When Negotiating an LPA, Waterfall Distribution Schedules Are Becoming An Increasingly Important Topic
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.
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.
“No Comment” Culture: Why Silence Is Often the Riskiest Legal Strategy
A “no comment” response is sometimes the right call when a legal problem arises. As a blanket policy, however, it lets allegations go unanswered, deadlines pass, evidence disappear, and manageable disputes grow into expensive litigation. The businesses that fare best are usually the ones that say little publicly while acting decisively behind the scenes. When […]
Utility-Scale Battery Storage Projects: A Legal Roadmap for Developers, Property Owners and Other Stakeholders
Utility-scale battery energy storage systems (BESS) are becoming an increasingly important component of the electric grid throughout New Jersey, New York, and Pennsylvania. As renewable generation expands, electricity demand increases and grid operators seek greater flexibility, battery storage can help balance supply and demand while providing additional capacity and reliability. For developers, battery storage presents […]
Navigating Disputes: Hire a Partnership Dispute Lawyer
A falling out between partners can be disastrous for any business. In many cases, the partnership will not survive. If you are in an unworkable situation with your partners, it may be time to consult a partnership dispute lawyer experienced in handling partnership breakups and dissolutions before the situation deteriorates any further. It is easy […]
Section 363 Sales in Bankruptcy: What Businesses, Lenders, and Buyers Need to Know
When a company enters Chapter 11 bankruptcy, many assume the process will culminate in a lengthy reorganization plan. However, distressed businesses are increasingly being sold through a different mechanism — a sale under Section 363 of the United States Bankruptcy Code. A Section 363 sale allows a company, as a debtor-in-possession in bankruptcy, to sell […]
Zoning Laws Explained: What You Need to Know Before Buying Property
Before buying property, it is critical to determine whether local zoning laws may affect your plans. If you plan to redevelop the property, you will want to confirm that local zoning regulations permit development as intended. If acquiring property that is already developed, you must verify that the use is permitted in the underlying zoning […]
Special Needs Trusts in New Jersey: Planning for Your Loved One’s Future
For parents of a child with a disability, estate planning raises concerns that go well beyond deciding who will inherit their assets. Parents may spend years making sure their child has the right care, services, and support. Eventually, they must also confront a difficult question: Who will take over when they can no longer do […]
No Aspect of the advertisement has been approved by the Supreme Court. Results may vary depending on your particular facts and legal circumstances.
Sign up to get the latest from our attorneys!
Explore What Matters Most to You.
Consider subscribing to our Firm Insights mailing list by clicking the button below so you can keep up to date with the firm`s latest articles covering various legal topics.
Stay informed and inspired with the latest updates, insights, and events from Scarinci Hollenbeck. Our resource library provides valuable content across a range of categories to keep you connected and ahead of the curve.
Let`s get in touch!
Sign up to get the latest from the Scarinci Hollenbeck, LLC attorneys!
