Calculating Catch-up Interest and Catch-up Management Fees — 3E Management, LLC | Private Equity Consulting in Dallas, TX (2024)

General Partners make profits from carried interest, or incentive fees. General Partners can only receive incentive fees once a certain investment performance has been attained. This means that the Limited Partners only begin paying these fees once the fund has reached a pre-established preferred return, also known as a hurdle rate, for their investments first. These rates are a percentage of the profits generated and are typically around 20% but can be as high as 30%.

Catch-up Clause in the PPM

The terms and conditions of a private equity real estate investment are outlined in a document called the Private Placement Memorandum, or PPM. The clauses in a PPM determine how the income and profits of a property are allocated between the General and Limited Partners. Most private equity funds include a catch-up clause in the PPM. The purpose of a catch-up clause is to compensate the General Partner based on an investment’s total return rather than the return in excess of the preferred return. In other words, a catch-up is used to compensate the GP for the incentive fees lost due to a preferred return. After the LP’s preferred returns are reached, the GP will typically receive a disproportionately large amount of proceeds in order to “catch up” to the missed incentive fees due to the preferred return.

Calculating Catch-up

In practice, a catch-up means that a GP will earn a fee of a percentage of profits after the LP earns a preferred return. The LP will receive 100% of the property’s cash flow until their preferred return is reached. Once the preferred return is met, the GP will receive 100% of the income and profits until they reach their performance fee. For example, consider a deal where a LP has a 10% preferred return, and a GP has a 15% performance fee and a catch-up provision. The property’s income and profits would first be allocated 100% to the LP until the 10% hurdle has been reached. Then, the GP would receive 100% of the income and profits until they receive the 15% performance fee in full. Finally, any remaining cash flows are split between the GP and LP based on a predetermined schedule, with the majority typically going to the investors.

How the GP/LP Benefits from a Catch-up

If a deal includes a GP with a 15% performance fee, an 8% preferred return, and returns a 10% IRR, the GP receives 15% of 10%, or 1.5% of the total annualized profits. Without a catch-up clause, the GP is only entitled to 15% of the profits over the 8% preferred return, so they receive 0.3% of the annualized profits [0.15 X (0.10 – 0.08) = 0.003]. The investor is protected with or without a catch-up clause as the GP are not entitled to an incentive fee unless the investment meets the hurdle. A typical catchup structure is also paired with an investor-friendly clause outlined in the PPM known as the “clawback”. The clawback feature is meant to protect investors if a fund manager takes any incentive fees that exceed the amount agreed upon. This means that if the capital is not fully returned to the investors, the GP is obligated to pay back all the catchup funds they received.

Conclusion

The catch-up clause and clawback clause are features of the PPM that determine how a property’s income and profits are split between the General Partners and Limited Partners, as well as the fees paid to the investment manager. The specifics of the terms are laid out in the PPM, which is a document that should be closely read by potential investors to understand the investment’s risk profile and compensation they will receive.