How Private Equity Funds Think About Returns, Risk & Carry
PE interviews stop being 'Can you build an LBO?' and become 'Do you think like a fund?' This guide gives you the fund-level mental model: how returns are measured, where risk hides, and how carry actually gets paid.
Note
Module Reading: This article accompanies the Returns, Risk & Fund-Level Thinking module in our Private Equity interview prep track.
Most PE interview prep focuses on deal-level mechanics—building an LBO, walking through Sources & Uses, calculating IRR. But the best candidates understand something deeper: how GPs think at the fund level.
This is where interviews shift from "Can you build a model?" to "Do you think like an investor?" Understanding fund-level thinking—how returns are measured, where risk actually lives, and how economics flow through waterfalls—is what separates candidates who get offers from those who don't.
The Fund-Level Mindset
When someone says "This fund targets 20%," ask yourself: Gross or net? Deal or fund? IRR or MOIC? These distinctions matter—and interviewers love to test them.
1. Returns in PE: Deal vs Fund vs LP Net
There are three distinct return levels in private equity, and interviews love to trap candidates by mixing them up.
A) Deal-Level Returns (Single Investment)
This is the return on one investment—a platform company plus any add-ons. Deal-level returns are driven by:
- Entry price (the multiple you pay)
- Value creation (EBITDA/FCF growth, margin improvement, pricing power)
- Deleveraging (debt paydown from operating cash flow)
- Exit price (the multiple you realize at exit)
B) Fund-Level Returns (Portfolio Aggregate)
Funds are portfolios of imperfect deals with different timing. Fund returns depend on:
- Winner vs loser mix—a few deals often drive most outcomes
- Concentration—how exposed is the fund to any single bet?
- Timing of cash flows—early distributions can boost IRR
- Recycling and follow-ons—capital redeployment where LPA allows
C) LP Net Returns (What Investors Keep)
LPs care about net-of-fees-and-carry performance. Industry reporting standards explicitly emphasize net measures for key metrics like TVPI and IRR. When evaluating fund managers, LPs focus on what they actually take home after the GP has been paid.
Interview Trap
If an interviewer says "This fund returned 25% IRR," immediately clarify: Is that gross or net? Gross fund IRR might be 25%, but after 2% management fees and 20% carry, net IRR could be 18-19%.
2. The PE Metrics You Must Speak Fluently
You need to know these metrics cold—what they measure, how to calculate them, and critically, what they hide.
MOIC (Multiple on Invested Capital)
MOIC = Total Value / Paid-In CapitalAlso called equity multiple or money multiple. Tells you how many times you made your money back.
Total Value=Distributions + Remaining ValuePaid-In Capital=Actual capital invested (not committed)Blind spot: MOIC ignores time. A 2.0x return in 3 years is excellent; a 2.0x over 8 years is mediocre. You need IRR to capture timing.
IRR (Internal Rate of Return)
IRR is the annualized return that accounts for timing of cash flows— when capital is called and when distributions are made.
Blind spots:
- Can be "gamed" by subscription credit lines (delaying capital calls)
- Early distributions disproportionately boost IRR
- Doesn't tell you how much money was actually made (need MOIC for that)
DPI, RVPI, TVPI (Fund Progress Metrics)
The Realization Metrics
| Term | Definition | Note |
|---|---|---|
| DPI | Distributions / Paid-In Capital | Realized multiple—actual cash back to LPs |
| RVPI | Residual Value / Paid-In Capital | Unrealized multiple—remaining NAV |
| TVPI | DPI + RVPI | Total value multiple (realized + unrealized) |
Why this matters: A fund with 0.5x DPI and 1.5x RVPI (2.0x TVPI) has only returned half of capital as cash—the rest is marks that may or may not be realized. LPs increasingly focus on DPI over TVPI because cash is real.
J-Curve (Why Early Returns Look Bad)
Private funds typically show negative performance early in their life. This happens because:
- Management fees are charged immediately on committed capital
- Investments are marked at cost (or slightly down for conservatism)
- Value creation hasn't had time to show up in marks
- No exits have occurred to generate realized gains
The classic J-curve improves as investments mature, get marked up, and eventually exit—turning negative returns positive.
PME (Public Market Equivalent)
PME answers the question: Did this fund beat public markets?It compares PE fund cash flows to a public index (e.g., S&P 500) to estimate opportunity cost and alpha.
- PME >1.0 means the fund outperformed the public benchmark
- Helps justify the illiquidity premium LPs pay for PE exposure
- Common methodologies: Kaplan-Schoar PME, Direct Alpha
The Interview Line That Shows Mastery
"I like to triangulate IRR + MOIC + DPI/TVPI, and sanity-check with PME so I'm not just celebrating illiquidity."
3. How GPs Underwrite Returns (Fund-Level Mindset)
A strong PE answer sounds like underwriting, not memorization. Here's how GPs actually think about returns:
A) Base Case: "How Do We Make Money?"
GPs build a return story that is simple and defendable:
Base Case Components
| Term | Definition | Note |
|---|---|---|
| Value Creation Plan | Specific levers tied to KPIs | Not generic—concrete initiatives with timelines |
| Deleveraging Path | How debt gets paid down | Cash conversion discipline, capex management |
| Exit Logic | Who buys it, why, at what multiple | Multiple exit routes preferred |
B) Downside Case: "What If the World Is Worse?"
GPs pressure-test every deal against adverse scenarios:
- Volume down 10-20%
- Pricing power evaporates
- Margin compression from input costs or competition
- Working capital drag (A/R extends, inventory builds)
- Higher interest rates / tighter credit markets
- Multiple contraction at exit
Then they ask: Do we survive? Do we still hit acceptable returns?The goal isn't to avoid all risk—it's to understand and price it.
C) Fund Fit: "Does This Deal Belong in Our Portfolio?"
Even a good deal can be wrong if it:
- Increases concentration beyond comfort (e.g., >15% of fund)
- Correlates with existing exposures (same macro drivers, end markets)
- Consumes disproportionate ops/management bandwidth
- Requires financing that won't exist in a stress environment
What Separates Good From Great Candidates
Anyone can talk about deal returns. Strong candidates talk about how the deal fits the portfolio—concentration risk, correlation with existing investments, and capital deployment pacing.
4. Risk: What Can Kill a PE Deal (The 7 Buckets)
Think about PE risk in 7 MECE buckets. If you can name these cleanly with mitigations, you'll sound senior.
The 7 Risk Buckets
| Term | Definition | Note |
|---|---|---|
| 1. Business Risk | Cyclicality, customer concentration, disruption, churn | Mitigate: recurring revenue, diversification, defensive positioning |
| 2. Execution Risk | Value creation plan fails, add-ons don't integrate | Mitigate: experienced ops team, realistic milestones, contingency plans |
| 3. Leverage/Refinancing Risk | Debt maturity wall, covenant pressure, rising rates | Mitigate: covenant headroom, staggered maturities, hedging |
| 4. Liquidity Risk | Can't exit when you want or at fair price | Mitigate: multiple exit routes (strategic, sponsor, IPO) |
| 5. Valuation Risk | Paid too high; exit multiple compresses | Mitigate: underwrite to flat/down multiples in base case |
| 6. Concentration Risk | One bad deal hurts the whole fund | Mitigate: position sizing limits, portfolio balance |
| 7. Governance/Operational Risk | Management quality, controls, reporting, fraud | Mitigate: DD on management, active board involvement, robust reporting |
How Funds Manage Risk in Practice
- Underwrite covenant headroom—not just a "comfortable leverage multiple" but actual cushion in stress scenarios
- Use downside cases to test survival (cash, covenants, liquidity under stress)
- Build portfolio balance—sector, geography, and exposure diversification
- Protect exits with multiple routes—strategic, sponsor-to-sponsor, and IPO as optionality
5. Carry & Waterfalls: How the Money Actually Splits
Understanding fund economics is essential for interviews. Here's how GP/LP money flows:
Step 1: Management Fees
Most funds charge an annual management fee around 1.5-2% of committed capital during the investment period. This typically steps down to 1-1.5% of invested capital after the investment period ends (usually years 4-6).
Why Fees Step Down
After the investment period, the GP isn't actively deploying new capital—they're managing existing investments to exit. Lower fee basis reflects reduced activity and aligns GP economics with fund lifecycle.
Step 2: Carried Interest ("Carry")
Carry is the GP's performance-based profit share—typically around 20% of profits—payable only after LPs hit certain return thresholds defined in the Limited Partnership Agreement (LPA).
Step 3: The Distribution Waterfall (4 Classic Tiers)
A standard waterfall allocates distributions in sequence. Until one tier is satisfied, you don't move to the next:
Standard Waterfall Structure
| Term | Definition | Note |
|---|---|---|
| Tier 1: Return of Capital | LPs receive their invested capital back first | 100% to LPs until capital is returned |
| Tier 2: Preferred Return | LPs receive a hurdle rate (often 7-9% IRR) | Compound return on capital before GP shares in profits |
| Tier 3: GP Catch-Up | GP receives distributions until caught up to carry split | Often 80-100% to GP until at agreed carry percentage |
| Tier 4: Profit Split | Remaining profits split per carried interest (e.g., 80/20) | 80% to LPs, 20% to GP after catch-up complete |
European vs American Waterfall
Waterfall Structure Comparison
| Aspect | European (Whole-Fund) | American (Deal-by-Deal) |
|---|---|---|
| Carry Calculation | Based on aggregate fund performance | Based on each deal independently |
| When GP Gets Carry | After LPs get capital back + pref on whole fund | Can receive carry on winning deals early |
| LP Protection | More LP-friendly—fund must work overall | Less LP-friendly—early winners pay carry before total picture is clear |
| Clawback Risk | Lower—carry based on realized fund performance | Higher—GP may need to return carry if later deals lose |
| GP Incentive | Focus on overall fund performance | Potential incentive to exit winners early |
Why Clawbacks Matter
In American waterfalls, if early deals generate carry but later deals lose money, the GP may have been overpaid. Clawback provisions require GPs to return excess carry at fund end—but enforcement can be complicated (personal guarantees, escrows, timing).
Clawback Mechanics
Clawback provisions ensure LPs receive the economics promised in the LPA. They're tested near fund end (or sometimes interim for deal-by-deal structures). Key elements include:
- GP personal guarantees or escrow requirements
- Tax gross-up provisions (GP may have paid taxes on carry already)
- Interim true-up calculations
- Fund-level aggregation at final liquidation
6. The Interview Framework That Always Works
When asked "How do PE funds think about returns, risk & carry?", structure your answer in this order:
5-Step Framework
- Return Levels: Deal vs fund vs net-to-LP
- Metrics: IRR, MOIC, DPI/TVPI, PME—and what each hides
- Underwriting: Base case + downside case + exit plan
- Risk: The 7 buckets + mitigations
- Economics: Fees + carry + waterfall + clawback
Clean, complete, hard to poke holes in.
7. Sample Interview Questions (With Model Answers)
8. Common Mistakes Candidates Make
Avoid These Errors
- Mixing up deal returns with fund net returns
These are fundamentally different concepts. Always clarify which level you're discussing. - Talking only about LBO drivers, ignoring portfolio + timing
Deal mechanics are necessary but not sufficient. Fund-level candidates discuss portfolio construction and cash flow timing. - Saying "IRR is better than MOIC" (or vice versa)
Neither is "better"—they answer different questions. Always cite both. - Describing carry without mentioning waterfall + clawback
Carry doesn't exist in isolation. Show you understand the full mechanics. - Ignoring exit risk
Liquidity and valuation risk are the most common real-world failure modes in PE. Not being able to exit—or exiting at a bad price—kills returns.
Frequently Asked Questions
Is "2 and 20" always the standard in PE?
No. While 2% management fee and 20% carry is common, terms vary significantly by fund strategy, size, and manager track record. Fees often step down after the investment period, and some top-tier funds command higher carry.
What's a typical preferred return?
Most PE funds have preferred returns in the 7-9% range, with 8% being very common. It's fund-specific and defined in the LPA.
Why do LPs prefer European waterfalls?
Because carry is based on whole-fund performance, reducing the risk that GP economics get paid early on winners and later need to be reversed via clawback when later deals underperform.
What does clawback actually do?
It's a mechanism to return excess carry if the GP was overpaid relative to final fund outcomes. Details vary, but it's a key protection—especially in deal-by-deal structures.
What's the cleanest way to benchmark PE vs public markets?
PME (Public Market Equivalent) is the standard approach. It compares fund cash flows to a public index to estimate opportunity cost and alpha.
What metrics should I cite in an interview?
Triangulate: IRR + MOIC + DPI/TVPI, and explain what each captures and misses. Add PME for public market comparison if relevant.
Key Takeaways
Key Takeaway
- Three return levels: Deal, fund, and LP net—don't mix them up
- Metrics work together: IRR for timing, MOIC for absolute return, DPI for realized cash, PME for benchmarking
- GPs underwrite three cases: Base (how we win), downside (how we survive), and fund fit (does this belong in our portfolio)
- 7 risk buckets: Business, execution, leverage/refi, liquidity, valuation, concentration, governance—with specific mitigations for each
- Fund economics flow through waterfalls: Return of capital → preferred return → catch-up → profit split
- European vs American waterfalls have different risk profiles—LPs generally prefer European for alignment
- Clawbacks protect LPs from GP overpayment in deal-by-deal structures
Understanding fund-level thinking is what separates candidates who can "do the work" from those who "think like investors." This is the mindset PE firms are hiring for—make sure you can demonstrate it under pressure.