Carried Interest

The Waterfall

 

Photo: Arnar Valdimarsson

A reader has just been hired by a fund-of-funds and asks:  "what does my boss mean when he talks about a European distribution waterfall?"

Simply, the waterfall refers to the sequence in which proceeds from the sale of a portfolio company are distributed.  European private equity funds don't usually pay carry to the fund manager until all capital that has been drawn down has first been returned to the investors. 

European Waterfall

- All drawn down capital is repaid to the LPs (cash that was called for realised and unrealised investments, management fees, other expenses of the fund), then

- The investors are paid a preferred return on all drawn down capital.  This hurdle rate is typically an 8% IRR.  And only then,

- The manager starts to get a 20% share of the remaining proceeds (usually with a catch up). 

An American waterfall is more GP friendly.  Most American private equity managers begin to receive a share of the profits (carry) as soon as they have returned the drawn down capital and paid a preferred return on the fund's realised investments.  They don't have to return capital on investments that still remain unrealised within the fund . . . this difference can bring forward carry payments by many years.

Hope this helps. Enjoy your new job!

Questions Continue about Gresham Model

In a recent post I mentioned that Gresham Private Equity is still trying to raise a new $600m fund.  One reader commented on Gresham's unusual relationship with corporate giant, Wesfarmers:

Gresham model is not sustainable. Wesfarmers are under serious pressure from equity analysts to stop backing the PE fund (or ideally divest the entire Gresham asset) . . . Gresham may not like it, but the PE team may have to spin out to survive.

It looks like he knew what he was talking about.   Wesfarmers reported their financial results yesterday and this is what Merrill Lynch analyst David Errington had to say:

The one aspect of Wesfarmers that we find totally unacceptable is its foray into private equity investments via Gresham Partners.  This year Wesfarmers lost $57m via its investments in Gresham . . . .

Why a large and respected company like Wesfarmers, that not long ago paid $19bn for the underperforming Coles businesses, is still undertaking investments in private equity ventures is totally beyond us.

We just don't understand it . . . and disagree with the strategy to continue investments.  The sooner Wesfarmers exits from private equity investments in partnership with Gresham Partners, the better we believe it will be for shareholders. 

Ouch.

Can Australian Private Equity Still Sell-Down?

Lead managers and underwriters for the hotly anticipated IPOs of Myer and Kathmandu should be appointed within the next week or two.  It's important that these two listings are well received by the market because they will set the tone for a long list of upcoming Australian private equity IPOs.

I'm curious to see what sell-down the market accepts.  Historically Australia has been unusually tolerant of private equity owners that cashed in their equity chips at IPO.  Sell-downs of 70%-100% were the local norm. 

By contrast, in the United States a private equity sell-down of 20%-50% of the fund's shareholding would be more typical and in Hong Kong the sell-down is usually limited to less than 40%.  The balance of the PE fund's shareholding is escrowed for 6-12 months or for the prospectus forecast period.

Fund Raising Watch - #2

Still no first closing announcement from CHAMP or any of the other Aussie fund raising hopefuls.

I understand that NAVIS (Malaysian based but with an office in Sydney) has finally reached a first closing of US$400 million.  They were originally targeting US$2 billion for their Fund VI, but cut the target back to $1.25 billion when the GFC hit.  Frankly, with a first closing at $400m you have to question whether they will even come close.

Speaking of NAVIS, here's an interesting interview with Nick Bloy, one of the firm's two managing partners.

It's a Buyer's Market

  

Credit: Natalie Maynor

I had lunch yesterday with one of the top M&A lawyers in Sydney.  We talked about the dramatic decline in prices being offered for assets, and he commented on an equally clear shift he has observed in the deal terms that private equity firms are demanding before they'll invest.

Some of these "buyer's market" changes include:

Earn-outs are becoming more common in PE deals.  This slightly surprised me because earn-outs (where the total purchase price paid depends on the future performance of the company) are notoriously painful to negotiate and their enforcement can do more damage than good.

Escrow of sale proceeds:  PE firms are increasingly insisting that a portion of the sale proceeds be placed in escrow to provide security for potential warranty claims.

Seller liability caps on warranties are increasing, with caps of 50% or more of the purchase price now common.

Warranty and indemnity time periods have lengthened . . . 2-3 years is the new 12 months.  Warranties are also more likely to be given at both signing and completion, and the de-minimis levels for warranty claims have come down.

Material Adverse Change (MAC) clauses are being included in most transactions to protect against a negative event between the time of entering into a purchase agreement and closing the deal.

Non-compete provisions are extending . . . though uncertainty and debate still remains about their enforceability.