.
 Paid-in capital: The cumulative amount of contributed capital since fund inception. The year of fund
inception is referred to as the fund’s vintage year (VY).

Timing of fund flows

The timing of a PE fund is one in which most of the cash outflows (capital calls) occur early in the fund’s
life (during the investment period) and most of the cash inflows (distributions) occur later in the fund’s life
(during the harvest period from monetizations of the investments). Properly accounting for the timing
differences between the fund’s cash-in and cash-out events is fundamental to assessing the time-weighted
returns on PE investments.

Consider a PE fund that has $1,000 million in committed capital and calls $330 million in Year 1 and
$300 million in Year 2 of its life. Assume that the fund pays a 2% annual management fee on committed capital.
The capital accounts that correspond to this example are shown in Figure 1. Note that every year has two
distinct points in time: a beginning and an end—that is, in a given year, January 1 is separated from December 31
by a 12-month period. Generally speaking, capital calls are assumed to take place at the beginning of the year
and management fees are paid before investments are made until distributions arise.6 Therefore, the fund’s
invested capital in any period is contributed or called capital less management fees. At the beginning of Year 1,
GPs have $310 million at their disposal to invest in portfolio companies.

Figure 1. Timing of fund flows (in millions of dollars).

Assumptions:
Committed capital = $1,000 million
Management fee as % of committed capital = 2% per annum
LPs’ share of profits = 80%
GPs’ share of profits = 20%

1 2
Assets 0 343
Plus: Capital call 330 300
Less: Management fees −20 −20
Cumulative invested capital 310 623

ΔValue of investments 33 111

NAV before distributions 343 734
Less: Distributions to LPs and GPs 0 0
NAV after distributions 343 734
Source: All figures created by note writer.

It takes time for the investments to grow (or lose) value, and over the course of the year, GPs assess their
investments’ progress and determine the change in value relative to their initial cost or value at the end of the
previous period (ΔValue of investments). GPs differ widely in how they assess the value of investments and in
practice enjoy a good deal of discretion in how they value them.7 By convention in cash flow (CF) analysis,
events that arise during the year are assumed to fall at the end of the year. In this example, GPs report that the
value of their investments has increased by $33 million over the course of Year 1 and therefore, at the end of
Year 1, the NAV of the fund’s assets before distributions is $343 million. Distributions arise from exits as the
fund’s investments are liquidated and deducted from NAV before distributions. At the end of Year 1, it is too
soon for any exits to have occurred, and therefore the NAV before and after distributions is $343 million.

Note that the beginning of Year 2 falls at the end of Year 1 (January 1, Year 2 = December 31, Year 1).
NAV after distributions in Year 1 becomes the value of the fund’s assets at the beginning of Year 2. At the
beginning of Year 2, another $300 million is called and $20 million is deducted for management fees.8 The
fund’s cumulative invested capital is $623 million, which is the total value of capital calls less fees to date, plus
the unrealized gains or losses on prior investments. At the end of Year 2, the fund’s investments grow in value
by $111 million or 17.8% (= $111 million ÷ $623 million). The NAV before and after distributions is
$734 million.

Performance Metrics

With this timing in mind, let’s turn to the issue of how GPs and LPs are compensated and calculate some
widely used PE fund performance metrics. Figure 2 extends the previous example over the life of a PE fund,
which is shortened for expositional purposes to 7 years from the typical 10 to 12 years. In our example, we
introduce 80%/20% profit sharing between the LPs and GPs and assume that GPs cannot participate in profits
until LPs have been paid back the entirety of their contributed capital. In our example, the information is now
displayed in columnar form and, as noted, the values at the top of Figure 2 fall at the beginning of the year
and those farther down fall at the end of the year.

Relative to the earlier example, there are two additional capital calls at the beginning of Years 3 and 4. The
first distribution of $500 million occurs at the end of Year 4 and is followed by a $360 million distribution in
Year 5, a $250 million distribution in Year 6, and a $1,146 million distribution in Year 7. Because the fund’s life
is assumed to be 7 years, all of the NAV before distributions is paid out as a liquidating dividend in Year 7.

To determine the split of profits under the 80%/20% profit-sharing rule, we apply the make-whole
provision. Before GPs can participate in profits, LPs must have the entirety of their contributed capital returned
to them. In Figure 2, when the final takedown of $50 million occurs at the beginning of Year 4, at that point,
cumulatively LPs have paid in $820 million to the fund. Because GPs have not called all of the committed
capital (the fund is not fully drawn), the make-whole provision is determined relative to $820 million. Therefore,
until LPs receive cumulative distributions of $820 million, the full amount of any distribution accrues to them.
At the end of Year 4, the first distribution of $500 million is paid, and this reduces the amount the LPs are
owed to $320 million. When the next distribution of $360 million is paid, however, the balance owed to LPs
turns negative (−$40 million) because the cumulative distributions ($860 million) now exceed the amount owed
to LPs by $40 million. The $40 million is the amount subject to carry and GPs are entitled to receive 20% of this
amount as carry or $8 million in Year 5. Therefore, the total distribution in Year 5 ($360 million) is split with
$8 million going to GPs and $352 million going to LPs. After Year 5, LPs have been made whole, and any
remaining distributions are shared according to the 80%/20% rule.
 Next, we determine the CFs to LPs and GPs. The CFs to LPs include capital calls and their share of
distributions, whereas the CFs to GPs include management fees and their share of distributions. Because the
fund flows are displayed in columns, to account for the beginning-of-year convention, the CF series is moved
one column to the left. To understand this timing, consider the CFs to LPs. Note in Year 4 that $50 million is
called at the beginning of the year and $500 million is distributed at the end of Year 4. The CFs to LPs show a
$50 million outflow at the beginning of Year 4 (end of Year 3), and during Year 4, cash is received from the proceeds
of exits, and a $500 million inflow is distributed to LPs at the end of Year 4.

The treatment of management fees changes as distributions arise. Under LPA agreements, GPs are often
required to escrow the proceeds from exits to ensure that the monies are paid out according to the waterfall
agreement.9 For convenience, GPs frequently net fees from the LPs’ capital accounts, and after Year 4, it is
assumed that LP management fees are paid from escrowed proceeds.

To assess fund performance, we calculate two commonly used metrics: the since-inception (SI) internal
rate of return (IRR) and the ratio of total value to paid-in capital (TVPI), which is also known as the investment
multiple. IRR is a time-weighted return that accounts for the timing of capital calls and distributions, whereas
TVPI is the sum of distributions to date plus the remaining undistributed value of fund assets, divided by paid-
in capital. The SI-IRR is a special case of the IRR that equates the present value of all capital calls to the present
value of all distributions (inclusive of the final liquidating distribution). Since LPs are primarily interested in
how the fund performs on a net-of-fee-and-carry basis, the net SI-IRR and the net TVPI to LPs are calculated
from the CFs to LPs as displayed in Figure 2. The net SI-IRR to LPs is 20% and the net TVPI to LPs is 2.4×
(= sum of all distributions to LPs [$1,969 million] divided by paid-in capital [$820 million]).

Because distributions arise later in the fund’s life and fees are paid up front, an NPV can also be used to
assess the time weighting of the fund’s inflows and outflows. Because there are typically no immediate capital
outflows for GPs, an IRR cannot be calculated to assess GP performance and an NPV can be used to weight
the upfront nature of fees in relation to the back-end nature of carry. A discount rate is required to calculate an
NPV, and in practice the appropriate discount rate by which to benchmark PE investments is often difficult to
determine. Here we assume a discount rate of 15% per year. Using this rate, the NPV to LPs is $162 million
and the NPV of income to GPs is $207 million. Note that the NPV calculations recognize that the first CF
accruing to LPs and GPs in the respective CF series occurs at the beginning of the year.10
Page 6 UV6986

Figure 2. Application of the make-whole provision based on LPs’ contributed capital only (in millions of dollars).
Year 0 1 2 3 4 5 6 7
Beginning of the year
Assets 0 343 734 1,094 974 904 894
Plus: Capital calls 330 300 140 50
Less: Management fees -20 -20 -20 -20 -20 -20 -20
Cumulative invested capital 310 623 854 1,124 954 884 874
End of the year
ΔValue of assets (over the year) 33 111 240 350 310 260 272
NAV before distributions 343 734 1,094 1,474 1,264 1,144 1,146
Less: Distributions to LPs and GPs 0 0 0 -500 -360 -250 -1,146
NAV after distributions 343 734 1,094 974 904 894 0

Application of Make Whole

Amount owed to LPs before distributions 0 330 630 770 820 320
Less: Distributions to LPs and GPs 0 0 0 0 -500 -360 -250 -1,146
Amount owed to LPs (subject to carry) 330 630 770 320 -40 -250 -1,146
Amount of GPs’ carry 0 0 0 0 8 50 229

Distributions to LPs 0 0 0 500 352 200 917 1,969

Distributions to GPs 0 0 0 0 8 50 229 287
Total fund distributions 2,256
Total fund profits 1,436
LP profits 1,149
LP share of profits 80%
CFs to LPs -330 -300 -140 -50 500 352 200 917
CFs to GPs 20 20 20 20 20 28 70 229

Net SI-IRR to LPs 20.0%

Net TVPI to LPs 2.4
NPV to LPs 162.4
NPV Income to GPs 207.4
Frequently Used Variations in Management Fees and Carry

Several recent studies of PE fund terms provide evidence on the norms with respect to management fees
and carry. First, for PE funds established in VY 2010 and VY 2011, management fees average roughly 2%. Due
to their typically greater size, buyout funds have somewhat lower fees (mean = 1.9%; median = 2%) compared
to VC funds (mean = 2.3%; median = 2.5%).11 For buyout funds, fees decrease with the size of the fund and
average 2% on funds below $1 billion, 1.75% for funds between $1 billion and $5 billion, and 1.5% on funds
larger than $5 billion. After the investment period ends, nearly 40% of funds reduce the level of management
fees (on average by approximately 60 basis points) and 90% of funds change the basis upon which fees are
calculated from committed capital to some measure of (net) invested capital (e.g., paid-in capital less the cost
basis of distributed investments).12 The decline in fees after the investment period ends recognizes that the bulk
of the fund’s capital should have been invested and that the expenses of identifying new investments should be
accordingly lower.

For carried interest, the median carry rate is 20% across all funds, and this rate does not vary by fund size.
Although a majority of funds have carry determined by a whole-fund distribution rule, the incidence of this
rule varies considerably depending on where the fund is located and its investment orientation.13 For VY 2010
and VY 2011 funds, a whole-fund distribution rule is used by 88% of European funds, 74% of Asian and rest-
of-world funds, and 48% of North American funds.14 But 49% of North American funds, predominantly U.S.
VC funds, determine carry using a deal-by-deal distribution rule. A whole-fund distribution rule is considered
a more LP-friendly term because when carried interest is determined on a deal-by-deal basis, it can give rise to
clawback liability. As discussed later, clawback liability can arise from profits that GPs receive from early exits
that, if fund performance later falters, ultimately should have been paid to LPs—funds that LPs often find
difficult to recover from GPs.

GPs can also raise the threshold for profit participation by including a preferred or hurdle rate in the LPA.
Preferred rates typically range from 6% to 12% per annum, and 8% is the most commonly observed rate. The
vast majority of buyout funds and approximately 35% to 40% of VC funds include a preferred rate. LPs benefit
from a preferred rate because they receive a minimum rate of return beyond their contributed capital before
the GPs can participate in profits. When GPs provide a preferred rate to LPs, it is almost always coupled with
a GP catch-up provision. A catch-up provision allows GPs to “catch up” to LPs and receive their 20% share
of profits after LPs have been made whole.

Because of the high incidence of a preferred return, a GP catch-up clause, and deal-by-deal distributions
of profits in LPAs, the following sections of this note discuss how the CFs to LPs and GPs and returns differ
from those shown in Figure 2 when these terms are included.
Preferred Rate

In Figure 3, we extend our example to include a 6% preferred rate.15 The hurdle rate is an annual
compounded rate paid on contributed capital. In Year 1, $330 million of capital is called at the beginning of the
year and, under the preferred rate, the make-whole amount (amount owed to LPs) is raised to $350 million
(= $330 million × 1.06) at the end of Year 1. Relative to Figure 2, which did not include a preferred rate, the
balance owed to LPs before GPs can participate in carry increases by $20 million in Year 1
(= $350 million − $330 million). Since there are no distributions in Year 1, $350 million carries over as the
beginning balance in the LPs’ capital account when another $300 million is called. At the beginning of Year 2,
cumulatively, LPs are owed $650 million before GPs can realize carry, and the 6% hurdle increases this amount
to $689 million (= $650 million × 1.06) at the end of Year 2.

The same distributions occur as in our earlier example, but due to the preferred rate, GPs do not participate
in carry until Year 6 in Figure 3 compared to Year 5 in Figure 2. Therefore the main effect of a preferred rate
is to delay GP profit participation by raising the threshold of the make-whole provision. The inclusion of a
preferred rate increases the net SI-IRR to LPs to 20.5% and the net TVPI to LPs to 2.5×. The increase in
returns stems from the fact that LPs receive a greater share of fund profits from a 6% promised return above
their contributed capital. Since the total payout of distributions is the same (= $2,256 million), under a preferred
rate, LPs receive 82.8% of the profits in Figure 3 compared to 80% in Figure 2. The LPs’ 82.8% share of
profits is equal to their cumulative profits ($1,189 million) divided total fund profits of $1,436 million
(= $2,256 million − $820 million of paid-in capital). As a consequence, under a preferred return, GPs receive
less than 20% of the funds profits, or 17.2%.

Apart from the increase in LPs’ expected returns, there are some other important considerations with
respect to a preferred rate. If the preferred rate reflects LPs’ cost of capital, it incents GPs to invest in companies
that exceed the LPs’ cost of capital. If an investment is unlikely to exceed the preferred rate, GPs have an
incentive to look for better investments, and thus a preferred rate encourages GPs to avoid low-risk, low-return
investments that may not be able to clear this hurdle. The most frequently observed preferred rate of 8% may
have originated with pension funds that often use this order of discount rate to calculate future fund liabilities.
To the extent PE investments clear this discount rate, pension fund managers achieve a return sufficient to
meet their future financial obligations.16 Because the carried interest in a PE fund is a performance-based
reward, only profits that exceed the LPs’ cost of capital should be viewed as superior performance.
Page 9 UV6986

Figure 3. Application of the make-whole provision based on LPs’ contributed capital and a preferred return (in millions of dollars).
Year 0 1 2 3 4 5 6 7
Beginning of the year
Preferred Return
Preferred rate per annun 6%
Assets 0 350 689 879 484 153
Plus: Capital calls 330 300 140 50 0 0
Balance owed to LPs under preferred rate 330 650 829 929 484 153

End of the year

Amount owed to LPs under preferred rate before distributions 350 689 879 984 513 162 0
Less : Distributions to LPs and GPs 0 0 0 -500 -360 -250 -1,146
Amount owed to LPs (subject to carry) 350 689 879 484 153 -87.5 -1,146
Amount of GPs’ carry 17.5

Distributions to LPs 0 0 0 500 360 232.5 917 2,009

Distributions to GPs 0 0 0 0 0 17.5 229 247
Total fund distributions 2,256
Total fund profits 1,436
LP profits 1,189
LP share of profits 82.8%
CFs to LPs -330 -300 -140 -50 500 360 232 917
CFs to GPs 20 20 20 20 20 20 38 229

Net SI-IRR to LPs 20.5%

Net TVPI to LPs 2.5
NPV Income to GPs 189.4
Preferred Rate with a GP Catch-up Provision

Because the GPs’ share of profits drops below 20% with the inclusion of a preferred rate, a catch-up clause
is frequently included with a preferred rate to restore the GP share of profits to 20%. Under a GP catch-up
clause, once the LPs have been made whole (i.e., received their contributed capital plus the preferred return
back), GPs are entitled to “catch up to LPs” and receive 20% of the additional profits paid out under the
preferred return above the LPs’ capital contributions.

In Figure 4, we calculate the cumulative profits that GPs are paid under the preferred return. In Year 1,
LPs receive $20 million in additional profits under the preferred return (= $350 million − $330 million); in Year
2, $39 million (= $689 million − $650 million); and so forth. Cumulatively, LPs receive $202 million in additional
profits under the preferred return. At the end of Year 6, LPs are made whole (at this point, they have received
distributions equal to their cumulative contributed capital plus the preferred return), and LPs are not owed any
further payment under the make-whole provision in the final year.

Referring to the waterfall calculations shown in Figure 4, under the catch-up clause, GPs receive additional
distributions or carry of $50.6 million (= [$202 million ÷ 0.80 − $202 million] or [$202 million × 0.20 ÷ 0.80])
in Year 7. In Figure 3, the entire final distribution of $1,146 million was split between the LPs and GPs
according to the 80%/20% rule. Here, however, note that $50.6 million of the final-year distribution is directed
to GPs, leaving only $1,095.4 million to be distributed according to the 80%/20% profit-sharing rule. In Year
7, the LPs’ distributions are $876.3 million (= 80% × $1,095.4 million) and the GPs’ distributions are
$269.7 million (= $50.6 million catch-up provision + 20% × $1,095.4 million).

The total cumulative distributions and profits the fund generates remain unchanged, but the catch-up
provision alters the division of the distributions and profits. Under the catch-up clause, the cumulative profits
that accrue to GPs are $287.3 million (= $17.5 million in Year 6 + $269.7 million in Year 7) and their share of
total profits is restored to 20% (= $287.3 million ÷ $1,436 million) with the inclusion of a GP catch-up clause.
This is undoubtedly why GPs overwhelmingly seek to include a catch-up clause if they grant LPs a preferred
return on the fund.
Page 11 UV6986

Figure 4. Application of GP catch-up clause (in millions of dollars).

Deal-by-Deal Distribution Rule for Carried Interest

In our final example, we consider GPs that have negotiated a deal-by-deal distribution rule in their LPAs.
As mentioned, this more frequently applies to U.S. VC funds, and often some of the most reputed VC funds.
Just as the name suggests, a deal-by-deal distribution rule determines carry based on the amount of capital
contributed to a given deal compared to a whole-fund distribution rule. Suppose we alter our earlier examples
to allow for a deal-by-deal distribution rule rather than evaluating carried interest on a whole-fund basis. Assume
that LPs contribute a total of $330 million in capital in Year 1, and this is used to fund Deal 1 for $200 million
and Deal 2 for $130 million. At the end of Year 3, GPs have an early success on Deal 1 and exit it for
$300 million. If GPs also have a preferred rate of 6% per annum and a catch-up clause, then the split of the
profits on the proceeds of Deal 1 are as shown in Figure 5.

Figure 5. Application of deal-by-deal distribution rule with a preferred rate and GP catch-up clause
(in millions of dollars).
0 1 2 3
Beginning of the year
Preferred Return
Preferred rate per annum 6%
Capital account balance 0 350 371
Capital call: Deal 1 200
Capital call: Deal 2 130
Amount owed to LPs 330

End of the year

Deal 1 212.0 224.7 238.2
Deal 2 137.8 146.1 154.8
Amount owed to LPs before distributions 349.8 370.8 393.0

Exit proceeds from Deal 1 300.0

Profits on Deal 1 100.0 =300 − 200
Profits owed to LPs under preferred rate 38.2 =238.2 − 200
Amount owed to GPs under catch-up clause 9.6 =38.2 × 0.2 ÷ 0.8
Remaining amount to be distributed 52.2 =300 − 238.2 − 9.6
GPs’ 20% share of remaining distribution 10.4 =0.2 × 52.2

Distributions (carry) paid to GPs on Deal 1 20.0 =9.6 + 10.4

Distributions paid to LPs on Deal 1 280.0 =300 − 20

In this case, GPs receive a total of $20 million in carry from the $300 million exit on Deal 1. The balance
of exit proceeds is paid to LPs and they receive $280 million (= $300 million − $20 million). But the $280 million
that LPs receive on Deal 1 is less than their total capital contributed to the fund of $330 million and $393 million
inclusive of the preferred return at the end of Year 3. Therefore, if carry had been determined by a whole-fund
distribution rule rather than a deal-by-deal distribution rule, LPs would not have been made whole and the GPs
would not have received any carry from Deal 1. Thus a deal-by-deal distribution rule allows GPs to receive
carry on early successes, whereas a whole-fund distribution rule may not. Assume that the remaining years of
fund life elapse without another exit. At this point, the fund is likely nearing bankruptcy and LPs could be
attempting to liquidate the fund. LPs will attempt to claw back the $20 million in profits that GPs received
from their early participation in Deal 1 but, as with any protracted legal proceeding, these funds could prove
costly for LPs to recover, and this explains why over time LPs prefer carry determined by a whole-fund
distribution rule.
Conclusions

Understanding the flow of funds through a PE fund is often a challenging task for newcomers to PE. This
note provides an introduction to the economics of PE fund flows by emphasizing the basic terminology of
LPAs and providing applications of frequently employed compensation terms and practices. In reality, the
division of returns between GPs and LPs is fraught with many details, and LPAs can run 100 pages or more.
But a better understanding of fundamental contract terms can help prepare those seeking to enter the PE
industry with a solid foundation to tackle the more complicated terms that arise in practice.