What is a Waterfall Structure in Fund Accounting?

The importance of simplicity, for fund accounting and for investors, in the allocation of investment returns to investors and management cannot be overstated.


What is a Waterfall Structure in Fund Accounting?

The mechanism by which an investment fund’s gains are allocated by fund accounting between the limited partners (LPs) and the general partner (GP), the distribution waterfall, is a vital factor when establishing an investment fund. It is a critical and intricate process requiring an experienced fund accounting team.

Simplicity for Fund Accounting and for Investors

The importance of simplicity, for the sake of both fund accounting and investors, cannot be overstated when it comes to waterfalls. Both investors and management are involved in creating the investment return. How investment returns are allocated by fund accounting between the two must be simple for investors to understand, straightforward for fund accounting to implement and perceived as equitable compensation for management performance and investor risk by all parties. From the start, the fund accounting provider must have a complete understanding of the waterfall framework and all of its stipulations. If the structure is overly complicated, fund accounting can advise you that it’s execution may end up costing a lot of money in the long run.

Fund Accounting and How Waterfalls Work

Waterfalls are defined by the Limited Partnership Agreement (LPA) or LLC Operating Agreement as a series of buckets or phases in the distribution by fund accounting of incoming cash. Each bucket contains its own allocation mechanism for fund accounting to apply and represents a tranche of income from portfolio investments. When the first bucket is full, additional incoming capital for the period flows through the second bucket and fund accounting applies a new allocation mechanism. The LPs often receive the majority of the cash in the early buckets, while the GP receives the majority in the later buckets. This structure motivates the fund manager to optimize the fund’s returns.

Waterfalls typically have four distribution buckets or phases for fund accounting to execute:

  • Return of Capital – Fund accounting distributes 100 percent of earnings to investors until the complete amount of their invested capital is returned.
  • Preferred Return — Fund accounting distributes 100% of profits to investors until a predetermined yearly rate (a preferred return) is attained investors (usually 7-9 percent).
  • Catchup – Fund accounting distributes 100% of profits to the manager in order to “catch up” on his or her contractual performance fee or carried interest (typically 20 percent )
  • Carried Interest — Fund accounting distributes a set percentage of profits to the manager in exchange for good performance (usually 20%), with the rest going to the investors (typically 80 percent).

Fund Accounting and the Cost of Complexity in Distribution Waterfalls

The structure of a waterfall can become exceedingly granular with many elements for fund accounting to track. Complex waterfalls are common among venture capital and real estate fund managers. Special circumstances and side letters for specific LPs add a layer of intricacy adding to the complexity and cost of the fund accounting task. The higher the granularity of a waterfall structure, the more items fund accounting will have to track from the start and apply to calculations. Waterfalls can be triggered by the closing of a transaction, can happen at a predetermined interval or can only happen when the fund is winding down. Any waterfall event has associated fund accounting costs specific to the level of complexity.

Fund Accounting and the Life of the Fund

Fund accounting must set up waterfall tracking for a fund based on the LPA’s structure and a concept of what things will look like when the fund matures in the future. When choosing a waterfall structure, managers should consider how detailed this tracking will have to be for fund accounting. Aside from the potential complexity for fund accounting, there is also the matter of investors’ and auditors’ perceptions to consider. Is the payment structure to be executed by fund accounting made transparent to the investor during the sales process? Is it tough to explain the allocations? Is this waterfall in perfect accordance with the formation documents? Is the compensation mechanism, in the eyes of a layperson, fair to all parties? Is the waterfall completed at the individual investor level or at the fund level and then distributed by fund accounting to the investor? How much work will fund accounting have to do as a result of this structure?

Various Fund Types and Implications for Fund Accounting

In terms of waterfalls, fund types vary widely. Fund accounting must be familiar with the particulars of waterfalls for all fund types. For example, with a planned internal rate of return (IRR), real estate fund investors expect consistent profits on their investments. In terms of fund accounting, the investor is essentially a fixed-cost debtor to the fund. In most cases, there will be a mid-stream waterfall with a return cap. – In traditional private equity fund accounting, fund proceeds are normally shared by the LPs and GPs throughout the fund’s life. Investors in hedge funds seeking short-term gains prefer quarterly returns, net of carried interest, with all parties benefiting together after that.

The general partner (GP) normally contributes a small sum to the fund (the “GP co-investment”), usually 1 to 2% of the overall commitment. The general partner will allocate this amount depending on the waterfall structure when fund accounting distributes funds back to investors. The money to be transferred to the GP is maintained by the GP prior to the waterfall. The amount to be given to each LP by fund accounting will subsequently be redistributed between the GP and the LPs via the waterfall.

Various Investor Types and Fund Accounting Considerations

Waterfalls can be used at both the individual and fund level. For fund accounting, the individual-level waterfall adds the most complexity. For fund accounting, tracking allocations for investors who joined the fund at different times, under different provisions, or over the course of several tax years adds to the fund accounting burden. Any side letters to individual investors will need to be tracked by fund accounting for one-time waterfall structure adjustments. This is important to consider during fund accounting set up. If, for example, the fund’s preferred return is 8% and the carried interest is 20%, side letters for certain investors may raise the preferred return to 12% and limit the carry to 15%. The variances for each individual will be significant and fund accounting will have to track this.

Fund Accounting and Deal-by-Deal Waterfall Structures

Deal-by-deal waterfalls are intended to hold managers accountable for their deal decisions. Deal-by-deal waterfalls are easier for fund accounting to set up and administer. They were common in private equity funds ten years ago. It is a commitment-based structure in which investors are equalized during the fund’s lifetime, a process administered by fund accounting. If investors join the fund at different dates, fund accounting makes adjustments to level the playing field and make all investors equal at the fund level.

Before committing 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 with data collected directly from your general ledger provide the most transparency and are the easiest for fund accounting to repeat each time the waterfall is needed. The best way to ensure the waterfall’s correctness throughout the fund’s lifecycle is to ensure that fund accounting captures the relevant data, dates and steps from the first period close.

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