Samuel Petrecky

SVP, Fund Accounting

D istribution waterfalls, the method by which the capital gained by a fund is allocated between the limited partners (LPs) and the general partner (GP), is a critical consideration in setting up an investment fund. Simplicity is key. How investment returns are allotted to investors and management must be easy for investors to understand, practical for fund accounting to execute and perceived by all parties as representing equitable compensation for management performance and investor risk as both parties are involved in creating the investment return. The waterfall structure must be thoroughly understood in all its permutations by the fund accounting provider from the outset. If the structure is too complex, it can cost significant money down the road.

Waterfalls are structured as a set of buckets or phases in the distribution of incoming capital as delineated in the Limited Partnership Agreement (LPA) or LLC Operating Agreement. Each bucket represents a tranche of income from portfolio investments and contains its own allocation method. When the first bucket is full, additional incoming capital flows into the next bucket and a new allocation method applies. The early buckets are typically allocated largely to the LPs, while later buckets favor the GP. This structure encourages the GP to maximize the return of the fund.

Waterfalls usually consists of four buckets/phases:

  • Return of Capital – 100% of profits are distributed to the investors until the total amount of their contributed capital is returned.
  • Preferred Return – 100% of profits are distributed to the investors until a predetermined annual rate (a preferred return) is reached (usually 7-9%).
  • Catchup – 100% of profits are distributed to the manager to “catch up” to management’s contractual performance fee or carried interest (typically 20%)
  • Carried Interest­ – a stated percentage of profits is distributed to the manager rewarding performance (typically 20%) with the remainder distributed to the investors (typically 80%).

Complexity Comes at a Cost

Waterfall structures can become very granular. Venture capital and real estate fund managers often have complex waterfalls. Special situations and side letters for particular LPs add significant complexity. The greater the granularity of the waterfall structure the more items fund accounting will have to track from the outset and calculate on an ongoing basis. Waterfalls may be triggered by the completion of a deal, may occur periodically at a predetermined interval or may only happen upon the wind down of the fund.

These buckets can be simple and straightforward or quite complex. If you’ve never been through a realization event, you may not realize what you’ve created in your waterfall structure. Fund formation attorneys, when setting up funds, may know what is legally permissible with regard to creating waterfalls but may be unfamiliar with the practical implications of a complex waterfall structure. As a matter of fund accounting, there is a price to complexity. There are significant costs associated with tracking and reporting everything in a complex waterfall.

Looking Ahead

Fund accounting must set up waterfall tracking for a fund based on the structure designated in the LPA and on an understanding of what things will look like in the future as the fund matures. How intricate this tracking will have to be for fund accounting is something to consider in deciding upon a waterfall structure. There is, importantly, the perception of the investors and auditors to consider. Is the payment structure clearly disclosed to the investor in the sales process? Are the allocations difficult to explain? Is this waterfall clearly in alignment with the formation documents? Does the compensation methodology appear to the layman to be equitable to all parties? Is the waterfall at the individual investor level or is it completed at the fund level and then allocated down to the investor? How much work will this represent for fund accounting?

The GP usually commits some amount to the fund (the “GP co-investment”), typically 1 to 2% of the total commitment. When distributing capital back to the investors, the general partner will allocate this amount based on the waterfall structure. Before the waterfall, the amount to be distributed to the GP is kept by the GP. The amount to be distributed to each LP will then go through the waterfall and be redistributed between the GP and the LPs.

Different Fund Types

Different fund types are different with regard to waterfalls. – Real estate investors expect big returns on their investments with a targeted internal rate of return (IRR). The investor essentially represents debt to the fund, a fixed cost. There will typically be a mid-stream waterfall with a cap on returns. – In traditional private equity, usually LPs and GPs share the proceeds throughout the life of the fund. – Hedge fund investors, looking for short-term gains, want quarterly returns, net of carried interest, with all parties benefiting together after that.

Different Investor Types

Waterfalls can be applied at the individual level or the fund level. The individual-level waterfall adds the most complexity for fund accounting. Tracking allocations for investors who entered the fund at different times, under different provisions or spanning tax years adds a significant fund accounting burden. Any side letters for individual investors will have to be tracked for one-off adjustments to the waterfall structure. If, for example, 8% is the preferred return  and 20% is the carried interest that applies to the fund but side letters for prominent investors raise the preferred return to 12% or limit the carry to 15% those variations for each individual will have to be tracked from the inception of the fund. Side letter provisions can be far more intricate and individualized than this, requiring extensive and granular tracking by fund accounting.

Waterfalls applied deal-by-deal are intended to hold management accountable for the deal choices they make. Deal-by-deal waterfalls are simpler to implement and execute and were typical for private equity funds ten years ago. It is a structure that is commitment-based in which investors are equalized throughout the life of the fund. If investors come into the fund at different times fund accounting makes corrections to uniformize them and equalize all investors at the fund level.

Before you commit to a waterfall structure be sure to have the opinion of your fund accounting provider that it does not add more complexity to your fund operations than it is worth. Waterfalls that can be executed with data pulled directly from your general ledger offer the most transparency and are the easiest to replicate each time you need to run the waterfall.  Ensuring that fund accounting captures the appropriate data, dates, and steps for the waterfall, from the first period close, is the best way to ensure its accuracy through the life of the fund.