Private Equity Distributions: The Waterfall
I regularly return to Oxford to help out with the private equity course. Back in 2016 I wrote a post answering some of the questions from our class. It still gets read regularly, so here it is again….
Distributions Clause
Here’s a simplified distribution clause from a Limited Partnership Agreement. It works on the usual “2 and 20” rule: the PE house gets 2% of capital as a management fee and 20% of fund profits. As is usual for UK clauses, this is a European style, or whole fund return waterfall.
“Distributions of Income and Capital:
All amounts allocated to the General Partner and the Limited Partners shall, after payment of or making appropriate provision (if any) for costs, liabilities, Tax, expenses and working capital requirements of the Partnership, be distributed in the following order:-
(i) General Partner Management Fee: firstly to the General Partner in respect of the amounts payable to the General Partner in relation to any Management Fees which have not been paid;
(ii) Return of Limited Partner Capital Contributions: secondly to the Limited Partners (pro rata to their respective Capital Contributions) until they have received back their aggregate drawn down Commitments;
(iii) Preferred Return: thirdly to the Limited Partners (pro rata to their respective Capital Contributions) until aggregate distributions under this paragraph (c) are equal to the Preferred Return (8%);
(iv) Catch-up: fourthly 80% to the General Partner and 20% to the Limited Partners (pro rata to their respective Capital Contributions) until the General Partner has received amounts equal to 20% of the total amounts distributed to Limited Partners under paragraph (iii) above and to the Limited Partners and the General Partner under this paragraph (iv); and
(v) 80/20 split: thereafter 80% to the Limited Partners (pro rata to their respective Capital Contributions) and 20% to the General Partner.”
Explaining The Waterfall
The distribution clause sets out who gets what from the proceeds of the fund. The order is critical: each limb must be paid out before proceeds are allocated to the next. So, for example, (i), (ii) and (iii) need to be paid out before the GP gets a share of the profits.
(i) General Partner Management Fee
It’s customary for the GP to have first call on the proceeds to recover any management fees that remain outstanding.
Are GP fees and expenses too high? Is 2% of committed capital plus a load of other expenses fair, even where the fund has not performed?
Fairness is irrelevant here: this clause (i) ensures that the GP gets his fees before the LPs see a penny back.
(ii) Return of Limited Partner Capital Contributions
Next up, the LPs get back the capital they put into the fund. If there isn’t enough money left in the fund to return all the capital, the available money gets split between the LPs according to the relative proportions of how much capital they put in.
In a European style fund, the LPs will get back all the capital they put into the fund. (E.g. if the LPs contributed £100m of capital, they receive £100m under sub-clause (ii).)
If the GP has invested some of its own money into the fund on the same basis as the LPs, it will also get its capital back at this stage.
(iii) Preferred Return
By the time we get to stage (iii), the fund is beginning to make a profit. The first people to see a return from this profit are the LPs, who are paid out up to a preferred rate of return (known as the hurdle rate).
The LPs receive a return of 8% per annum for each day when each $ of capital was outstanding in the fund from drawdown to return.
The logic for the hurdle rate is that it reflects the cost of capital for the asset class in which the fund is investing. For mature deals in developed markets, that is customarily set at 8%. However, the hurdle rate can be higher for riskier asset classes such as distressed debt or emerging market investments.
The preferred return enables the LPs to meet the cost of capital for that asset class before the GP takes any profit share. In other words: the GP only gets a profit share if they beat the market.
(iv) Catch Up
If the fund has met the hurdle rate, the GP begins to see some of the profit. Under the catch up provision, additional profits beyond the hurdle rate start to get allocated to the GP — the fund is now said to be “into the carry”.
Profits now get allocated to the GP until the agreed catch up threshold is reached. In our model clause, the GP’s catch up threshold is the point at which the LPs and GP reach an 80/20 split of profit overall.
To illustrate this with some numbers: if $800m had been returned to the LPs under part (iii), the GP could get up to $200m under part (iv).
(The GP’s share could of course be lower: if there were only $900m available for distribution, the LPs would get $800m under (iii) and the GP would get $100m under (iv). Such is the impact of the LPs having a preferred return.)
The catch up in our model clause preserves the broad “2 and 20” idea that the PE house takes 20% of profits overall. However, the LPA we reviewed in class was much more GP friendly: the so-called “catch up” provision in that agreement took the GP far beyond an 80/20 split!
(v) 80/20 Split
If there is a surplus profit beyond stages (i) to (iv) it gets split 80/20 between the LPs and the GP. If the fund does well, this is a great deal for the GP: it’s getting 20% of the profit from the fund, and has typically put in just 5% of the capital. Senior staff members at the GP can expect huge bonuses.
Economic Incentives
The carried interest structure strongly incentivizes the GP to beat the market. Unless the GP beats the hurdle rate, all it gets are the management fees and other costs and expenses that can be charged back to the fund.
The carried interest structure also meets LP concerns by giving them a preferred return up to the cost of capital for that asset class. With that preferred, the LP will often be happy with an incentive structure that strongly encourages the GP to generate additional value.
This dynamic played out in our negotiations in class:
the GPs (who were convinced that the fund would see massive profits) tended to focus on getting better carry terms;
the LPs (who were somewhat less convinced of the potential for massive profits and more concerned to meet their cost of capital) tended to focus on the hurdle rate.
Most of us managed to negotiate deals that balanced out these two different risk preferences to everyone’s satisfaction.
However, this structure is not always a perfect alignment of interests. What happens, for example, in an era of low returns, where it becomes less likely that the PE house will reach the carry?
Arguably, the fees and expenses charged under the LPA become a more important part of the private equity business model. Worse still, could such environment increase the temptation to try and make money through hidden fees and expenses?