Fund Accounting and Private Equity Waterfall Review

Practice flashcards covering fund accounting principles, NAV calculations, and the mechanics of Private Equity distribution waterfalls including ROC, hurdles, catch-ups, and clawbacks.

What is the primary purpose of fund accounting?

To accurately track a fund's investments, income, expenses, and liabilities so investors always know the true value of their investment through a fair and transparent calculation of the Net Asset Value (NAV).

What is the formula for Net Asset Value (NAV)?

$$\text{NAV} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Units Outstanding}}$$

What are three common examples of fund expenses?

Management fees, custody fees, audit/admin fees, and legal fees.

In the context of fund accounting, what is the importance of Accrual Accounting?

It ensures that all income earned and all expenses incurred are recorded regardless of when cash is received or paid, maintaining transparency and accuracy in NAV calculation.

How is Net Investment Income (NII) calculated?

$$\text{NII} = \text{Total Income} - \text{Total Expenses}$$

What is the difference between Realized and Unrealized Gains/Losses?

Realized Gain/Loss comes from securities that have been sold, while Unrealized Gain/Loss represents the change in value of investments that are not yet sold.

What is a Private Equity distribution waterfall?

The sequential order in which cash distributions at exit from a fund are allocated among stakeholders, specifically Limited Partners (LPs) and the General Partner (GP).

What are the four standard tiers of a Private Equity distribution waterfall flow?

1. Return of Capital (ROC), 2. Preferred Return (Hurdle), 3. GP Catch-up, and 4. Carried Interest (Profit Split).

What happens during the 'Return of Capital' (ROC) tier?

LPs get back $100\%$ of their contributed capital first to ensure capital protection before any profit sharing occurs.

How does Return of Capital (ROC) affect the management fee basis?

After the investment period, the fee base may step down to net invested capital or cost basis, where ROC reduces the base, leading to lower fees for investors.

What is the difference between a Hard Hurdle and a Soft Hurdle?

In a Hard Hurdle, the GP receives carry only after the LP receives capital and the full preferred return. In a Soft Hurdle, the GP can start receiving carry even before the hurdle is fully achieved.

What is 'Carried Interest' (Carry)?

The performance fee earned by the GP, typically $20\%$ of profits, after LPs have received their capital back and the preferred return (hurdle) has been met.

Define 'Clawback' in Private Equity.

A mechanism requiring the GP to return previously distributed carried interest if, by the end of the fund's life, the overall net performance falls below the required hurdle.

How does the Hurdle Rate differ between Private Equity and Hedge Funds?

In Private Equity, it is often a fixed percentage (e.g., $8\%$ p.a.) compounded annually on contributed capital. In Hedge Funds, it is often a performance target (e.g., $\text{SOFR} + X\%$) calculated on NAV.

What is a 'High Water Mark' (HWM) in Hedge Funds?

The highest NAV previously achieved by the fund; the GP must exceed this peak before any new performance fees can be earned.

What are 'Side Pockets' and why are they used?

Side Pockets are used to hold illiquid or underperforming assets separately, allowing the main fund to continue distributions while the side pocket assets are realized later.

What is the 'GP Catch-up' tier in the waterfall calculation?

A step where the GP receives $100\%$ of distributions until they have received their agreed percentage (e.g., $20\%$) of the total performance profits distributed up to that point.

In a numerical example where the LP received $\$29.40\,M$ in preferred profits and the catch-up is $20\%$, how much is the GP's catch-up distribution?

$\$7.35\,M$, because $\frac{7.35}{29.40 + 7.35} = 20\%$.