What happens after LPs receive their preferred return in a waterfall structure?

In a waterfall structure typical of private equity fund distributions, Limited Partners (LPs) are often entitled to a preferred return before the General Partners (GPs) receive any share of profits. This preferred return is a predetermined rate of return on their invested capital, and once it has been satisfied, the next phase of distributions occurs.

After LPs receive their preferred return, GPs have the opportunity to "catch up" on their profit share. This means that the GPs start to earn a larger portion of the profits that remain after the LPs have received their preferred return. This catch-up provision is a way to balance the profit-sharing arrangement between LPs and GPs, ensuring that GPs can begin to recover their investment and earn incentive compensation as the fund performs well.

This approach aligns the interests of both parties and encourages GPs to maximize the fund’s performance, knowing they will begin reaping rewards after meeting LP expectations. Thus, choosing the option stating that GPs can begin to catch up to their profit share accurately reflects this element of the waterfall structure.