Guide to Private Equity Waterfalls

A distribution waterfall can be visualized as a money waterfall with numerous buckets.

Waterfalls, clawbacks, and catch-ups are terms used in private investing to describe how distributions flow from the investment to the partners, what happens if things go wrong, and how the manager’s performance fee is structured. Every investment has a specified waterfall, and it’s crucial to understand how it works because an unfavorable waterfall can tip risk in the investor’s favor. Assets take time to sell, with an investment time horizon of 10 years or more.

Waterfall analysis and Private Equity

A general ‘waterfall’ visualizes the sequential breakdown of a starting value (ex: revenue) to a final result (ex: profit) by depicting intermediate values and ‘leakage’ points. Companies can use this to track data at each step. Private equity is a type of alternative investment that involves money that isn’t traded on a public exchange. Private equity funds and investors invest directly in private enterprises or engage in buyouts of publicly traded companies, culminating in the delisting of public stock. Institutional and individual investors fund private equity, and the funds can be used to support innovative technology, make acquisitions, grow working capital, and boost and stabilize a balance sheet.

Understand distribution waterfall or waterfall analysis

The technique by which capital is allocated to a fund’s numerous investors as underlying investments are sold for gains is referred to as a distribution waterfall. The total capital gains produced are dispersed according to a cascading system made up of successive layers, which is why the term “waterfall” is used. When one tier’s allocation requirements are met, the extra funds are subjected to the following tier’s allocation rules, and so on.

How does waterfall analysis work to distribute private equity?

A distribution waterfall can be visualized as a money waterfall with numerous buckets. The allocation techniques for the various buckets vary. It is typically used to distribute proceeds from realized investments and cash inflows among the fund’s private equity fund sponsors and investors. The term “distribution waterfall” also describes how a fund’s investors are paid as underlying investments are sold. It may stipulate that an investor receives his or her initial investment plus a preferred return before the general partner’s share in the earnings. This type of setup can boost investor confidence in the equity fund and its profit potential.

  • Return of capital – When an investor receives a portion of their original investment that is not deemed income or capital gains, this is known as a return of capital. A return of capital reduces an investor’s adjusted cost basis. Any further return will be taxable as a capital gain once the stock’s adjusted cost basis has been reduced to zero.
  • Preferred return – In Limited Partnership Agreements for Funds, Preferred Return is a frequent technique. The annual rate of return that the Limited Partners in a Fund must achieve before the general partner begins to share in distributions is known as the Preferred Return. The preferred return is based on the capital contributions of the Limited Partner. The Preferred Return Clause can be regarded as the limited partners’ minimum yearly yield or the baseline performance metric. Preferred Return rates vary according to the asset class and market conditions, but they often hover around 8%.
  • Catch-up – The Catch-Up provisions greatly favor the General Partner (GP). A Catch-Up clause is designed to heavily distribute distributable revenues to the general partner until they have received a specified amount of profits. Catch-up provisions frequently follow the Preferred Return tier. The General Partner receives anything from 50 percent to 100 percent of dividends under catch-up clauses. Because the LPs receive 100% of the funds before this tier, the Catch-Up tier allows the GP to catch up to their distribution portion.
  • Carried interest – The General Partner obtains a disproportionate percentage of the income, known as carried interest or promotion. General Partners are rewarded with carried interest if they manage their investments well. Effective performance-based provisions, such as the Preferred Return clauses outlined above, ensure that Limited Partners continue to receive a reasonable return on their investment before a General Partner earns Carried Interest.

Why do businesses need to build a waterfall structure?

After liquidating investments, a private equity fund’s distributions are paid out in a waterfall structure. The typical waterfall structure requires limited partners to get their contributed capital for investments and management first, followed by the preferred return, and finally, the excess return net of the carry to the GP. After the invested money and preferred returns have been paid back, the GP earns a carry in the typical waterfall structure. This ensures that the GP receives its carry early in the fund’s existence. In the more non-traditional “European style” waterfall structure, GPs must repay both the invested capital on liquidated investments and the invested capital on unliquidated investments.

Important terms to know for waterfall analysis

Few of the important terms to be aware of to understand completely the waterfall analysis which is as follows:

Important terms to know for waterfall analysis

  • Investment Tiers – Low-risk assets, such as cash and money markets, are at the bottom of the pyramid; moderately risky assets, such as stocks and bonds, are in the middle; and high-risk speculative assets, such as derivatives, are at the top. The method argues for allocating the most capital to low-risk assets at the bottom of the pyramid and the least amount to speculative assets at the top.
  • Sponsors vs investors and Limited Partners (LPs) vs General Partners (GPs) – Limited Partners (LP) are investment professionals who are vested with the responsibility of making decisions regarding the ventures that must be invested. In contrast, General Partners (GP) are investment professionals who are vested with the responsibility of making decisions regarding the ventures that must be invested. It is vital to understand how the PE operates in order to comprehend the concept of Limited Partners (LP) and General Partners (GP). When a PE firm is formed, it will have investors who have put money into it. Each PE company would manage many funds.
  • Residual Split – Every independent sales organization and the independent agents that work for them strive for a large, healthy residual portfolio. As a result, it should come as no surprise that how you divide those crucial residuals with your agents is crucial. Split percentages and residual agreements have a significant impact not just on your bottom line but also on your ability to attract and retain the best people available.

How does waterfall calculation work in private equity distribution?

Distributable Cash related to any Portfolio Investment (including income realized pending investment in such Portfolio Investment or pending payout of Distributable Cash relating to such Portfolio Investment) will be distributed to the Partners (including the General Partner) in proportion to their respective Percentage Interests in such Portfolio Investment. The sum allotted to any Limited Partner pursuant to the preceding sentence will be immediately redistributed among the Limited Partners.

Carried interest

Carried interest is a type of incentive compensation that is used to attract and retain talented investment managers and is generally treated as a share of the fund’s profits. This is also known as the “carry” “performance share”, “allocation”, “promote”, “promoted interest”, or “override”, in which all terms can be used interchangeably.

In terms of taxation to the General Partner, they are generally treated as capital gains (although there are suggestions in the United States to change this). The market standard for the carried interest size depends on the type of funding, such as:

  • For buyout and real estate funds: 20% of the profits
  • For Venture Capital Funds: 20% of the fund’s income, with some Funds charging more.
  • Funds of funds: starts from 5% to 10%

Preferred return

Preferred Returns are customary in the industry for leveraged buyout funds and funds of funds. Preferred Returns are less common in venture capital funds and hedge funds, but they are often utilized to attract institutional investors. Investors are increasingly successful in obtaining preferred stock

To formulate preferred returns, it is usually a compounding of a fixed interest rate computed annually (market standard), semi-annually or quarterly. Typically, the percentages vary from 5% to 12%, with 8% as the current standard.

Example of waterfall analysis calculation for private equity

Assume a general partner invests 5% of the required equity for a real estate project and raises the rest 95% with a 6.00 percent preferred return, both utilizing an IRR computation. Following the preferred return, the top tier distributes the cash flows so that the GP gets 20% and the LP gets 80%, but only until the LP gets an IRR of 8%.

Any money left over after the 8% will go towards the residual split (not to be confused with residual value or exit events). Any money left over after you’ve exhausted all of the lesser investing tiers is referred to as residual. It’s basically the last tier with no hurdle cap. The term “residual” is often used but is not included in most agreements. The extra cash flow will be shared 50/50 in our private equity waterfall example, with the GP and LP getting equal amounts.

How does European and American waterfall analysis work in private equity?

The American waterfall encourages a deal-by-deal return schedule because it permits managers to be compensated before investors receive their entire investment and preferred return. The distribution proceeds are allocated at a “whole fund” level in the European waterfall, and each payout reflects the overall performance rather than being related to a specific investment.

The carried interest is calculated on a net cumulative basis and is only distributed to the manager after all contributed capital, and the preferred return have been returned to the investors. The first distributions in a European waterfall often refund all of the donated capital. The distribution proceeds are often allocated on a deal-by-deal basis under an American waterfall.

As a result, each investment’s performance is related to it. In the early years, this strategy is more advantageous to the GP since it distributes carried interest more quickly by making the carry payable with regard to each investment that brings the fund to a net-cumulative-profits-to-date position. If the first deal’s internal rate of return (IRR) is higher than the preferred return in this form of deal-by-deal cascade, the first deal may return some carried interest.

Distribute your private equity with waterfall analysis with Eqvista software

The waterfall analysis is a method that investors and shareholders can use to develop financial models of how much each shareholder will get when the firm is sold. Users can view possible exit situations using these cap table models, which go through sophisticated calculations. If you are someone who is looking for help in the distribution of your private equity with the waterfall analysis, we have got you covered with our software which helps in this process. To know more about the software. Fill up the sign up form and get started with us.

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