Private Equity Terminology That You Should Know!

The Limited Partnership Agreement (LPA) is the rulebook of the flow of money in private equity, and its terms define the relationship between investors (LPs) and the fund manager (GP).

Committed Capital vs. Invested Capital? American vs. European Waterfall? The language of private equity can feel like a barrier to entry, but mastering it is non-negotiable for any serious investor. 

Let's demystify the most critical terms that govern the flow of money in private equity.

1. The Capital Journey: From Promise to Investment It all starts with Committed Capital, the total amount an LP promises to invest in a fund. This capital isn't paid all at once. Instead, the GP makes a Capital Call to draw down portions of that commitment as needed to fund new investments. To bridge timing gaps between needing cash for a deal and receiving it from LPs, funds often use a Subscription Line of Credit, a short-term loan backed by the LPs' commitments.

2. The "2 and 20": How GPs Get Paid The classic fee structure has two parts:

• Management Fees: This is the "2" (though it's often lower now). It's an annual fee, typically 1.5%-2% of committed capital, that covers the firm's operational costs like salaries and rent.
• Performance Fees (Carried Interest): This is the "20." It's the GP's share of the fund's profits, usually 20%, but it's only earned after the fund clears a "hurdle rate" (a minimum return, often 8%) that goes to investors first. 

3. The Payout: How Profits are Distributed This is where it gets complex, and the details matter immensely.

• The Waterfall: This is the mechanism in the LPA that dictates the order of profit distribution. The key distinction is between a GP-friendly American (Deal-by-Deal) Waterfall, where the GP can collect carried interest after each successful exit, and an LP-friendly European (Whole-of-Fund) Waterfall, where the GP must return all committed capital plus the hurdle rate to LPs before collecting any carry.
• The Clawback: This is the LP's safety net in an American waterfall. If a GP collects a performance fee on early winning deals, but later deals underperform, the Clawback provision forces the GP to return any excess performance fees, ensuring they only get their agreed-upon share of the total net profits.

These terms aren't just jargon; they dictate risk, alignment, and ultimately, the net returns that end up in an investor's pocket. Understanding them is the first step in effective due diligence. There are sample LPAs and other helpful private equity documents available through Institutional Limited Partners Association (ILPA).