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Most private equity (“PE”) funds are structured as limited partnerships.  Under private equity jargon, distribution waterfalls manage the split of fund returns amongst the investors (referred to as limited partners or “LPs”) and the fund manager (referred to as general partner or “GP”).

This article discusses the differences between two standard distribution waterfall models used by private equity funds: the European and the American equity waterfall models.

What is a Distribution Waterfall?

Distribution waterfalls, or equity waterfalls, determine how the income of a fund is allocated between a fund’s investors and the fund manager as the fund exits its underlying investments. PE funds almost always provide for performance-oriented compensation to the GP to align its long-term interests with those of the LPs. The performance compensation is referred to as carried interest or ‘carry’ and is paid through the allocation of fund income or the ‘waterfall’.

The waterfall model should be clearly set out in the fund’s limited partnership agreement (the “LPA”) or terms and conditions to ensure that both the LPs and the GP have a clear understanding of how the GP will be compensated.

How are Equity Waterfall Models Designed?

Most equity waterfalls adhere to a tiered cash flow structure. These models distribute the fund income to a cascading structure made up of different levels. Parties assign specific rates of return, or hurdle rates, to each distribution tier. Once a tier’s investment structure meets its goal hurdle rate, the next level starts.

Investors compare this equity model to a fountain of water whose pools become full and then spill into the next tier. Once this financial basin fills, it trickles into the one beneath it, and the process continues. It finally ends when all parties receive their initial investments and rates of return upon completion.

There are three common tiers in a distribution waterfall in PE funds:

1. Return of capital – On the initial tier, the fund allocates 100 percent of distributions to the partners (both LPs and GP). They continue to receive these returns until each partner recovers all of its capital contributions. Some funds provide for LPs receiving their capital contributions in preference to, or prior to, the return of capital to the GP.
2. Preferred return – Once the partners (or limited partners, as the case may be) recover all of their capital contributions, they continue to collect 100 percent of fund distributions until they reach a preferred rate of return. This rate is sometimes referred to as the hurdle rate. This amount will vary from fund to another, but it generally hovers around seven to nine percent.
3. Carried interest – After the return of capital and the preferred return are satisfied, additional distributions from the fund are split between the GP and the LPs, where by the GP will receive a stated percentage of the distributions, while the rest goes to the LPs. While the simple form is that the GP receives a percentage (generally between 15 percent and 20 percent) from all further distributions, some funds provide for a tiered carried interest allocations, where the percentage received by the GP increases with higher distributions.

Different Equity Waterfall Models

There are two broad equity waterfall models practiced by the PE industry: European waterfall and American waterfall.  These terms do not refer to geographical locations of investment, but rather to distribution paradigms.

1. American Waterfall: The GP’s performance is evaluated against the hurdle rate on a deal-by-deal basis, and the GP is paid carried interest on a deal-by-deal basis.
2. European Waterfall: The GP’s performance is measured against the hurdle rate at the fund level, and is only paid carried interest once the fund returns all capital contributions and the preferred return (if any).

Note: Hybrid Waterfall: Certain types of funds, such as real estate funds, may use hybrid-type waterfall that designates American waterfall model for certain types of income (for instance operating) and European waterfall for different income (like sale proceeds).

The American model favors the GP because it can earn carried interest from certain fund exits irrespective of how other fund investment fare. It also accelerates the payment of carried interest to the GP. The European model is friendlier to investors because the GP only earns carried interest after the LPs recover all their capital contributions.

Most emerging managers will be pushed to European waterfalls, but it may delay GP growth.

The Importance of Claw-back

Fund LPAs are advised to carry claw-back provisions that permit the LPs to recover from carried interest or performance fees paid to the GP any shortfalls in the return of their capital contributions and preferred return and any excess of paid carried interest over the agreed percentage. This is a very important provision in PE funds that have an American waterfall, and also useful in cases of European waterfall.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

The strength of private equity funds lies in their ability to invest in illiquid opportunities that take years to mature and yield returns. At an initial take, however, this can sound very dangerous to investors. But the way private equity fund managers were able to raise record amounts of capital to manage despite this seemingly long horizon and lack of liquidity is through giving investors comfort in the fund terms, and developing practices that align investor interests with fund manager interests over the life cycle of the fund.

Amongst such developed practices is the establishment of fund advisory boards and limited partners’ advisory committees. This article discusses the roles each of these bodies plays within a private equity fund.

Advisory Boards and Limited Partner Advisory Committees in General

It is important to note that private equity funds are not mandated by law, considering the commonly used fund jurisdictions, to have advisory boards or committees. Yet, it is best market practice to include both because each can serve an important purpose for the management of the fund.

Advisory Boards

Advisory boards provide advice and market insight to the fund manager (referred to as General Partner or (“GP”). Their advice assists with sourcing transactions, and the advisory board’s existence lends credibility to the fund. With this in mind, advisory boards should be composed of industry experts or service providers in the area of the fund’s focus. Common candidates for advisory boards are established private equity fund managers (assuming there is no direct competition), economic experts, and service providers to the private equity industry.

Limited Partner Advisory Committees

Limited Partner Advisory Committees (“LPAC”) differ from advisory boards. While an advisory board consists of industry and financial experts who can advise the GP, an LPAC is composed of a representative (3 to 5) group of investors (referred to as limited partners or “LPs”) that are appointed by the GP. Rather than providing high-level guidance to the GP, an LPAC helps handle more sensitive matters that the GP faces to ensure that they are managed to the comfort of the investors. These include:

• Conflicts of interest. An LPAC allows a smaller, focused group to make decisions about conflicts of interest between LPs and GPs. Common conflicts of interest include investments in affiliated funds, purchases from or sales to affiliates of the GP, service contracts with GP affiliates, and review of valuations prepared by the GP. The LPAC has the power to approve or disapprove conflict-of-interest transactions.
• Waivers of LPA restrictions. The Limited Partnership Agreement or fund terms and conditions (referred to as an “LPA”) may include restrictions on the fund or the GP, including the partnership term, caps on investments, industry restrictions, restrictions on investment in foreign companies, investment period, and change of control restrictions. The LPA may provide that the LPAC can take action to waive certain restrictions or approve certain decisions.
• General oversight. Depending on how the LPAC is structured, the committee may have the power to provide additional oversight and transparency to the fund. The LPAC could receive additional financial and other data including access to fund auditors and approval of accounting variances. If granted this power, the LPAC acts as a balance to the GPs power over the fund.

In order to have a highly effective LPAC, it is advisable that it is composed of knowledgeable LPs that are not affiliated with the GP. Any duties or powers allocated to the LPAC should be clearly detailed in the LPA, and each member should be aware of the scope of their responsibility. Members of an LPAC are likely to be concerned about their own liability based on the fund’s actions, so you will need to consider insurance and indemnification provisions.

Make Smart Decisions

If you are considering establishing or investing in a private equity fund, it pays to focus on the details of the fund’s structure. Take some time to determine whether the fund would benefit from an advisory board or an LPAC. Then spend the time to make sure either or both bodies are effectively staffed and that all details are included in a well-drafted LPA or fund Terms and Conditions.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

What is Venture Debt?

Venture debt is a form of debt financing that can be used by early and growth stage startups to raise capital. It can be used instead of, or in conjunction with, equity financings. Venture debt is an attractive form of raising capital for startups because it can usually be arranged much more quickly, an important consideration for startups facing a limited runway.

The main difference between venture debt and traditional debt financing is that venture debt is available for companies that lack assets or positive cash flow, or that want greater flexibility in the lending terms. Traditional lenders are often reluctant to finance equipment for startups based on the widely-accepted notion that startups have a high rate of failure. Venture lenders have emerged to fill this gap; such lenders can be individuals, venture capital investment companies or funds, or banks specialized in venture lending. The market for such lending in the Middle East is still in its infancy, but we envision growth in the sector in the near future.

Venture debt has benefits for both entrepreneurs and investors. Valuation of startups proceeds in a stair-step fashion between financing rounds, meaning that the inclusion of incremental capital from a loan allows startups to achieve greater progress between rounds, increasing the company’s valuation ahead of the next equity financing, and helping startups meet their milestones.

Types of Venture Debt

1. Venture term loans:

Venture term loans are generally structured as three-year loans (or series of loans) with warrants for equity. They can be used for runway extension, acquisition financing, project financing, growth capital, or equipment financing. The interest rate is usually 0-4% higher than traditional loans to compensate for the increased risk to the lender.

2. Lease financing:

Lease financing is a type of financing where the owner of the asset leases such assets (i.e. permits the lender to use the asset) in exchange for periodical payments. This can be especially useful for startups that require equipment to scale, and may also provide a tax benefit in certain jurisdictions where ownership of the asset is taxable (consider Saudi Arabia).

3. Revenue-based investments:

Revenue-based investments are a type of venture debt where repayments are tied to monthly revenues rather than a typical amortized payment schedule, often with a cap on the total amount (1.3x to 2.5x of principal amount of the loan). This reduces the payment (cash flow) risk on the company and offers lenders the comfort of a repayment commitment, but without a harsh timed payments requirement on the startup that does not look to its fluctuating cash flows or revenues. This type of venture debt product is commonly seen in angel and seed financings globally.

4. Convertible Notes:

Convertible Notes are the most commonly used form of venture debt, but unlike the other forms of venture debt these debt instruments can be converted into equity in the company. SAFE Notes and KISS Notes are the standard forms of convertible notes or securities, often used in venture investing because they allow parties to avoid complex term negotiations for investment in the earliest stages of growth companies.

Terms

Both startups and lenders should pay particular attention to the terms of the venture debt agreement, in particular the costs involved in borrowing. These costs can include a cost for borrowing the money, a cost while the money is being loaned, and sometimes even a cost to exit the loan.

The amount of the loan will be up for negotiation, but startups will generally be successful in borrowing around 30% of the last round on favorable terms. Lenders protect their rights by receiving warrants on the company’s common equity, and will often include covenants to ensure repayment, but borrowers will not be required to put up any form of collateral. The debt is usually short term, unlike more traditional commercial loans, due to the growth trajectories of VC-backed companies and the standard equity raise path (with a new equity financing every 18 months).

When to USE Venture Debt:

• To purchase equipment during the growth phase;
• After eliminating the concept phase risk and identifying product market fit;
• When aiming to reduce founder and investor dilution;
• To avoid exhaustive due diligence.

When to AVOID Venture Debt:

• If there exists a significant risk of default. Venture debt lenders can call the loan and force the company to be sold or liquidated.
• When a new raise is imminent. Investors will have to agree to repay the debt or invest below the debt in order of preference

Remember: Venture debt may be an attractive means of avoiding dilution, but it should be used carefully by entrepreneurs. If you are unsure about product market fit, venture debt can end the company before it even has a chance to begin. Entrepreneurs should remember it is sometimes better to have a smaller shareholding, than to have no company at all.

Waqfs under Islamic law and trusts under English law are very similar. Both trusts and waqfs involve detaining property, leveraging a 3rd party to manage decisions for that property, and the eventual distribution of that property to a beneficiary. Still, both of them have key differences that make them entirely different. Not only are waqfs created uniquely, but they have some legal components that differ drastically from traditional English trusts. To fully understand trusts, waqfs, and the differences between them, let us break them down by definitions and legal components.

What is Waqf?

“A waqf was void without an ultimate charitable object.” Thus, outwardly at least, the motive for the creation of a charitable trust was to perform good works and please God. Only this declared motive was relevant to the validity of the trust.” — Influence of the Islamic Law of WAQF on the Development of the Trust In England: The Case of Merton College

A waqf is a charitable trust (or endowment) under Islamic law that is inalienable, irrevocable, and perpetual. The term waqf directly translates to “detain,” and a waqf can be thought of as detaining property for charitable or religious purposes for the sake of Allah. An essential component of waqfs is that the assets being donated cannot be consumable. In other words, money can be donated, but it will be invested, and the interest from that investment will go towards the charitable cause.

Here are a few legal waqf definitions:

• Qurba: Getting closer to God through good deeds.
• Waqif: The founder of the waqf
• Mutawalli: The trustee for the waqf

There are two different types of waqfs — waqf al-Khairi and waqf al-Dhurri.

What is Waqf al-Khairi?

When a person plans to donate property, buildings, or assets for the sole purpose of virtue and charity for Allah, they are creating a waqf al-Khairi. Those who create waqf al-Khairi will choose public or quasi-public interests (e.g., mosques, roads, religious institutions, specific groups, etc.) The primary thing to note about these trusts is that they are being donated directly towards public (or quasi-public) charitable causes from the start.

What is Waqf al-Dhurri?

When a person plans to donate to a charity but wishes for their next-of-kin to receive benefits from that donation, they would create a waqf al-Dhurri. Like waqf al-Khairi, these waqfs can be both public and quasi-public.

The primary difference between waqf al-Khairi and waqf al-Dhurri is the allocation of the principal interest of the donated assets. With al-Khairi, both the remainder and current income are donated to charity, while the al-Dhurri allocates the remainder to charity and the current incomes to a next of kin.

What is a Trust?

A trust is a legal arrangement whereby a trustee holds onto assets granted by a granter for the behalf of a beneficiary. Trusts can be used to benefit charity, shield wealth from taxes, and distribute income to children upon death. However, charitable trusts (a specific subset of the English trust) is remarkably similar to the waqf. In fact, some scholars recognize the Islamic waqf as a primary influencer of English trusts and trust laws.
But that does not mean that they contain identical components.

The Differences Between a Waqf and a Trust

There are 3 primary differences between waqfs and trusts. For the purposes of this article, we are speaking specifically of charitable trusts and waqf-Khairi — since they are most similar in goal, reach, and concept.

1. Waqfs are Religious or Piously Based

All waqfs are created to promote charity as recognized by the Shariah. All waqfs must be “ayn” (capable of being touched), and the vast majority of waqfs are property and usufruct. However, waqfs can also be a donation of money, in which case the money will be invested into income-generating projects or investments and the generated income will be utilized for the charitable purposes of the waqf (or descendants in the case of waqf al-Dhurri)

In English law, trusts are legal tools that are typically leveraged to shelter income or benefit children. There is an immediate difference in concept and utilization due to the nature of the trusts. Waqfs are religious or pious, and they are legally dictated by the Qur’an and the Sunnah. English trusts, on the other hand, are dictated by a variety of legal documents and can be created for any reason.

2. Waqifs Cannot Receive Benefits from Their Waqf

When a grantor creates a trust, he or she can list themselves as the beneficiary of that trust. In the case of living trusts and self-settled trusts, trusts can be utilized entirely as a tool to shelter income from taxes. Waqfs, on the other hand, require that the waqif receive no benefit from the waqf itself. The creation of a waqf is the benefit itself, and the creator is given Hasanah (or continuous “good reward”) through their charitable deed.

3. Waqfs are Both Irrevocable and Perpetual

Once a waqf is created, it cannot be revoked under any circumstances. The waqif has no rights to revocation and cannot give himself rights to revocation the moment that the waqf is announced. This is also important — waqfs are considered created the moment the waqif announces his intentions. Thus, the waqf is legal before legal papers are drawn up.

Waqfs are also perpetual. While the creation of a waqf immediately transfers assets to the charitable cause, waqfs can also be created posthumously. In this case, it would be dictated in the will — which is called a suspended waqf. In the event that the waqfs original beneficiary ceases to exist (e.g., a mosque eventually ceases to exist) the assets from that waqf will instead be utilized for one of the following:

• To benefit the poor
• To benefit religious knowledge
• To benefit a purpose nearly identical to the original purpose
• To benefit the upkeep of other waqf assets (i.e., the income of one waqf can be leveraged to pay for the upkeep of another waqf)

With English trusts, rights don’t have to be either perpetual or irrevocable. There are legal reasons that trusts can be revoked, and there are plenty of trusts that are not perpetual.

Businesses, investors, and individuals looking for assistance with waqfs or that are interested in establishing a waqf, contact us. Hammad & Al-Mehdar Law Firm is a leading Saudi Arabian law firm with over 35 years of experience, and we give people the legal tools to help themselves, their community, and the greater good of Saudi Arabia.