How does a typical private equity waterfall work, including preferred return, catch-up, and carried interest, and how do you model it in a financial forecast?

• A. LPs receive preferred return first; after hurdle, catch-up to GP; then carried interest (usually 20%); model by tracking cumulative distributions to LPs and GP against hurdle and catch-up.
• B. GP receives all profits first, then LPs; no catch-up.
• C. There is no hurdle; all profits are split 50/50.
• D. Carried interest is 50% with no catch-up.

Answer: (A)

The main idea being tested is how a private equity waterfall allocates profits between limited partners and the general partner across a deal’s life, and how to mirror that in a forecast. In practice, investors (LPs) get their invested capital back plus a preferred return before the GP starts taking any carry. That preferred return is often framed as a hurdle rate—an annualized return the LPs must receive on contributed capital before upside is shared with the GP.

Once the LPs have earned the hurdle, the next phase is a catch-up. This step is designed so the GP can “catch up” to the intended carried ownership. In most structures, the catch-up allocates a large portion of subsequent profits to the GP (sometimes effectively 100% to the GP for a period) until the GP’s cumulative share equals the target carried interest on the overall profits (commonly 20%). After the catch-up is satisfied, the remaining profits are split according to the carried interest arrangement (e.g., 20% to the GP and 80% to the LPs).

Modeling this in a financial forecast means tracking distributions to LPs and the GP in sequence:

• First, allocate cash flows back to LPs to return their contributed capital plus the accrued preferred return.

• Then apply the catch-up so that the GP reaches the target carried percentage on total profits.

• Finally, distribute any remaining profits according to the carried interest split.

Keep in mind there are variations (different hurdle rates, compounding versus simple, and different catch-up formulas), but the described sequence—preferred return to LPs, catch-up to align the GP, then carried interest on the residual—is the standard framework and is what this question is testing.