Put simply, capital gains are any profits earned from the sale of an asset, while a capital gains tax is the levy paid by investors on those profits. Private equity investors need to have a comprehensive understanding of capital gains as they are the primary method of returns, and the way they are taxed will have a significant impact on any profits made.

If a private equity investor disposes of their stake in a company or a private equity firm sells a portfolio company entirely, the difference between the initial investment and exit price is classed as capital gains, and there will be a tax due – assuming that it is sold for a higher price. So, for example, if a private equity firm buys a company for $10 million and sells it for $20 million, the capital gain is $10 million.

Once a private equity investment is sold, profits are then typically distributed using a so-called waterfall structure, through which capital gains are shared between limited partners (LPs) and general partners (GPs).

A typical waterfall distribution goes like this: once LPs have received the equivalent value of their initial investments, they will then receive an allocated amount known as the ‘hurdle rate’ – a predetermined minimum rate of return before GPs receive any money, usually anywhere around 6-10 percent. Only when the hurdle rate threshold is reached will GPs be able to realize any profits, usually by way of a so-called ‘catchup tranche’, which will see them receive 100 percent of any remaining capital gains until their participation percentage (typically 20 percent) is achieved. Following that, any residual gains tend to be subject to an 80/20 split in favor of LPs.

Depending on the firm’s jurisdiction and the duration of the investment, how private investors are taxed on capital gains can vary. It’s important to remember that any management or admin fees charged by private equity firms will affect the overall value of capital gains received by private investors.