HOW HOW PRIVATE GETS PAID EQUITY GETS PAID

JOURNEY TO THE FREE WAVE

3E MANAGEMENT, LLC.

THE MILLENIAL BACKPACKER IN THIS ISSUE

2 AMERICAN VS. EUROPEAN WATERFALL STRUCTURES

5 INVESTMENT PERIOD

6 ALLOCATION OF MANAGEMENT FEES

7 CLAWBACK CLAUSE

8 DEFERRED DISTRIBUTIONS

1 UNDERSTANDING A F U N D M O D E L

AMERICAN VS . EUROPEAN WATERFALL STRUCTURES

When dealing with a fund, one of the most ...mechanics are typically detailed in the important aspects is the distribution distribution section of the Limited method. Private equity firms typically Partnership Agreement (“LPA”). An allot the money from an investment based American-style distribution waterfall is on a distribution waterfall model, applied on a deal-by-deal basis and is which is a method of disproportionately typically more beneficial for the GP. allocating distributions to the Limited Because it is applied on a per deal basis, Partner (“LP”) and General Partner (“GP”). deal performance is independent of other Instead of the distributions being allocated deals in the fund, from a promote pro-rata based on the ownership standpoint. An American-style percentage, the distribution waterfall distribution waterfall favors the GP as it allows for the distributions to be made allows them to receive promote based on other calculations. There are two distributions before the LPs have received structures: American and European. The their entire capital back plus a specified specifics of the Distribution Waterfall... preferred return. 2 American-style waterfalls will require that received their capital back plus 8% on the LPs only earn capital back and preferred entire portfolio, so long as they have return for the specific deal the distributions achieved their capital back plus 8% on the are coming from. For instance, let’s take a equity invested in the distributing distribution waterfall with 4 tiers: (i) 100% investment and other sold investments. LP until they receive Capital back plus 8% preferred return; (ii) 90% LP / 10% GP until On the other hand, a European-style the LPs achieve a 10% IRR; (iii) 80% LP / distribution waterfall is applied at the fund 20% GP until the LPs achieve a 14% IRR, level and tends to be more beneficial for and (iv) 70% LP / 30% GP thereafter. In an the LP. Under the European-style, the GP American-style fund, the GP could start to will not receive promote distributions of receive their disproportionate share of the any kind until all of the LP's capital distributions before the LPs have... contributions have been repaid and their preferred rate of return has been reached.

Because of this, it is possible for the GP to If a fund performs well, then the GP would wait years to receive their promote likely still receive the same % of profits in distributions (~6 years on average for a either an American or European-style fund. European-style closed-in fund with a 10 However, the America style would pay the year investment term).. GP earlier. When a fund reaches mid-tier returns or lower, then the American style "An American-style distribution could still see the GP receiving promote distributions even if the fund achieves waterfall is applied on a deal- negative returns, which would not happen by-deal basis." in the European style-waterfall.

3 DISTRIBUTION WATERFALL MODEL

a m e t h o d o f disproportionately a l l o c a t i n g distributions t o t h e L i m i t e d P a r t n e r (“ LP ”) a n d G e n e r a l P a r t n e r (“ GP ” ) i n v o l v e d o n a n i n v e s t m e n t .

4 INVESTMENT PERIOD

The investment period of a fund is a set For example, a fund in the investment period after raising capital, generally 3-4 period with $100MM of capital charging a years, that the fund can freely invest the 1.5% could take a $1.5MM raised capital into assets. During the fee based on the committed capital. investment period, management fees are However, after the investment period is usually charged and calculated based on over, the fund has invested $75MM but sold committed capital. After the investment $25MM of their investments. Since the period, fees are usually calculated based on investment period is over, the fund can the fund’s invested capital in non-disposed only charge on the invested capital deals. outstanding. Thus, the fund could only receive $750,000 (1.5% x ($75M-$25M)).

The fees charged during the investment ...brunt of the fund’s investment period period are one of the reasons for the expense load. notorious j-curve: the j-shaped trend line for a fund’s IRR. Typically, the returns for a One aspect that should not be confused is private equity fund are negative for the first how the management fee is calculated. couple of years and then positive The management fee is calculated based thereafter. With the investment period, on the equity one has in the deal, not the funds are charging fees on capital that has fair value of the investment. So when fund not yet been invested. Thus, the IRR during managers have a deal that isn’t going well this time is infinitely negative because you and they write down the fair value of the are paying fees but receiving no returns or investment to $1, the LP would still have to distributions. You are completely cash flow pay management fees based on the negative. Likewise, early deal performance amount of equity in the deal. The same can appear to suffer due to bearing the goes for vice versa. entire... 5 If the fund manager had a high-performing investment and writes up the fair value, you are not going to pay more in fees simply because the value of the investment went up. The fees are entirely based on the equity in the deal and not the fair value.

ALLOCATION OF MANAGEMENT FEES

The method in which the fund allocates management fees across their investments can have a large effect on the distributions made to the GP. Fund managers can either allocate fees at the fund level, or on a per deal basis, and these management fees generally range from 1% to 1.5% of the .

If the fund allocates fees at the fund level, it will come at a cost to the IRR. For instance, a $100MM fund invests in their The fee is allocated based on called capital, first deal for $10MM and charges 1.5%. so funds will generally allocate fees across Right off the bat, the investors will be deals based on the proportion of capital charged $1.5MM in fees on their first deal. used in the deal. For example, if you used This essentially wipes out any potential 20% of your total capital for a deal, you distributions that the LPs were hoping to would charge 20% of your total fee to that pocket and demolishes their initial deal. However, allocating fees on a deal-by- IRR. deal basis also has its downsides. One main downside is the accrual of fees and

But, if you allocate fees on a per deal basis expenses for later deals and its effect on you will continue paying fees over a longer the distributions. For instance, imagine you period of time, but your individual have 10 deals over 4 years. Deals 1-9 deals investment IRRs will be more consistent were invested in year 1, and deal number 10 compared to the other investments. was invested in year 4.

6 In this case, deal 10 will have to perform at a higher level for its distributions to make it CLAWBACK: through the waterfall tiers. This is because deal 10 has to bear it’s share of years 1-3 a feature detailed in the expenses, even though it was not yet LPA that refers to the invested. Although a clear impediment to LP’s right to recoup deal 10’s performance, this method is used to minimize the effects of the j-curve. It is cashflow previously better to have later deals bear their portion distributed to the GP. of early expenses, at a slight negative to IRRs, than have early deals bear the entire portion with massive penalties to their IRR.

CLAWBACK CLAUSE

A Clawback is a feature detailed in the LPA ...it turns out the later deals in the fund that refers to the LP’s right to recoup aren’t as successful as the initial deal, and cashflow previously distributed to the GP. A the LPs never receive their entire capital clawback is common in American-style back. Thanks to the clawback feature, the waterfalls and is calculated upon LPs are entitled to reclaim the promote liquidation of the fund. Clawback they overpaid to the GP. However, one provisions play a key role in protecting the thing to note is that the clawback feature LPs from overpaying incentive fees to the is only as good as the fund manager’s GP. For example, in the American-style ability to repay. Many LPAs will require a waterfall the GP could begin receiving portion of promote be deposited into distributions before the LPs had escrow accounts to ensure that at least a reached their required investment return portion of promote is easily recoverable in hurdles. Let us say the GP takes a promote the clawback clause is exercised. distribution and over the life of the fund...

7 DEFERRED DISTRIBUTIONS

If you are in an American-style waterfall, ...cashing out on all their deals up front deferred distributions will most likely be a without guaranteeing the performance of constant theme when dealing with later deals, so the fund will defer 40%-60% promote distributions. A deferred of the earned promote distributions until distribution is, as the name suggests, when the fund as a whole reaches capital back a distribution to the GP is delayed. Since plus preferred return. Additionally, American-style waterfalls are on a per-deal distributions can be deferred 100% if it basis, the GP can receive a promote does not appear that the fund will return distribution on the first deal after the LPs the capital plus preferred return to the LPs hit their hurdles for the specific deal. based on a hypothetical liquidation using Usually the LPs do not want the GP... the current fair value of the assets.

Investors in European-styled funds will not encounter deferred distributions due to the fund-level structure of the European waterfall. In the European-style waterfall, the GP only receive a promote distribution after the LPs receive all of their capital back plus a preferred return.

8 3E MANAGEMENT Our Affiliate Companies

www.3emanagement.org TOP SHELF MODELS

tsmfinancialmodels.com (469) 333-1250 TOP SHELF ACADEMY & find us on tsmfinancialacademy.com

Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.

Vice President Chris Biesanz previously worked in the private fund industry running back office accounting, middle office operations, partnership allocations, audit support, and general fund consulting. 3E MANAGEMENT, LLC. HOW PRIVATE EQUITY GETS PAID

JOURNEY TO THE FREE WAVE

THE MILLENIAL BACKPACKER