Structures · room 11 of 11
Carry and the waterfall.
No rulebook writes a waterfall, and the constitution writes all of it. Proceeds arrive at four gates in a fixed order, never at a split, and most negotiations are conducted entirely at the last of the four. The order the gates come in decides whether the manager and the investors are aligned or only look aligned.
01 · The structure
The economics of a fund
No rulebook writes a waterfall. The constitution writes all of it.
A periodic charge funds the manager's operations and is borne by the vehicle. Carried interest is a share of profit, and it arrives only after four gates, in a fixed order.
Four terms carry the economics, and all four are documentary. The constraints on them come from the constitution, from investors' own policies, from where the entitlement is held, and from the disclosure standard attaching to the rung the vehicle stands on.
- The periodic charge
The running charge borne by the vehicle, which funds the manager's operations through the years before any profit exists. It is the one part of the manager's economics that does not depend on an outcome, which makes the basis of computation a question about the manager's own balance sheet before it is a question about alignment.
- Carried interest
The manager's share of profit. It is held by named individuals, and the convention is that they hold it through a partnership of its own rather than through the manager entity. It is contingent, it is computed rather than agreed, and the computation is the subject of this page. What it is a share of, and on which date that share is struck, are questions the headline does not reach.
- The priority return
A compounding return on contributed capital, at a stated rate, which investors receive in full before the manager takes a share of anything. It is negotiated as investor protection and it is also a threshold the strategy has to clear. What it compounds on, and from which date, is settled in the definitions rather than in the rate, and it moves the answer further than the rate does.
- The catch-up
The band that brings the manager's share up to the agreed proportion of the profit distributed so far. Where that band starts, and what counts as profit distributed so far, are definitions and not headline terms. Two drafts carrying the same headline split distribute differently across the same portfolio, and all of the difference sits in a rate the term sheet does not state.
Each of the four is ordinary and each is negotiated in a paragraph. What they produce together is settled by the order, and the order is drawn once.
02 · The topology
The waterfall, drawn
Proceeds arrive at a gate, never at a split.
One fork sits under the stem, and it decides when the manager first receives anything contingent. Read the branches beneath it as the same four gates computed against two different pools, never as later stages.
One realisation, four gates, two bases of computation
- 01 Return of capital Contributed capital attributable to the realised investment is returned to the investors before anything else moves. Whether capital attributable to written-off investments, and to the charge already borne, comes back at the same time is not a detail of this gate. It is the clause at which the two bases of computation actually diverge.
- 02 The priority return Investors receive a compounding return on that capital, at the stated rate, until it is satisfied in full. The rate is fixed at the term sheet, and whether it was tested against what this strategy can actually clear, or carried across from the last fund, is fixed at the same moment.
- 03 The catch-up The manager then receives a stated proportion of further distributions until it holds the agreed share of the profit distributed so far. A full catch-up reaches that point inside one band. A partial catch-up shares the band with the investors, and takes as long as the distributions take.
- 04 The split Everything beyond is divided in the agreed proportions. This is the only one of the four that most term sheets describe, and it is the last of the four to be reached. A negotiation conducted entirely at gate 04 has agreed the least consequential of the gates.
05 · the point of divergence · where the basis of computation is chosen
05a
Whole-fund computation
- 05a.iCapital and priority return satisfied across the whole fund first
- 05a.iiCapital attributable to written-off investments carried in the same pool
- 05a.iiiCorrection rarely reached, because little has been distributed that could need repaying
The manager waits, and funds its operations from the periodic charge alone through the years before the first carried interest arrives. Whether it can do that is arithmetic, and the arithmetic is done before the basis is chosen or it is done in year three.
05b
Deal-by-deal computation
- 05b.iEach realisation computed on its own capital and its own priority return
- 05b.iiCarried interest distributed on the early winners, years before the portfolio is finished
- 05b.iiiCorrection moved out of the sequence and into a clawback covenant
It reaches the manager earlier and relies on the clawback for correction. Without a funded escrow and a properly secured obligation, the correction is a sentence in a document rather than a mechanism.
Six mechanisms hang off that sequence, and none of them is drawn. Each is a separate document term negotiated separately, and several of the six sit outside the constitution altogether.
At the end of life, if the manager has taken more than the agreed share of aggregate profit, it repays. The obligation runs backwards, from the end of the sequence to the beginning, and it is the only thing that corrects a computation which distributed too early. It is owed by individuals and met in cash, which is what separates it from every other term on this page.
A stated proportion of each carried-interest distribution is held back so the clawback can be met. That proportion is fixed once, against a portfolio that does not exist yet, and it is the only part of the obligation that is funded in advance. Everything above it depends on a guarantee, and the guarantee is drafted somewhere other than the constitution.
The waterfall is described continuously and struck on dates. Which dates, and what is valued on each of them, decides when the manager is first in carry. A term sheet describes the sequence. The interim computation dates decide when it actually runs, and they are ordinarily settled by whoever drafts the definitions rather than by whoever negotiated the terms.
Where a separate partnership holds the entitlement, that partnership and not the fund governs the individuals inside it. Vesting over time, good-leaver and bad-leaver treatment, and the mechanic for reallocating a departed member's unvested share are all terms of that partnership. None of them appears in the fund's own constitution, and investors negotiating the constitution do not see any of them.
Cash into the fund alongside the investors, and the arrangements by which that cash is funded. It is the part of the alignment that is not contingent on an outcome and not computed by anybody, which is why an investor reads it first and a manager negotiates it last.
A defined group whose departure, or reduced time commitment, suspends the investment period until the investors consent to a replacement. It sits on the input to the sequence rather than on its output: it stops new investment, and it removes nobody. That is the whole of what it does, and it is the whole of what an investor buys with it.
The sequence is the part everybody negotiates. The six terms beneath it are the part that decides whether the sequence can be enforced.
03 · The two bases
Basis of computation
One basis corrects itself. The other relies on a promise made years earlier.
Two bases, four questions. The answers differ on every one of the four, and not one of the four differences is visible in the headline terms a term sheet carries.
| By basis · by question | When the manager first receives carried interest | The clawback exposure created | The escrow that makes the clawback credible | The alignment consequence |
|---|---|---|---|---|
| Whole-fund computation | After the investors have received their contributed capital and the priority return, measured across the whole fund. On a long-dated portfolio that is years, and on some strategies it is most of the life of the vehicle. | Small by construction. Little has been distributed to the manager that could later need repaying, so the correction is rarely reached and the covenant behind it is rarely tested. | A modest holdback, because the obligation it secures is unlikely to be large. The escrow is a formality here rather than the load-bearing term, and it is ordinarily negotiated as one. | The manager and the investors reach their outcomes in the same order. The cost of that is borne by the manager and by nobody else, and it is a balance-sheet question rather than a drafting one. |
| Deal-by-deal computation | On the first realisation that clears its own capital and its own priority return, which can fall inside the investment period, while most of the portfolio is unrealised and unpriced. | Real, and it grows with every early distribution. The individuals have received the cash, met whatever their own position required of it, and no longer hold it. The obligation to repay arrives at the end of life, which is both the moment it is least fundable and the moment the investors owed it have the least remaining leverage over anybody. | The load-bearing term, and the one the whole basis rests on. Sized against a portfolio that has not happened yet, and tested for the first time at the end of the vehicle's life, against individuals rather than against the vehicle. | The manager can be in profit while the fund as a whole is not. Alignment then depends on a correction that has to be funded years later by individuals whose entitlement has already vested and already been distributed to them. |
04 · When it is reached for
The occasion
Both bases are ordinary. Only one of them was chosen for this portfolio.
Four occasions decide the economics, and every one of the four is knowable before a single economic article is drafted. Three are answered by the portfolio and the strategy behind it, and the fourth by the programme.
- Whole-fund computation
The answer where outcomes across the portfolio will be widely dispersed, where the investor base expects it, and where the manager can carry its own operations until the whole fund has cleared. That last condition is the one the negotiation skips. It is a number the manager already holds, and it can be produced in an afternoon.
- Deal-by-deal computation
Reached for where the team needs its economics inside the investment period rather than after it, which is a real need and not a defect. It is the wrong answer in any portfolio where early winners and late losers are both likely, unless the correction at 05b.iii is funded and secured at the drawing. The realisation order of a portfolio is not knowable in advance. That is the whole of the argument, and it does not improve with confidence.
- A priority return above what the strategy clears
The quiet failure. Carried interest becomes decorative, the manager's real economics reduce to the running charge, and the alignment the whole structure exists to create is gone. Nobody objects at closing, because at closing a high priority return reads as investor-friendly. It is tested against the strategy at the drawing, or it is tested by the portfolio.
- Carried interest across a programme
Where a fund, a parallel vehicle and a co-investment vehicle run beside each other, each computes its own waterfall unless an express basis says otherwise. There is no default aggregation and nothing supplies one. The manager can be in carry on one vehicle while another is under water, and every investor in the programme reads the programme as one thing.
None of the four is a matter of taste. The portfolio and the strategy decide three of them, the programme decides the fourth, and every one of the four is known before the constitution is drafted.
05 · The binding constraints
What binds
No regulator writes any of this. It binds exactly as hard.
Eight constraints bind the economics of a private fund. Every one is created by a document one of the two sides drafts, and each surfaces at a different moment in the life of the vehicle.
The constitution alone creates it. No rulebook read on this site writes a waterfall, so a market standard is a habit and not a rule, and a term inherited from the last fund carries no authority beyond the document it was copied out of. Surfaces in the first negotiation where an investor asks why this shape and not another.
Where the carried interest is held, and by whom. The jurisdiction of the carry vehicle, the individuals' own positions and the vesting mechanic each bear on it, and the three sit in three separate documents drafted by three separate sets of hands. Surfaces at formation if it is planned for, and at a departure if it is not.
The escrow proportion, the guarantee, whether the obligation is several or joint and several, and whether it survives a member's departure. Four terms, drafted in four places, and the clawback is worth the weakest of them. Surfaces at the end of life, when the individuals who owe it are least able to fund it.
Key person suspends. Removal is a separate provision carrying a separate consent threshold, and both sit in the same constitution, drafted at different moments by different hands. Which of the two an investor believes it bought is settled in the definition, and the definition is written once. Surfaces on the departure.
Nothing aggregates a programme by default. The express basis that would do it is a document term reaching three constitutions at once, and each of the three is drafted by whoever drafts that vehicle. Surfaces at the first distribution from whichever vehicle realises first, which is rarely the one the programme is named after.
The schedule itself, the good-leaver and bad-leaver definitions, the reallocation mechanic, and whether unvested entitlement returns to the remaining team or to the fund. Four terms of the carry partnership, settled in advance or not settled at all. Surfaces on the departure, and there is no retrospective drafting available afterwards.
Created by a side letter, and it reaches the terms of every other side letter in the raise. What it reaches is decided by its scope wording, and that wording is fixed in the letter that creates it. Surfaces when the election notices go out.
A waterfall is run by an administrator against the words as drafted, on a date, with the valuations available on that date. A definition that cannot be operated is not a definition, and every term above it is worth what can be computed from it. Surfaces at the first computation date, in a model that will not resolve.
A rule you can read has an author you can cite. These eight have an author too, and it is whichever side drafted first.
06 · Where it breaks
Failure
Each of these was signed by everyone. None of them was decided by anyone.
Five failure points, each created at drafting and met years later. The first carries the mark because its correction requires cash from individuals who no longer hold it.
- 01 Carried interest distributed on the early winners, in a portfolio whose later losses trigger the clawback The escrow was set at a proportion chosen when everybody was optimistic, and the guarantee was drafted by people who did not expect to reach it. Every other failure on this list is corrected by a document. This one is corrected by a transfer of cash that has already been spent, which is not a correction at all.
- 02 A catch-up drafted at a rate that produces a different split from the one the term sheet described Discovered at the first distribution, by an investor, in a model. Nobody misled anybody: the term sheet described a share, the draft described a mechanic, and the two were read by different people at different moments. There is no drafting cure afterwards, because the cure is a transfer of value from one side of the register to the other and somebody has to consent to it.
- 03 Key person defined by name in a fund raised five years ago The named individual has moved to a different part of the business, the definition has never been re-tested against what the individuals actually do now, and the trigger has two ways to fail. It fires when nobody wanted it to, freezing the investment period in the middle of a transaction, or it fails to fire when every investor had assumed it would. Both outcomes were decided at drafting, by a definition nobody has read since.
- 04 One carry vehicle spanning two funds A departure in year four crystallises entitlements in both, including in the fund that has not yet returned capital to anybody. The reallocation mechanic drafted with one fund in mind now operates across a second whose economics stand at a different point in their life, and the departing member, the remaining team and two sets of investors have three different views of what should happen.
- 05 A most-favoured-nation right that sweeps in a term granted for reasons that had nothing to do with price A strategic investor was given something for a strategic reason, and the scope wording of the anchor's right does not exclude it. The concession spreads across the register at the next election, and the manager reads that wording closely for the first time when the notices arrive. The exclusions were the negotiation. They were treated as the boilerplate.
Not one of the five is a surprise about the market. Each is a surprise about a document that was already signed.
07 · The three requests
The anchor investor
Three requests arrive in one letter. They are answered in three different documents.
A seat on the advisory committee, a reduction in what the investor pays, and a most-favoured-nation right. The first two are terms. The third is machinery, and it reaches every other term in the raise.
The committee exists because the constitution creates it, and its composition, its reserved matters and what a member may see are constitutional terms. A promise of a seat is therefore either a promise to exercise a power the constitution already grants, or a request to amend the constitution, and which of the two it is can be established by reading the document rather than by negotiating. The second question is what the member's presence does to the conflicts process, because the committee is one of the places that process runs through.
Not a promise about conduct: a differential term. Whether it is delivered through a separate class or series of the vehicle, or through an arrangement standing outside the constitution, decides two things at once. Whether the raise needs a constitutional amendment before the next close, and whether every other investor's most-favoured-nation election reaches it. This is the request capable of changing the vehicle rather than the paperwork around it.
Machinery rather than a term. The operative part is the exclusion set: by commitment size, by investor type, and by category of term. Drafted without one, it reaches every concession granted to anybody for any reason, including concessions that were granted for reasons unconnected with price. The election notices go out after the terms are granted, which is exactly why the scope wording is settled before the first of them is granted.
The three arrive together and are answered separately. Which of them reaches the constitution is the sentence a manager should be able to say before the letter is acknowledged.
08 · ADGM and the DIFC
The two centres
The centres do not write the economics. They fix the standard the description of them is judged against.
Three points, and only three. Each is this site's published reading of one centre or of both, and the sourcing is stated beneath it.
- The manager's own conduct duty
In the DIFC an Authorised Firm carries its own obligation to identify and address conflicts, and in substance to disclose material inducements connected with how a client came to be introduced. That duty is the manager's, whatever status any other party holds. Where a placement arrangement, an introduction or a related-party service sits inside the economics of the vehicle, this is the provision that reaches it, and it reaches it through the manager rather than through the fund.
Published on this site at Conduct and classification · The DIFC. No counterpart reading is published here for ADGM, so none is stated for it.
- The standard the rung fixes
At the public rung the offer document is of prospectus grade, drawn to a mandated content standard and issued under liability for what it says and for what it omits. Below it the standard is lighter by design, and what reaches an investor is a document carrying prescribed disclosure rather than a prospectus standing behind a registration an authority granted. The rung therefore fixes the standard against which the description of the economics is judged, and no disclosure can be judged without the standard it was written to.
Published on this site at The funds · ADGM and The funds · The DIFC.
- The forum, if a term is tested
A dispute about a catch-up is a dispute about a contract, and it is heard wherever the constitution says it is heard, which is a consequence of the domicile chosen at formation and drawn at vehicles and legal form. That is answered at the drawing of the structure, years before anybody has a reason to ask it.
Published on this site at Vehicles and legal form.
Where the reading stops · August 2026
Not one of the three writes a line of the waterfall. Whether either centre goes further and mandates a particular form of disclosure of the manager's own share, at any rung, is read from primary text or it is not stated at all.
09 · Where our part ends
The line
We draw the sequence. Your counsel drafts the articles that create it.
Whether an entitlement is held in the right place, and what it costs the individuals behind it, are tax and legal questions. Our structural analysis provides the framework within which appointed tax and legal counsel answer them, and a structural page that answered them itself would be worth less rather than more.
Seven items stay with the client and its own appointed advisers, and the last row below is what the room hands them.
Drafting and negotiation of the whole of the constitution's economic articles, including the definitions the computation actually runs on rather than the headline terms it is described by.
For the vehicle, for the carry vehicle and for every individual behind it, in every jurisdiction any of them touches. This page names the question and puts it to the counsel who answers it.
Partnership and employment counsel on vesting, on the good-leaver and bad-leaver definitions, and on the reallocation of a departed member's unvested share.
The holdback arrangements, the guarantee standing behind the clawback, and whether the obligation is several or joint and several, drafted before the first distribution rather than at the first shortfall.
The administrator's and the auditor's computation of the waterfall on each date it is struck, against the definitions as drafted rather than as described.
The most-favoured-nation election, its legal scope, and what has to be offered to whom once a notice has gone out.
The description of all of it, to the standard the rung requires, in the document that will be read back to the manager in any dispute about any of it.
What this room ends on: the four gates and the two bases drawn, what a draft actually produces set against what the term sheet describes, every shape rejected with the constraint that removed it, and the questions the instruments leave open stated rather than answered.
We draw the four gates and the two bases, compare what a draft actually produces with what the term sheet describes, and state which of an anchor investor's three requests reaches the constitution. The drafting, the negotiation and the signature stay where they are.
Read against the tier ladders and the DIFC conduct reading published on this site · August 2026