One of the financial modeling techniques I have chosen to be highly proficient in is building various types of waterfall structures that are used in private equity. This is one of my biggest types of customers and nearly every deal has its own structure, but all involve similar terms and motivations. It was one of the most challenging things for me to get a good grasp on and it is also difficult for many others, no matter what level they are. As a result, I've had huge demand for this knowledge and it is extremely useful.
Relevant Templates:
Waterfall structures in private equity are a method of defining contribution rates and allocating the returns (or profits) generated from investments. They outline how these returns are distributed among the various stakeholders, typically the limited partners (LPs) who are the investors, and the general partner (GP) who is the fund manager. Here's a high-level overview:
Types of Waterfall Models
European Waterfall (Whole Fund Model):
- Characteristic: Profits are distributed only after all LPs have received their initial capital and preferred return across the entire fund (see this preferred equity model).
- Advantage: Simplicity and fairness, as it treats all investments uniformly.
- Key Point: Lower risk for LPs since it prioritizes their returns.
American Waterfall (Deal-by-Deal Model):
- Characteristic: Carried interest can be paid on a deal-by-deal basis, as soon as profits are realized from individual investments, even if other investments are still underperforming.
- Advantage: Potential for higher and quicker payouts for the GP.
- Key Point: Higher risk for LPs since profits are distributed before the entire fund’s performance is known.
Hybrid Waterfall:
- Characteristic: A combination of European and American models, often with a deal-by-deal payout subject to a future clawback if the fund underperforms.
- Advantage: Attempts to balance GP incentives with LP protection.
- Key Point: Complexity in administration and potential for disputes over clawbacks.
Note, I've seen pretty much every single combination of the above and there are quite a lot of variations depending on how the GP/LP want to structure terms. The main things to understand are what is the preferred return, is it an IRR hurdle or not, do unpaid returns accrue or not, do unpaid returns compound or not, does the GP have catch-up provisions and is it based on total cash received or a pref. rate (potentially an IRR hurdle)
One of the more unique waterfalls I recently modeled was a GP/LP setup where the preferred return was paid first (simple interest, non-compounding) and then 100% of cash flows went to LP until they got all their investment back, then cash was split x/y% until the LP received a defined total equity multiple (counting all cash received so far), and then after that hurdle is met, a new percentage split (50/50).
Key Concepts to Understand
Preferred Return (Hurdle Rate):
This is the minimum annual return that LPs are entitled to receive before the GP can participate in profits. It's a risk mitigation mechanism for investors.
Catch-Up Provision:
After LPs receive their preferred return, the GP may receive most or all subsequent profits until a specific split (e.g., 80/20) is reached.
This is the GP’s share of any profits earned by the fund, typically around 20%, and is a significant source of income for GPs.
Clawback Provisions:
These are designed to protect LPs by ensuring that the GP doesn't receive more than their entitled share over the life of the fund. They may have to return excess distributions if the fund underperforms.
Distribution Waterfalls:
Detailed calculations that dictate the order and amount of distributions. These need to be fully understood and agreed upon in the fund's legal documents.
Limited Partner Agreements (LPAs):
LPAs outline the terms of the investment, including the waterfall structure. Understanding the LPA is critical for both LPs and GPs.
Risk and Reward Balance:
Waterfall structures aim to balance risks and rewards between LPs and GPs. This balance is crucial for the fund’s success and attractiveness to investors.
Fund Performance Metrics:
Understanding metrics like Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) is essential, as these are often used in determining distributions.
Regulatory and Tax Considerations:
Being aware of the regulatory and tax implications of different waterfall structures is important, especially in cross-border investments.
Final Thoughts
For anyone entering the PE space, it's crucial to not only understand these models and concepts but also to stay informed about evolving trends and regulations in the industry. Additionally, real-world experience and case studies can provide deeper insights into how these waterfalls are negotiated and executed in practice.
