Distribution Waterfalls

THE DEFINITIVE GUIDE FOR LIMITED PARTNERS LPs Are Diving into Waterfalls

Investing is about returns, and in private equity, how those returns are distributed to investors is dictated by the waterfall provisions of the Limited Partnership Agreement.

Yet, many investors have been paying Despite the challenges, many LPs investment data, these organizations less attention to this important are taking the plunge and wading are helping to break open the “black calculation than they should, mainly deeper into waterfalls in order box” and giving LPs the information because of the complexity of the to understand and project their they need to understand and monitor calculation and the difficulty in impact on investment returns. the waterfall. getting enough detailed information The sense of urgency has been to review it for reasonableness. spurred on by recent cases in which This white paper examines the high-profile institutional investors importance of distribution waterfalls, Part of the problem lies in the lack failed to recognize and understand the difference between the European of consistency around the data performance fees charged by the and American models, and the General Partners (GPs) provide to GPs. Across the board, LPs are key elements that LPs need to their investors, but the complexity becoming more rigorous about understand in order to confidently of the waterfall calculations has monitoring their investments review waterfall calculations. also created a considerable barrier. and more proactive about raising While most Limited Partners (LPs) potential issues with their GPs. have developed a level of comfort and familiarity with the more The work of industry bodies such Despite the straightforward calculations used as the Institutional Limited Partners challenges, many to determine management fees, Association (ILPA) and standards the distribution waterfall is more such as the Global Investment LPs are taking complicated and nonstandard, which Performance Standards (GIPS) is the plunge and can make even the most seasoned LP supporting this shift toward more feel out of their comfort zone. active oversight. By encouraging wading deeper into greater transparency around waterfalls

212-203-4685 | [email protected] | PEFServices.com 2 Waterfalls 101

A distribution waterfall defines the way the profit of a fund is distributed between the LPs and the GP. It also defines the distribution of carried interest to the GP once the threshold return is exceeded.

Essentially, the total profit is LPs according to the carried interest Given the impact that waterfalls distributed according to a cascading, calculation. have on returns, it’s important for tiered structure that gives the LPs to understand and be able to waterfall its name. When one tier’s However, distributions can vary review and verify basic waterfall allocation requirements are satisfied, significantly, depending on the calculations. According to a survey the excess funds are allocated method of waterfall used. While by Probitas1, 53% of fund managers according to the requirements of there are technically two different say that the distribution of carried the next tier, and so on. Typically, waterfalls (European and American), interest between senior investment distributions flow to the LPs first in waterfalls can also be hybrids or professionals is an important area of order to return contributions plus include variations and modifications focus, and 36% say the same about a preferred return, after which they that impact the way the returns are carry distribution waterfalls. are split between the GP and the distributed.

A BASIC WATERFALL SCHEDULE

Distribution Waterfall LPs assuming GP 1% equity interest GP (Equity) GP (Carry)

Return of Capital 99% 1% 0% Preferred Return 99% 1% 0% GP Catchup 0% 0% 100% Remainder 79.2% 0.8% 20%

1 Probitas Partners, Private Equity Institutional Investor Trends for 2017 Survey

212-203-4685 | [email protected] | PEFServices.com 3 Key Components of the Waterfall

Every waterfall calculation includes several key components: return of contributions, the preferred return to LPs, and the carried interest to the GP.

The waterfall is calculated on a realized basis at the time of an actual distribution and an unrealized basis for financial reporting. The unrealized waterfall assumes a hypothetical liquidation of the fund as of the reporting date. By understanding these components, you can better understand how it will impact your distributions and capital account at every step.

RETURN OF CONTRIBUTIONS The return of contributions is generally the first step in the waterfall, with 100% of distributions going to LPs until their capital contributions are recovered. While this is a fairly straightforward part of the waterfall, it’s worth examining these areas:

• Does the waterfall use European, American, or a hybrid method? • How are the expense contributions returned? Are they returned pro rata based on the cost of the investment being returned? • Are GP-waived management fees included in the return of contributions? • Are rolled deal fees included in return of contributions? • How are “written-off” vs. “written-down” investments treated? • Is the allocation based on commitment percentage or contributed capital percentage?

PREFERRED RETURN The preferred return is typically distributed after contributions are returned. When reviewing the calculations for the preferred return, be aware that:

• The time period typically starts on the due date of the capital call (rather than the actual payment date) and ends on the distribution date. • Some calculations begin when the initial investment is made. • Distributions might not be based on all contributions, because in certain situations capital calls for expenses must be paid in addition to the investors’ commitment. • The preferred return calculation can vary (i.e., simple interest, IRR, compounded). • Subscription lines of credit may impact the calculation.

212-203-4685 | [email protected] | PEFServices.com 4 CARRIED INTEREST Once contributions and the preferred return have been distributed to the LPs, the carried interest can be distributed to the GP:

• In some cases, there is a 100% catchup to the GP; in others, a split GP/LP catchup provision prolongs the hurdle calculation and delays full carried interest further. • Most funds have a 20% carried interest percentage, although this can vary depending on the fund type. For special purpose vehicles (SPVs), the percentage can be higher depending on the type of deal, while it can be lower for fund of funds and co-investment funds. • A clawback provision is standard, as is an escrow account in which 30–50% of the carried interest is deposited.

REALIZED AND UNREALIZED WATERFALL The waterfall should be calculated on both a “realized” and an “unrealized” basis. The realized waterfall allocates the actual cash proceeds from investments. It may include written-down and written-off investments. The carried interest includes the actual carried interest paid.

The unrealized waterfall is based on the hypothetical liquidation of the fund as of the reporting date. It assumes that all investments are realized at fair value and the carried interest includes both paid and accrued amounts. The accrued carried interest is typically shown as a reallocation line in the “Statement of Changes in Partners’ Capital” in the fund’s financial statements.

With the key components of the waterfall defined, let’s look at the variations of the European and the American waterfalls.

The waterfall should be calculated on both a “realized” and an “unrealized” basis

212-203-4685 | [email protected] | PEFServices.com 5 European vs. American Waterfalls

There are two basic methods into which private equity distribution waterfall schedules are classified: European or American.

The two methods are typically and distributable to the manager only the carry payable with respect to differentiated by the ways in which after a full return to the investors each investment that gets the fund they deal with the timing and of their contributed capital and to a net-cumulative-profits-to-date allocation of distribution proceeds to preferred return. With the European position. In this type of deal-by-deal GPs and LPs. In the end, the result waterfall, the first distributions waterfall, the first deal may return should be the same; it’s only the typically return all of the contributed some carried interest if the deal’s timing that differs. capital. internal rate of return (IRR) is above the preferred return. In the European waterfall, the With an American waterfall, the In the next few sections, we’ll take allocation of the distribution distribution proceeds are generally a closer look at the ways in which proceeds is determined at a “whole allocated on a deal-by-deal basis. these methods differ, the variations fund” level, and each distribution As a result, performance is tied to that exist for each, and the impact on reflects the aggregate performance each individual investment. This the timing of distributions for LPs. rather than being tied to an individual method is more beneficial to the GP investment. The carried interest is in the earlier years as it distributes determined on a net cumulative basis carried interest faster by making The two methods are differentiated by the timing and allocation of distribution proceeds.

212-203-4685 | [email protected] | PEFServices.com 6 Waterfall Methods: Pros, Cons, and Variations

Typically, the European waterfall is preferred by LPs, while the American waterfall is preferred by GPs.

Because the American waterfall In a European waterfall, 100% distributions rather than maximizing supports a deal-by-deal return of the contributed capital and long-term investment returns. Also, schedule, it allows managers to get preferred return is paid out to due to the delayed compensation, paid before investors receive all of investors on a pro rata basis before the European waterfall may also their invested capital and preferred the GP receives any distribution of make it challenging to attract senior return. For LPs, the drawback is that carried interest. Because it’s pro investment professionals to private while this waterfall still entitles the rata, all capital is treated equally equity firms and delay spin-out LP to a preferred return and their and distributions are paid out in teams, especially if they are not return of capital, it’s structured proportion to the amount of capital bringing a mature portfolio with so that a manager could receive a invested. One potential drawback them. disproportionate share of cash flow for the LP is that with a European early in the fund’s life cycle if there waterfall, managers may realize are significant early exits. positions quickly in order to receive

American Method European Method Distribution proceeds On a deal-by-deal basis At an aggregate fund level are paid... Prior to investors receiving 100% of After investors receive 100% of their Managers can be paid their invested capital and preferred invested capital and preferred return carried interest... return Returned for realized investments Returned in full before the General Partner Contributions are... and a pro rata portion of expense takes any carried interest contributions Calculated and returned for realized Calculated based on all contributions and Preferred returns are... investments and a pro rata portion of returned in full expense contributions Managers can receive a disproportionate Managers may be incentivized to realize The main disadvantage is... share of distributions earlier in the life of positions quickly rather than maximizing the fund long-term investment returns

212-203-4685 | [email protected] | PEFServices.com 7 European and American Waterfalls

To see how European and American waterfalls differ, let’s look at the Year 3 and Year 4 distributions in this example:

Y3 Distributions Y4 Distributions Total Distributions 10% LP GP 10% LP GP 10% LP GP American $4,950,000 $550,000 $4,470,000 $530,000 $9,420,000 $1,080,000 European $5,500,000 $ - $3,920,000 $1,080,000 $9,420,000 $1,080,000

As you can see, while both waterfall methods result in the same total distributions, the European method supports larger distributions for the LP and no distributions for the GP in Year 3.

To see a comparison of the American and European waterfall, including the pro rata portion of expenses, preferred return, and catch-up, download this Sample American and European Waterfall Calculations spreadsheet.

WATERFALL TRENDS AND VARIATIONS While there are generally two methods of the distribution waterfall, in reality, LPs are likely to see many different variations and modifications.

GPs may offer: • A choice of American vs. European waterfall, with a discounted management fee and/or carried interest offered to LPs that choose the American waterfall. • A discounted management fee in exchange for a higher carried interest rate above higher hurdles. • A hybrid waterfall in which a European calculation is applied until distributions reach a certain percentage, after which they are distributed according to the American waterfall. • A modified American waterfall in which: ◦ Write-downs as well as write-offs are included in the calculations. ◦ All expenses and preferred return are distributed before carried interest is paid. ◦ Carried interest or interim clawback is modified to be based on the unrealized waterfall position.

212-203-4685 | [email protected] | PEFServices.com 8 Checking the Waterfall

Now that we have identified the key components of a waterfall calculation and analyzed the European and American methodologies, we can examine the items that LPs can focus on during the review of the waterfall calculations.

Waterfalls are highly individualized • Timing and priority of return of (before any reduction for carried and complex calculations, and it’s contributions and preferred return interest)? If the answer is yes, generally unrealistic for LPs to • Treatment of waived management for a European waterfall there expect to be able to review and fees and rolled deal fees should be no carried interest confirm every figure. However, they • Tax distributions allocation. can identify potential red flags by • The recycling of proceeds • Are your inception-to-date gaining familiarity with the provisions • Additional hurdle provisions contributions plus preferred outlined in the Limited Partner return less than your Other information that is typically Agreement (LPA) and conducting a distributions plus your gross not available to LPs can complicate few basic reasonableness checks. capital account balance? If yes, their analysis: your carried interest allocation • Fee-, non-fee-, or reduced-fee- should be roughly 20% of the paying investors excess of your distributions plus • Side-letter agreements your gross capital balance less your contributions (assuming a Each of these variables can impact 20% carried interest). how fees are calculated and allocated • If there is a current period net as well as the timing of distributions. loss, is prior carried interest CONDUCT allocation being reversed? REASONABLENESS CHECKS TALK TO YOUR GP To conduct reasonableness checks on In the rare instance where the the waterfall calculations, it’s helpful review uncovers something that to have quarter-to-date, year-to-date, doesn’t add up, reach out to the and inception-to-date data, including GP for clarification. The majority separately stated carried interest of GPs are very open to answering (paid vs. accrued), management fees, investor questions, and starting a and any other category of expense conversation is a better use of your REVIEW THE LPA that might not be allocated pro rata. time than painstakingly recalculating PROVISIONS the waterfall. The distribution section of the LPA Some questions to ask are: contains information that can help • Are your inception-to-date LPs interpret the waterfall and the contributions greater than special provisions that can impact the your distributions plus your waterfall calculations, including: gross capital account balance

212-203-4685 | [email protected] | PEFServices.com 9 Taking the Plunge

The waterfall involves a complex set of calculations, and many LPs have felt hesitant to dive in.

However, as GPs commit to greater impacts returns is essential to the key elements, and conduct transparency and data-sharing with evaluating performance results and reasonableness checks to help ensure their LPs, there are fewer excuses for gaining more visibility into a fund’s that they protect investment returns maintaining a hands-off approach to overall performance. and identify potential issues. the fund’s waterfall calculation. While the waterfall has often been We hope this white paper has given In recent years, LPs have taken more seen as an impenetrable “black box,” you the knowledge and tools you proactive roles in monitoring their understanding its impact doesn’t need to confidently assess the impact investments. Reviewing a fund’s fees have to involve complicated analysis of waterfalls on your investment and expenses, for example, has now or a complete recalculation. LPs returns. become a routine part of the process. should be able to understand the two Understanding how the waterfall main waterfall methods, recognize

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