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:
- 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.
- 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.
- 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.
- 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.
- 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.