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
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
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
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.