Fund-as-a-whole, deal-by-deal, European or US model, whichever way you look at the distribution waterfall, it demands a multitude of decisions. And it seems modifications to the structure are only increasing. But given the crucial role the waterfall plays – namely ensuring alignment – what are the most important factors to consider when building your own?
The distribution waterfall is the lynchpin of the private equity model. Used to determine how a fund’s returns flow back to investors and managers, this crucial mechanism creates that all-important alignment.
However, when it comes to setting up the structure, no two funds will be alike. These highly unique models necessitate a plethora of adjustments to find the right fit for both manager and investor.
The days of opting for the European-style fund-as-a-whole model versus the US deal-by-deal structure speak of simpler times. Today, this central pillar of private equity investing encompasses a vast array of fee and profit sharing features, but more than that, it highlights the growing pains of an industry moving out of the shadows and into the mainstream.
Getting to grips with the waterfall model first requires an understanding of the variables and how they can be adjusted.
The initial and most obvious step in the distribution waterfall is repaying capital to investors. However, even at this seemingly simple juncture, adjustments can be made. “The GP might also offer to cover certain management or advisory fees before the profits are allocated. For example, management fees could be deducted from the distributable profits,” explains Ivana Paprckova, Associate Director at Highvern.
Next is paying the preferred return, or hurdle rate, which by and large has remained at 8%. But of course, this represents another lever to be pushed or pulled. Says Paprckova: “If the GP wants to make the fund more appealing, it can adjust the amount of preferred return the investors will receive.”
Step three is the catch-up, which determines how quickly the manager receives its carried interest. “The most common profit split ratios are 50:50 or 80:20. A shorter period is more GP-friendly and a longer period is preferred by investors,” says Paprckova.
The last step in the distribution waterfall is the final profit split or carried interest. Typically, managers split the remaining profit, after the preferred return has been paid, on a 20:80 ratio. But as with the catch-up, this ratio is also subject to adjustment.
Says Paprckova: “Every step of the distribution can be tweaked, and every tweak will make the structure either more preferable to investors or to the manager, and of course, more complex.”
Hearts and minds
In a recent study tracking fund terms and conditions, MJ Hudson’s Eamon Devlin commented, “The intricacies of the waterfall and how carry is calculated and distributed should be a master’s degree in itself: complexity and ambiguity levels are high. These clauses will be a rich source of litigation in the future.”
Indeed, waterfalls are as much about power as they are alignment. Explains Paprckova: “The selection of the waterfall model will depend on the experience of the manager. First time funds without an established reputation in the market will have to offer more favourable terms to attract investors.”
Paprckova says the same is true for mega funds: “For these managers, it’s not uncommon to see anchor investors being offered special terms in side-letters. This could be in the form of individual IRR hurdles, to specific catch-up or profit allocation ratios.”
Furthermore, well-established managers with enviable track records can leverage favourable supply and demand dynamics through the waterfall structure. According to the same MJ Hudson fund economics report, in-demand managers have been able to push deal-by-deal structures, which work in the GP’s favour as they pay-out faster than fund-as-a-whole models. However, the report also notes that these managers are more frequently offering both deal-by-deal and fund-as-a-whole models, with funds dually domiciled in Europe and Cayman as a means of providing access to different investors. This approach also gives investors the option over which structure they prefer.
Says Paprckova: “Every GP tries to find a balance, whether that be through repaying fees and recouping a larger return later on. As investors prefer tangible, or known returns, the repayment of fees can act as an incentive, as fees are a set, non-variable compared with the preferred return.”
While it might be tempting to tinker with the waterfall model to maximise profits, or as a means of attracting investors, “The more complex the structure, the more costly and greater risk of differing interpretations, or even disputes at pay-out,” warns Paprckova.
“A simpler waterfall calculation means less risk and fewer costs. To decrease complexity, try to avoid tampering with waterfalls through a side-letter and maybe seek to structure any reduction outside the fund with a contractual agreement between the investor and the carry vehicle,” says Paprckova. “An alternative to investor specific waterfall calculations is providing discounts to management and advisory fees. In practice, this requires managers to anticipate and keep a lid on management fees.”
However, even simple structures require tricky calculations; constant valuation of the underlying assets, attribution of fees, side letter variables and profit share ratios. For CFOs, FDs and fund controllers tasked with calculating waterfalls, sophisticated software systems are now a must. “Fund administrators with modern technology can be a great help in calculating and monitoring carried interest calculation. The accounting software offers to build carry models into the system, which will then track the IRR and automate accruals, and produce management information,” says Paprckova.
The waterfall sits right at the heart of private equity; it maintains the industry’s crucial alignment, it is a vital negotiating tool when fundraising, an essential incentivisation mechanism, and above all, the key factor in how much cash a manager eventually takes home. But, with so many variables at play when it comes to getting the right structure, it is unlikely the complexity of these calculations will lessen. However, efforts to create simpler and clearer structures benefits all parties; the more fair, open and transparent the waterfall, the greater the alignment, the fewer the costs and risks, the better the industry.