Distribution Waterfalls and Outsourced Fund Accounting
The dreary but necessary set of back-office processes that make up fund administration are not usually thought of in terms of your reputation as a fund sponsor.
The mechanism by which a fund’s capital gains are allocated by your fund accounting team between the limited partners (LPs) and the general partner (GP) is crucial when structuring an investment fund. It’s a precise and time-consuming process that requires an experienced and knowledgeable fund accounting team. There are several factors to consider upon set up of your fund to streamline the fund accounting task in processing waterfalls.
Simplicity Will Benefit Your Investors and Your Fund Accounting Partner
The importance of simplicity in waterfalls for both fund accounting and your investors cannot be overstated. Because both the GP and the LP are involved in the creation of the investment return, the allocation of investment returns to investors and management by fund accounting must be simple to understand for investors, simple to implement for fund accounting, and perceived as equitable compensation for management performance and investor risk by all parties. From the beginning, the fund accounting provider must have a complete understanding of the waterfall framework, all of its requirements and all of its exceptions. Fund accounting will inform you if the structure is overly complicated to the extent that it will cost you a lot of money for fund accounting to execute.
Waterfalls for fund accounting distribution usually have four buckets or phases:
- Return of Capital – LPs receive 100% of earnings from fund accounting until their whole investment capital is returned.
- Preferred Return — Fund accounting allocates 100% of profits to investors until a predefined yearly rate (a preferred return) is achieved (preferred return is usually 7-9 percent).
- Catchup – Fund accounting allocates 100% of gains to management in order to “catch up” on his or her contractual performance fee or carried interest (performance fees are typically 20 percent )
- Carried Interest – A fixed percentage of profits (usually 20%) is allocated to the management by fund accounting, a reward for good performance, with the remainder going to the investors (typically 80 percent).
Your fund accounting waterfall is defined by the Limited Partnership Agreement (LPA) or LLC Operating Agreement. It’s a series of buckets or phases in the allocation of incoming funds that fund accounting will use to allocate distributions. Each bucket has its own fund accounting allocation procedure and represents a portion of portfolio revenue. When the first bucket is full, fresh incoming capital is routed through the second bucket, with a separate allocation technique to be used by fund accounting. The LPs often receive the majority of the money in the early buckets, while the GP receives the majority of the money in the later buckets. This structure motivates fund managers to optimize the fund’s return to the benefit of all parties.
The Cost of Complexity in Distribution Waterfalls in Fund Accounting
The structure of a waterfall can become highly complex, with many elements to keep track of for fund accounting. Complex waterfalls are widely used by venture capital and real estate funds. Special circumstances and side letters for particular LPs add to the fund accounting complexity, raising its cost. The more granular a waterfall system is, the more items fund accounting will need to keep track of and apply to computations. Waterfalls can be triggered when a transaction is completed, at a predetermined period or when the fund reaches the end of its life cycle. Overall fund accounting costs are related in part to the level of complexity in waterfall events.
Fund accounting must set up waterfall tracking for a fund based on the LPA’s structure and an estimate of how things will look when the fund matures. When establishing a waterfall structure, managers should consider how intricate will have to be for fund accounting. Aside from the prospect of difficult fund accounting processes, there is also the issue of investor and auditor perspectives to consider. Is the payment mechanism that fund accounting will use transparent to the investor during the sales process? Is it difficult to articulate how fund accounting will handle distributions? Is the waterfall structure in alignment with the formation documents? Is the compensation mechanism, in the opinion of a layperson, fair to all parties? Is the waterfall completed at the individual investor level or at the fund level and then allocated by fund accounting to the investors? How much extra work will fund accounting have to do as a result of your waterfall structure?
The Fund Accounting Repercussions of Different Fund Types
The waterfalls of various types of funds differ. Fund accounting must be conversant with the characteristics of all fund-type waterfalls. With a predetermined internal rate of return (IRR), real estate funds anticipate significant returns on their investors. In terms of fund accounting, the investor is effectively a fixed-cost debtor to the fund. For fund accounting, there will nearly always be a mid-stream waterfall with a return cap. In typical private equity fund accounting, the LPs and GPs split the fund’s proceeds throughout its lifespan. Short-term gain-seeking hedge fund investors prefer quarterly returns, net of carried interest, with all parties benefiting in the end. Each waterfall has its own fund accounting procedure.
The general partner (GP) often makes a small contribution to the fund (the “GP co-investment”), which is typically 1 to 2% of the total commitment. The general partner will allocate this amount depending on the waterfall structure when fund accounting returns funds to investors. The GP maintains track of the money that will be transferred to him prior to the waterfall. According to the waterfall, the amount computed by fund accounting to be distributed to each the investors will be split between the GP and the LPs.
Waterfalls at either the individual level or fund level may be used. The individual-level waterfall adds the most complication for fund accounting. The expense of tracking allocations for investors who entered the fund at different times, under different provisions, or over the course of multiple tax years raises the fund accounting burden and cost. Any side letters to individual investors for one-time waterfall structure changes will need to be tracked by fund accounting. This is something to consider while establishing your fund accounting process. For example, if the fund’s preferred return is 8% and the carried interest is 20%, side letters for certain investors might raise the preferred return to 12% and limit the carry to 15%. Individual-level distribution variations will be significant, requiring fund accounting to keep track of the provisions that control them.
Deal-by-deal waterfalls are intended to hold executives responsible for their transactions. These waterfalls were popular in private equity funds ten years ago because they are easier to set up and operate for fund accounting. It’s a commitment-based structure in which investors are equalized over the duration of the fund’s life, with fund accounting overseeing the process. If investors joined the fund at different dates, fund accounting must allow for adjustments to level the playing field and make all investors equal at the fund level. Before you commit to a waterfall structure, make sure your fund accounting provider agrees that it will not add more complexity to your fund accounting than it is worth. Waterfalls that can be run directly from your general ledger provide the most transparency and are the easiest to repeat for fund accounting each time the waterfall is activated. To preserve the waterfall’s validity throughout the fund’s lifetime, ensure that fund accounting captures the relevant data, dates and steps from the first period closing.
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