Private equity: buyout mechanics, GP and LP structure, the J-curve, IRR versus MOIC versus DPI and the fee waterfall

What you will learn

• How a buyout fund is organised between general partner and limited partners
• How a leveraged buyout creates equity return from debt paydown, growth and multiple change
• Why fund returns follow a J-curve and what IRR, MOIC, DPI, RVPI and TVPI each measure
• How a whole-fund (European) waterfall with preferred return and catch-up distributes profit

Explanation

Structure

A private equity (PE) fund is usually a limited partnership with a planned life of about ten years. The general partner (GP) is the management firm that finds, buys and sells companies. The limited partners (LPs) are the investors: pension funds, insurers, family offices and, through feeder funds, wealthy private investors. LPs make a commitment; the GP draws it in capital calls over four to six years and returns it through distributions as companies are sold. The GP typically charges a management fee of around 1.5 to 2 percent per year on committed capital during the investment period, plus carried interest (carry), usually 20 percent of profits above a hurdle.

Buyout mechanics

In a leveraged buyout (LBO) the fund buys a mature company using a mix of fund equity and debt that is placed on the company itself. Equity return comes from three sources: (1) debt paydown from the company's cash flow, (2) earnings growth, and (3) multiple expansion, selling at a higher valuation multiple than the purchase multiple. Separate them: growth is skill, multiple expansion is often market luck, debt paydown is mostly leverage.

The J-curve

In the early years fees are charged on the full commitment while little capital is invested, and new holdings are carried at cost or marked down. Reported returns are therefore negative first, then rise as exits begin. Investors who judge a fund in year three are judging the bottom of the J.

Return measures

Rule of thumb: a high IRR with low DPI means the GP has marked companies up but not sold them. Trust DPI first, TVPI second, IRR last. A subscription credit line that delays capital calls can lift IRR without creating a single euro of extra profit.

Worked example

Hypothetical example, part 1 – one buyout. A fund buys a company for an enterprise value of €100 million, which is 8 × EBITDA of €12.5 million (EBITDA = earnings before interest, taxes, depreciation and amortisation). Financing: €60 million debt, €40 million fund equity. After five years EBITDA has grown to €16 million and debt has been repaid to €35 million. The company is sold at the same multiple of 8.

• Exit enterprise value: 8 × €16 million = €128 million.
• Equity at exit: €128 million − €35 million debt = €93 million.
• MOIC: €93 million / €40 million = 2.33×.
• IRR with a single entry and exit: 2.33 to the power of 1/5, minus 1, ≈ 18.4% per year.
• Sources: debt paydown €25 million, EBITDA growth (€16 − €12.5) × 8 = €28 million, multiple expansion €0. Total €53 million = €93 − €40.

Transaction fees, interest costs inside the company and taxes are excluded for clarity.

Part 2 – the fund waterfall. The fund has €100 million paid in and distributes €200 million in total, so profit is €100 million. Terms: 8% preferred return, 100% GP catch-up, then 80/20. Assume the preferred return, compounded over the actual holding periods, totals €40 million.

1. Return of capital: LPs receive €100 million.
2. Preferred return: LPs receive €40 million (running total €140 million).
3. Catch-up: the GP receives 100% until it holds 20% of profit distributed so far. Profit so far is €40 million, so the GP needs €10 million. Running total distributed: €150 million.
4. Remaining €50 million split 80/20: LPs €40 million, GP €10 million.

Result: LPs €180 million (1.80× net), GP carry €20 million, which is exactly 20% of the €100 million profit. Management fees (about €10 million over the life) were deducted before the €200 million was available, so deal-level gross returns were higher than the LP sees.

Common mistake

Practice activity

On paper: an LP paid in €50,000. After six years the fund has distributed €30,000 and reports a remaining NAV of €45,000. Calculate DPI, RVPI and TVPI, and state which part is realised.

Key takeaways

• A buyout's equity return comes from debt paydown, earnings growth and multiple change; separate them to judge skill.
• The J-curve means early negative returns are normal, not a verdict on the fund.
• Trust DPI first, TVPI second, IRR last; credit lines and marked-up NAV can flatter IRR.
• In a European waterfall the GP earns carry only after capital and the preferred return are paid, then catches up to its 20% share.

Next step

The next lesson moves to the riskiest end of private equity, venture capital and angel investing, where power-law outcomes and dilution decide the result.