The private equity industry has grown significantly in recent years. PE firms had a record $2.49 trillion in assets as of December 31, 2016. In total, 319 new firms launched last year.
Most private equity funds are structured as a limited partnership, under which the general partners (GPs) are authorized to manage the PE fund and select investments to be included in the fund’s portfolios. Investors, which may include both institutions and wealthy individuals, are limited partners (LPs), which do not participate in investment decisions.
The specific terms of the investment are set forth in a Limited Partnership Agreement (LPA). The LPA governs a wide-range of issues, including the duration of the fund, the calculation of management fees, and the payout structure.
Waterfall Distribution Schedules
When negotiating an LPA, waterfall distribution schedules are also an increasingly important topic. In general, distribution waterfalls establish the method by which the capital gained by the fund’s sale of the underlying investments is allocated between GPs and LPs. Typically, GPs do not receive an allocation of profits until investors receive their initial investment and a preferred return. Below is an example of a waterfall distribution schedule:
- Tier One: All of the distributions are allocated to the investors until all of their initial capital is returned.
- Tier Two: Also known as the “hurdle,” all additional distributions go to the investors until they obtain their “preferred” return rate (often between seven and eight percent).
- Tier Three: Also known as the “catch-up” tier, the full distribution is allocated to the GP until it receives an established percentage of the profits (often around 20 percent).
- Tier Four: The GP then receives a specified percentage (the same as used to calculate Tier Three distributions) of the distributions as carried interest.
The hurdle rate may also be further broken down into tiers, which are tied to the total amount of carried interest of the GPs.
European vs. American Waterfalls in PE Funds
After negotiating the basic terms, such as the hurdle and catch-up, the parties to an LPA must decide how the carried interest will be distributed. Waterfalls can be broadly termed as either “European-style” and “American- style.”
Under a European (or international) style waterfall, the distribution schedule is applied at an aggregate fund level. Accordingly, the GP does not receive carried interest distributions until the investors receive distributions equal to their total capital contributions to the entire fund as well as a preferred return.
In contrast, the American style applies the schedule on a deal-by-deal basis rather than at the fund level. That means returns are calculated for each investment, and GP receives its carried interest as profits are realized on the specific investment.
The whole-fund European model is preferable to investors because it defers distributions of carried interest to GPs, thereby allowing investors to receive more distributions of fund profits sooner. The American waterfall style is more advantageous for GPs of the fund because it distributes the total risk over all the deals.
As the name suggests, the European waterfall is frequently used by private equity funds in Europe and Asia. However, investors in the United States are increasingly seeking to adopt this approach. In response to investors increasingly seeking thresholds set at the fund level, GPs are proposing alternatives, such as deal-specific thresholds that include interim claw-back provisions. The result of this trend is that negotiating the waterfall distribution schedule is even more important. We encourage both investors and GPs to carefully review these terms and discuss their implications with experienced counsel.
Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.