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!

Comments

[Dan Jansen]

You didn't mention clawback!

One problem with the American system is that too much carry sometimes gets paid out early in the fund's life. Then if later investments go wrong the management team must repay the money . . . clawback.

[GP]

Good point Dan. I've read that clawback is emerging as a major issue on the current vintage of US funds.

The LPs hate clawback:
1. It damages their relationship with GP
2. Because the manager is usually only required to repay the carry on a post-tax basis, they often never actually recover the overpayment
3. In cases where members of the team have divorced, etc, it can be impossible to ever claw the money back . . . it's gone.

GP.

[LA investor]

My fund has a fair value test to reduce the chances of clawback taking place.

Before we pay carry we have to show the LPs that the fair value of the remaining portfolio exceeds a certain threshold.

Not perfect, but it helps.

[Jim]

Clawback is limited to the capital invested/drawdown. If GPs were really playing fair then the clawback should also apply to fees taken above and beyond the management fee!!!

For example, monitoring fees, transaction fees, etc. These can add up to enormous amounts and it's hard to justify them if the LPs have lost money on the fund.

[GP]

Interesting point Jim. Perhaps one reason that LPs have not tried to extend the definition of clawback is that it currently represents a far better protection than they get on their hedge fund investments.

Most hedge funds have a "loss recovery" provision which requires initial losses to first be repaid from future profits. But they don't allow profits taken by the manager to be clawed back if losses occur later.

GP