Distribution Waterfalls in Private Equity Funds

There are two main types distribution waterfalls in use today:

The deal-by-deal (“American”) waterfall
The whole fund (“European”) waterfall

As the informal nomenclature would suggest, the deal-by-deal waterfall is most commonly used by American private equity sponsors, while the whole fund waterfall is used most comonly used in Europe and Asia. The whole fund waterfall is also the form endorsed by the Institutional Limited Partners Association (“ILPA”) in its Private Equity Principles Version 2.0.1

Why is it called a “waterfall”? Well, the short answer of it is, because it reflects how water flowing from higher ground, falls into a series of pools at different heights. Each pool fills up and then the excess water overflows and fills the next lowest pool. The same applies for the distribution waterfall.

Deal-by-deal Waterfall

Let’s look at the deal-by-deal waterfall first. In essence, a deal-by-deal waterfall looks something like this: (sequentially)

One hundred percent of the cash inflows from a realized investment is paid to the fund’s investors until they have received an amount equal to their capital used in the realized investment, plus an amount equal to the unreturned invested capital in all previously realized investments, plus an amount equal to the unrealized losses on write-downs of unrealized investments, and the fees and expenses allocated to the these investments.2
Next, any cash inflows from a realized investment in excess of the amount paid in step 1 is paid to the fund’s investors until they have received an amount equal to the preferred return on the amount in step 1, typically expressed as a percentage thereon (eight percent compounded annually is the convention).
Next, any cash inflows from a realized investment in excess of the amount paid in steps 1 and 2 is paid to the fund sponsor until it has received an amount equal to 20 percent of the amount paid to the investors in step 2 and 3.
Finally, any cash inflows from a realized investment in excess of the amount paid in steps 1, 2, and 3 is split between the fund sponsor (20 percent) and the investors (80 percent).

I have put together a more formal version (i.e. something that might well be found in a typical limited partnership agreement (“LPA”)) in this PDF: Sample Deal-by-Deal Waterfall Clause. The purpose of this is to show you what your average law firm tends to do with the simplified form I wrote in this post, as well, as to highlight the fact that there are quite a few subtleties to this which we will not go into, but which skilled private equity fund sponsors and their counsel will negotiate extensively with skilled investors.

Example

A worked example may make it easier to understand what is going on. Let’s start by setting up the following scenario. It is currently Year 4, and the Demosthenes Fund (a $200 million private equity fund that uses a deal-by-deal waterfall) has made three investments, conveniently labeled A (invested $50 million at the beginning of Year 1), B (invested $10 million at the beginning of Year 2), and C (invested $40 million at the beginning of Year 3). At the beginning of Year 3, the investment in B was written-off. At the end Year 4, Demosthenes sold A to another private equity fund, Ender Capital Fund, for $200 million. Demosthenes charges a two percent management fee on committed capital during its five-year investment period. There are no other fund expenses that were charged to the investors. The table below may make it easier to follow this.

Now let’s trace how this would flow through the deal-by-deal distribution waterfall. First, part of the $200 million proceeds is used to return the $50 million the fund used to invest in A. Second, the fund returns the $10 million written off on the unrealized investment in B. Third, it returns the portion of the management fees allocated to A, in this case, being one-quarter of the management fee, since the investment in A is $50 million and the fund is a $200 million (i.e. 25 percent of the fund). Now, we calculate the preferred return on the amount distributed, compounded annually and beginning to accrue from the time the capital was drawn down until the day the preferred return is paid, and pay the $21.01 million preferred return to the investors. Next, we compute the 20 percent catch-up on profits distributed to investors (i.e. the preferred return) that the fund sponsor gets, which in this case is $5.04 million. Finally the remaining $109.15 million is divided between the investors and the fund sponsor in the ratio of 80 percent to the investors and 20 percent to the fund sponsor, i.e. $87.32 million to the investors and $21.83 million to the fund sponsor. Let’s look at the table below for a more visually simple way of following the waterfall.

Whole Fund Waterfall

Now, on to the whole fund waterfall. In essence, it looks something like this: (sequentially)

One hundred percent of the cash inflows from a realized investment is paid to the fund’s investors until they have received an amount equal to the total drawn down commitments.
Next, any cash inflows from a realized investment in excess of the amount paid in step 1 is paid to the fund’s investors until they have received an amount equal to the preferred return on the total drawn down commitments, typically expressed as a percentage thereon (eight percent compounded annually is the convention).
Next, any cash inflows from a realized investment in excess of the amount paid in steps 1 and 2 is paid to the fund sponsor until it has received an amount equal to 20 percent of the amount paid to the investors in step 2 and step 3.
Finally, any cash inflows from a realized investment in excess of the amount paid in steps 1, 2, and 3 is split between the fund sponsor (20 percent) and the investors (80 percent).

Similar to the position for the deal-by-deal waterfall, I have put together a more formal version in a PDF: Sample Whole Fund Waterfall Clause.

Example

Let’s start by setting up the following scenario. It is currently Year 4, and the Locke Fund (a $200 million private equity fund that uses a whole fund waterfall) has made three investments, conveniently labeled A (invested $50 million at the beginning of Year 1), B (invested $10 million at the beginning of Year 2), and C (invested $40 million at the beginning of Year 3). At the beginning of Year 3, the investment in B was written-off. At the end of Year 4, Locke sold A to another private equity fund, Bean Growth Fund, for $200 million. Locke charges a two percent management fee on committed capital during its five-year investment period. There are no other fund expenses that were charged to the investors. The table below may make it easier to follow this.

Now, let’s look at how the cash from disposing of A flows through the whole fund waterfall. The total amount of capital drawn down from the investors and invested is $100 million. A further $16 million of investor capital has been drawn down to pay management fees. Therefore, a total $116 million has been drawn down from investors. We can ignore the write-off of B, since it makes no difference (investors must get back the capital contributed to acquire B before any cash goes to the fund sponsor). The $200 million proceeds is first used to return the $116 million of drawn down capital to investors. Next, we calculate a preferred return of eight percent on the $116 million, compounded annually. This amounts to $29.56 million over the four years (calculated from the date of each capital draw down until the date that drawn down capital is returned). The fund sponsor (general partner of the fund) then gets a preferential allotment of profits, in this case 20 percent of $29.56 million plus 20% of the amounts in Step 3, or $7.09 million. Finally, the balance is split in the ratio of 80 percent to the investors and 20 percent to the fund sponsor, i.e. $37.87 million and $9.47 million respectively. As with the deal-by-deal waterfall, the table below makes it easier to see how this works in practice.

Analysis

Deal-by-deal Waterfall

Let’s take a look at this from the perspective of the investors in the private equity fund. At the end of this distribution, they have received distributions amounting to only the return of capital on investment A, the written-off amount on investment B, and the management fees and expenses allocable to these two investments. The capital invested in B, C, and D are still at risk.

The fund sponsor will have received some carried interest payments at the end of this transaction, but if subsequent investments suffer losses, it may have received more than its rightful share of carried interest. This necessitates a fairly complicated set of “clawback” provisions to return excess carry to the investors.3

From the fund sponsor’s perspective the deal-by-deal waterfall makes it easier to receive meaningful carry early in the fund’s life. This can assist with incentivizing junior investment professionals and attracting talent to the fund sponsor.

Whole Funds Waterfall

Let’s take a look at this from the perspective of the investors in the private equity fund. At the end of this distribution, the investors have received back all their contributed capital and preferred return. From an investor perspective this is the best situation to be in. All the invested capital has been returned and is no longer at risk (except to limited partner clawbacks). Disposition proceeds from other investments in the fund (B, C, D) will be gains for the investors. This is one of the primary reasons why the whole fund waterfall is often preferred by institutional investors.

Another reason why institutional investors prefer the whole fund waterfall is because the return of contributed capital earlier in the life of the fund (before carry is paid to the fund sponsor) is advantageous from a time value of money perspective. The sooner capital is returned to the investor the sooner they can reinvest it in other opportunities.4

Finally, a whole fund waterfall obviates much of the need for complicated and difficult to enforce general partner clawbacks.

From the perspective of the fund sponsor, the whole fund waterfall is less attractive. First, the delay in receiving carried interest is disadvantageous from a time value of money perspective. In the example above, the return on investment A was sufficient to return all contributed capital and expenses and pay carry to the fund sponsor. That will not always be the case and a manager may have to wait until near the end of the fund’s life to receive meaningful amounts of carried interest.

Second, a whole fund waterfall can make it difficult for the sponsor to retain talented junior investment professionals who often have shorter time horizons than senior investment professionals. The delay in receiving carry can result in junior investment professionals not being incentivized to either stay with the firm or select the best investments (since they do not expect to be rewarded for those deals for a long time).

Third, for first-time fund sponsors, the deferral of carried interest until the end of the fund term can limit their ability to attract talented professionals to join them, as there will not be much they can offer to reward performance. It is ironic, therefore, that often the funds that are most likely to need a deal-by-deal waterfall (at least in Europe and Asia), are the ones that are most often unable—due to lack of negotiating leverage—to obtain it from their investors.

On the flip side, though, it is operationally a lot easier to implement a whole fund waterfall, as the calculation methodologies are simpler. That being said, most competent fund administrators will usually be able to handle both deal-by-deal and whole fund waterfalls.

Conclusion

So, what do I think of the two models of distribution waterfall?

As someone who has been on both sides of the table, I would say it boils down to:

Geography: If you are in Europe or Asia the market norm is whole fund and deviations from this need to be explained and heavily negotiated with institutional investors. In the USA, you may have more leeway to use a deal-by-deal waterfall.
Leverage: The more successful your previous funds, the more leeway you will have to resist requests to modify the terms of your distribution waterfall.
Incentives: How do you intend to incentivize your investment professionals? The more that your incentive structure depends on carry the more you need to consider whether a deal-by-deal waterfall makes sense.
Operational capabilities: If you intend to do a deal-by-deal waterfall, be aware that it does come with more operational complexity that you or your fund administrator will have to deal with.

I will admit to a slight preference (despite the undoubtedly shocked gasps from some of my old colleagues) for the deal-by-deal waterfall due to the fact that it permits more tailored incentive programs and earlier distribution of carry, which I think can be vital for new fund sponsors. Also, there are ways—through appropriate general partner clawback mechanisms—to mitigate some of the risk of excess payment of carry.