What is the function of the catch-up clause in a distribution waterfall?

The function of the catch-up clause in a distribution waterfall is primarily to allow general partners (GPs) to "catch up" on profit sharing after limited partners (LPs) have received their preferred returns or initial distributions. In many private equity or investment funds, the distribution waterfall outlines the hierarchy and manner in which profits are distributed among LPs and GPs.

When the catch-up clause is activated, it enables GPs to receive a larger share of the profits following the LPs’ preferred returns until a specified threshold of profit distribution is reached. This mechanism is essential because it ensures that once the limited partners have been sufficiently compensated for their investment, the general partners can then receive their share of the profits, often proportional to their agreement, which might explore the incentive structure of the fund.

This feature encourages GPs to maximize the fund's performance since their ultimate earnings depend on how well the fund does in generating returns that surpass the LPs' expectations. Thus, the catch-up clause plays a vital role in aligning the interests of GPs with those of LPs, contributing to a more robust investment strategy.