What Are Waterfalls in Fund Accounting?

Your Limited Partnership Agreement (LPA) or equivalent fund establishment agreement determines the arrangement of your distribution waterfall. Via fund accounting, incoming investment proceeds will be allocated to the GP and LPs through a series of phases known as buckets. Fund accounting will divide portfolio revenue between the GP and the LPs using a separate method for each bucket. The first bucket represents the initial portion of revenue received. After the first tranche of revenue has been distributed according to the first formula, fund accounting distributes additional revenue according to the second formula of the waterfall, and so on. In the early buckets, the LPs are usually preferred, while the GP is preferred in the later buckets. As a result, the fund manager is motivated to maximize fund performance, which is benficial for everyone.

In a waterfall event, fund accounting typically distributes cash in four buckets:

• First Bucket: Return of Capital – until the LPs’ whole investment is returned, fund accounting pays them 100 percent of the earnings.
• Second Bucket, Preferred Return – fund accounting distributes all proceeds to limited partners (LPs) until a predetermined annual rate (the preferred return) is met (usually 7-9 percent ).
• Third Bucket: Catchup – fund accounting pays the GP 100 percent of revenue in order to “catch up” on the GP’s stated performance fee (carried interest, usually 20 percent )
• Fourth Bucket: Carried Interest – fund accounting provides the general partner (typically) 20% remuneration for good performance, with the remaining 80% going to the limited partners.

For fund accounting, very complex waterfall frameworks need a lot of tracking and processing labor. Real estate and venture capital funds typically develop the most intricate waterfall arrangements. The biggest complications and additional fund accounting charges are caused by side letters and exceptional conditions that relate to individual LPs. The more granular a waterfall system becomes, the more tracking and calculating becomes necessary for fund accounting. A completed transaction, the conclusion of a time frame or the wind-down of a fund can all cause a waterfall event. Your waterfalls’ complexity will have a significant impact on the entire cost of outsourced fund accounting. This should be considered and discussed with your fund accounting team from the very start

Fund accounting will follow the rules of the Limited Partnership Agreement (LPA) or other governing agreement when putting together the tracking your waterfall will require. At set up, fund accounting should be able to estimate the fund’s disposition and the nature of waterfall events as the fund approaches maturity. The difficulty of implementation for fund accounting should be a main consideration when creating a waterfall framework. The operational impact of a complex waterfall on fund accounting, as well as investor and auditor impressions, should be considered.

During the investment sales process, is the waterfall procedure fund accounting will follow fully explained to investors? Is it tough to describe and justify the distribution process of your waterfall? Is it stated explicitly in the fund creation instrument that the waterfall in its current form is permitted? Is the remuneration structure fair to all parties involved, in the opinion of a layperson? Will the waterfall be computed and dispersed at the individual or at the fund level before being allocated to the GP and LPs? Is the extra operational expense of a sophisticated waterfall justified by the amount of labor required by fund accounting to implement it?

Depending on the type of fund, there are many types of waterfalls. Your fund accounting partner should be conversant with the standard and unique features of waterfalls for each fund type. Real estate funds are expected to generate good long-term returns, according to LPs. In terms of fund accounting, the fund’s investors are basically fixed-cost debtors. Fund accounting will likely execute mid-stream waterfalls with a return cap. The majority of private equity waterfalls are more straightforward. Fund proceeds will be shared between the GP and the LPs at predetermined intervals throughout the fund’s life. Hedge fund waterfalls are typically quarterly. Hedge fund investors are looking for short-term gains. Fund accounting will disburse to investors net of carried interest, both investors and management profiting throughout the lifecycle.

Almost every waterfall will have its own set of exceptions and exclusions, as well as its own fund accounting process to follow. In many funds, the general partner will make a contribution of 1 to 2 percent of the total commitment, known as a co-investment. Fund accounting will distribute this amount to the GP when returning funds to investors, depending on the waterfall structure. The GP will keep track of how much money will be distributed to him before the waterfall. The proceeds calculated by fund accounting for distribution to investors are split between the GP and the LPs according to the waterfall.

Depending on management preference, waterfalls can be used either at the individual or fund level. The fund accounting process is most complicated by individual-level waterfalls. Investors who join the fund at various times, under various conditions or many times across several tax years complicate and raise the expense of the fund accounting role. Fund accounting must identify and record investors who have negotiated side letters separately and appropriately. The complexity and cost of setting up your fund accounting processes are important variables to consider. A single side letter may offer a 12 percent preferred return with only 15% carried interest, while other investors may receive an 8% preferred return with 20% carried interest. Calculations for payments may differ greatly from investor to investor. For each exceptional investor, an individual-level side letter necessitates an individual distribution calculation. Investors having special provisions must be coded by fund accounting and the provisions that control their distributions must be tracked by fund accounting beginning with the fund’s inception.

In theory, deal-by-deal waterfall models hold portfolio managers accountable for their transactions. They were popular with private equity funds a decade ago because they are easier to set up and administer in terms of fund accounting. Fund accounting is required by this commitment-based method to ensure that investors are treated equally throughout the fund’s life cycle. Fund accounting adjustments level the playing field by compensating for the fact that investors joined the fund at different times, ensuring that all investors are treated equally at the fund level.

A waterfall that is overly complicated can wind up costing you more in fund accounting expenses than it is worth. Before committing to a waterfall, be sure this isn’t the case with your fund accounting provider. For fund accounting, a waterfall that can be run directly from your general ledger is the easiest and most efficient, as well as the most transparent. In order for the waterfall to remain valid throughout the fund’s life, ensure that fund accounting captures all dates, steps and relevant data from the first period’s closing.