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Carried interest, management fees, preferred returns, hurdle rates, catch-up provisions, and clawbacks — the economic architecture of private equity funds is the most complex distribution logic in capital markets. This lesson explains how every element of that architecture translates into smart contract mechanics, and how firms like KKR, Hamilton Lane, and Apollo are already using it.
01 · Why Tokenize a Fund?
Private equity manages over $13 trillion in global assets. It is the highest-performing asset class over the past two decades. It is also, operationally, one of the least efficient — built on paper LP agreements, manually prepared quarterly reports, K-1s that arrive in March for investments made the prior January, and side letters negotiated bilaterally that create cap tables where no two LPs have exactly the same rights.
Capital calls are faxed or emailed. Distributions require wire transfers coordinated across dozens of banks. Carried interest calculations are performed in spreadsheets reviewed by external accountants. Secondary market transfers require GP consent, take weeks to execute, and involve legal documentation that can run to 200 pages. The entire operational apparatus is a monument to pre-digital finance — and it is exactly the kind of system that smart contracts were built to replace.
KKR tokenized a portion of its Health Care Strategic Growth Fund II through Securitize in 2022. Hamilton Lane followed. Apollo has explored tokenized feeder vehicles. BlackRock's BUIDL fund is functionally a tokenized money market fund. The institutional proof of concept already exists. What this lesson provides is the complete technical and economic framework behind it.
02 · The Two Token Types
A tokenized fund issues two fundamentally different instrument types. Understanding what each token encodes — and does not encode — is the prerequisite for understanding how the distribution waterfall works.
The LP token represents a fractional ownership interest in the fund's capital pool. Each LP token holder is entitled to their proportional share of distributions — subject to the waterfall order. LP tokens do not carry management rights over fund operations; they carry economic rights only.
The GP token encodes the general partner's economic rights — the management fee and the carried interest. These are the GP's compensation for managing the fund, and their structure creates the alignment of interest between manager and investor that defines the LP/GP model. The GP token is not publicly transferable; it is held by the GP entity and may not be sold without LP consent.
03 · The Core Mechanic
The waterfall is the economic heart of every LP/GP fund. It defines the exact order in which proceeds from portfolio investments are distributed — who gets paid first, who gets paid last, and under what conditions. In a tokenized fund, this logic is encoded in the smart contract and executes automatically on every distribution event.
100% of all distributions go to LP token holders until they have received back 100% of their contributed capital. No carry, no management fee, no GP participation in distributions until every LP dollar invested has been returned. This is the fundamental protection that makes LP investment viable — the LP is made whole before the GP participates in profits.
In a tokenized fund, the smart contract tracks total contributed capital per LP token wallet. Every distribution event first routes proceeds proportionally to all LP wallets until each wallet's cumulative receipts equal their recorded contribution. The capital return register is updated on-chain with every distribution — permanently and immutably.
Once capital is returned, 100% of distributions continue to LP token holders until they have received their preferred return — typically 8% per annum, calculated on contributed capital from the date of each contribution to the date of return. The preferred return is the LP's "cost of capital" — the minimum return they require before the GP participates in profits.
The smart contract calculates accrued preferred return per LP wallet using the contribution date recorded at token issuance, the contribution amount, and the configured annual hurdle rate. The calculation runs against each distribution event: if the LP's cumulative distributions since capital return are less than the accrued preferred return, 100% routes to LPs. Only when all LPs' preferred return is satisfied does the next tier activate.
Once LPs have received their preferred return, 100% of the next distributions go to the GP token holder — the "catch-up." The catch-up continues until the GP has received an amount equal to its carry percentage (typically 20%) of total profits distributed to date. The catch-up provision ensures that when the fund exits strongly, the GP ultimately receives exactly its 20% carry — not less, despite having received nothing until this tier.
Example: Fund raises $100M, returns $180M. LPs receive $100M capital return (Tier 1), then $8M preferred return (Tier 2) = $108M total. Remaining $72M to be split. GP catch-up captures enough to equal 20% of all profits: 20% × $80M profits = $16M GP carry. The catch-up tier routes distributions 100% to the GP until the GP wallet has received $16M. Then the residual flows to Tier 4.
After the GP catch-up is complete, all remaining distributions split: 80% to LP token holders (pro-rata by token count), 20% to the GP token holder. This is the steady-state carried interest split that defines PE economics — and continues until the fund is fully wound down. All residual profits from every portfolio company exit, beyond the catch-up, flow through this 80/20 split.
The smart contract's carry split logic is the simplest tier to encode but the most important to get right. The percentages are set at fund formation and are immutable — hardcoded in the contract, not adjustable by either party. The LP cannot reduce the carry; the GP cannot increase it. The immutability of on-chain waterfall logic eliminates an entire category of GP/LP dispute that arises in traditional funds when carry calculations are performed in spreadsheets.
The clawback is the GP's obligation to return over-distributed carry if the fund's final returns fall below the hurdle rate. In traditional funds, clawback enforcement is notoriously difficult — the GP may have spent the carry, moved assets offshore, or simply not have the capital to return. In a tokenized fund, a clawback reserve can be built into the waterfall: a percentage of each carry distribution is held in a smart contract escrow until the fund is fully realized.
The reserve mechanics: a configurable percentage (typically 25–35%) of each GP carry distribution is withheld and held in the smart contract's clawback escrow. At fund termination, if the total distributions to LP token holders satisfy the hurdle, the escrowed carry is released to the GP. If they do not, the escrowed carry is distributed to LPs to make them whole. The clawback obligation is now a funded reserve — not an unsecured promise from the GP.
04 · Under the Hood
The waterfall is the distribution logic. But a complete tokenized fund smart contract encodes several additional fund mechanics — each of which eliminates a manual process that traditionally requires fund administrators, legal counsel, and multiple parties' coordinated action.
The management fee accrues daily (fee rate / 365 × total committed capital) and is deducted from distributions before any waterfall calculation runs. The fee accumulator tracks accrued-but-unpaid management fees; each distribution event first clears the accumulated fee to the GP wallet, then processes the remaining proceeds through the waterfall. This eliminates the quarterly invoicing process through which GPs traditionally bill management fees.
Traditional PE funds call capital from LPs as needed — a capital call notice goes out, LPs have 10 business days to wire funds, and the fund administrator reconciles receipts. Tokenized funds can operate two models: (1) fully-funded at close — all committed capital deposited at token issuance — or (2) capital call model — where committed-but-uncalled capital is tracked in the contract and calls are issued programmatically. The capital call model requires LP wallets to maintain stablecoin reserves for call fulfillment, or a pre-funded escrow arrangement.
Many PE funds offer LPs co-investment rights — the ability to invest alongside the fund in specific deals, typically at reduced or zero management fee and carry. In traditional structures, co-investment rights are granted through side letters, exercised via separate subscription processes, and tracked separately from the main fund. In a tokenized fund, co-investment rights can be encoded as token options: an LP token holder above a certain threshold automatically receives a co-investment option token when a qualifying deal is identified. The option has a defined exercise window, a maximum allocation, and automatically converts to a deal-specific LP position if exercised within the window.
Traditional LP interest transfers require GP consent, legal documentation, and new subscription agreements — a process that takes weeks. In a tokenized fund, GP consent can be encoded as a two-signature transfer approval: the LP initiates a transfer request on-chain, which generates a pending transfer event. The GP wallet must countersign within a defined window (e.g., 30 days) for the transfer to execute. If the GP does not respond, the transfer either auto-approves (if the LPA permits) or auto-rejects. The consent record is on-chain and immutable. The process takes days, not weeks, and requires no legal documentation beyond the original subscription agreement.
Most PE LPAs include "key person" provisions — if named senior partners leave the GP, the fund enters a suspension period during which no new investments can be made and LPs may vote to terminate the fund or replace the GP. In a tokenized fund, a key person event can be declared on-chain by the GP or by a majority LP token vote. The fund contract immediately suspends new investment execution rights. LP token holders receive an on-chain governance vote to resume, terminate, or restructure. The entire process — which in a traditional fund requires written notices, consent solicitations, and legal opinion letters — executes through the smart contract governance module.
05 · Who Is Already Doing This
Tokenized fund infrastructure is not theoretical. The following structures are operational — providing both proof of concept and reference architecture for new tokenized fund issuances.
KKR partnered with Securitize to tokenize a portion of its Health Care Strategic Growth Fund II on the Avalanche blockchain. The tokenization enabled wealth management platforms to offer their clients exposure to a KKR private equity fund at lower minimums than direct LP commitments typically allow.
Hamilton Lane tokenized its Senior Credit Opportunities Fund through Securitize, enabling individual investors to access an institutional private credit strategy at minimums previously unavailable outside the RIA channel. The tokenized feeder structure provides all standard LP economic rights with on-chain distribution mechanics.
Apollo Global explored tokenized credit exposure through a partnership with Figure Technologies, enabling wealth managers to access Apollo credit strategies through tokenized instruments on the Provenance Blockchain. Apollo's approach emphasized T+0 settlement and automated distributions as primary operational benefits.
Franklin Templeton's BENJI fund — a tokenized US government money market fund on the Stellar and Polygon blockchains — is the longest-running tokenized fund product from a major asset manager. While a money market fund rather than PE, BENJI established the regulatory and operational template for tokenized fund structures that private equity managers have since adapted.
Securitize has emerged as the dominant institutional tokenized fund infrastructure provider — partnering with KKR, Hamilton Lane, Apollo, and others. Their DS Protocol (a modified ERC-1400 implementation) handles compliance, transfer restrictions, investor identity, and distribution mechanics for institutional-grade fund tokens.
BlackRock's BUIDL fund — launched March 2024, surpassing $1 billion AUM within weeks — is a tokenized money market fund that instantly became the benchmark for institutional tokenized fund credibility. BUIDL invests in US Treasuries and distributes yield daily as token dividends to all holders simultaneously.
06 · The Transformation
07 · What Fund Managers Need to Know
Most established fund managers use the feeder model — a new tokenized feeder fund holds a single LP interest in the existing main fund. This avoids restructuring the main fund's LPA, keeps institutional investors in the original structure, and limits the tokenization scope. Direct tokenization — where the main fund itself issues LP tokens — is cleaner economically but requires LPA amendment and approval from all existing LPs. For new funds, direct tokenization from day one is simpler. For existing funds, the feeder model is almost always the right starting point.
A fund that offers its LP tokens broadly — including to retail investors — risks being classified as an "investment company" under the Investment Company Act of 1940, which imposes extensive registration, disclosure, and operational requirements. Most tokenized fund structures rely on Section 3(c)(1) or 3(c)(7) exemptions — limiting investors to 100 beneficial owners or qualifying purchasers respectively. Exceeding these limits triggers Investment Company Act registration. This ceiling on investor count limits how far minimums can be reduced while maintaining the exemption.
The traditional PE fee structure charges 2% on committed capital during the investment period, switching to invested capital after. This distinction matters enormously in a tokenized fund because the fee calculation base must be tracked programmatically. If the fund uses a capital call model, the smart contract must track committed capital (total LP token commitments) separately from invested capital (amounts actually deployed). Getting this calculation wrong — even by a small margin — creates GP/LP disputes that are technically resolved but legally contentious.
A tokenized fund's secondary market price depends on an accurate NAV — the value of underlying portfolio investments. For liquid assets (public equities, money market instruments), NAV can be calculated continuously from on-chain price feeds. For illiquid PE investments, NAV requires quarterly appraisals that must be input to the contract by an authorized oracle. The quality of the NAV oracle — how frequently it updates, who controls it, and how disputes are resolved — directly affects secondary market pricing fairness.
Traditional PE funds rely heavily on side letters — bilateral agreements between the GP and specific LPs granting preferential terms (reduced fees, co-investment rights, most-favored-nation clauses). Side letters are negotiated individually and create a cap table where no two LPs have identical rights. Encoding side letter terms in a tokenized fund is technically possible but operationally complex — each LP's token metadata must reflect their specific terms. This is manageable for a small number of anchor investors but becomes unwieldy at scale. Most tokenized fund structures standardize terms across all token holders, eliminating side letters in exchange for the operational simplicity of a uniform token class.
If an existing fund is being tokenized — rather than a new fund being launched as tokenized from inception — the GP must obtain consent from existing LPs before changing the fund's transfer agent, record-keeping mechanism, or capital account structure. Most LPAs require LP majority approval (by capital commitments) for material amendments. Some LPs will consent quickly; others will require extensive diligence on the blockchain infrastructure and security. Build a 6–12 month LP consent process into the timeline for any existing fund tokenization.
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