In this blog post, Amala Haldar, a student pursuing a Diploma in Entrepreneurship Administration and Business Laws by NUJS, analyses the concept of distribution waterfall.
A distribution waterfall may precisely be imagined as a waterfall having water (read money) in several buckets. The allocation methods are different for different buckets. It is usually used to allocate proceeds from fund’s realized investments and cash inflows among its private equity fund sponsors and investors in the fund.
Distribution waterfall is also used to describe the method by which capital is distributed to a fund’s investors as underlying investments are sold. It specifies, for example, that an investor will receive his or her initial investment plus a preferred return before the general partners participate in the profits. Such an arrangement can increase the investor’s confidence in the equity fund and its potential profitability for them.
Here, we shall discuss distribution waterfall in relation to private equity funds. Distribution waterfall forms the center of the economic relationship between a private equity fund sponsor and its investors. There are certain conventions that are adhered to. However, it is one of the most heavily negotiated terms of any private equity fund.
Usually, there are two main types of distribution waterfalls. They are as follows:
- American waterfall
- European waterfall
A close look at the working of both the methods would help us get a better understanding.
This is also called a deal-by-deal waterfall. A deal-by-deal waterfall involves the following steps:
- Step one, hundred percent of the cash inflows from a realized investment is paid to the fund’s investors until they have received an amount equal to their capital used in the realized investment, plus an amount equal to the unreturned invested capital in all previously realized investments, plus an amount equal to the unrealized investments, and the fees and expenses allotted to these investments.
- Then comes step two, here, any cash flows from a realized investment more than the amount paid in step 1 is given to the fund’s investors until they have received an amount similar to the preferred return on the amount in step 1, usually expressed as a percentage (eight percent compounded annually).
- Any cash flows from the realized investment more than the amount paid in the above steps is paid to the sponsor until it has received an amount equal to 20 percent of the amount paid to the investors in the steps mentioned above.
- In the final step, any cash flow from a realized investment more than the amount paid in steps 1, 2 and three is split between the fund sponsor (20 percent) and the investors (80 percent).
This method incentivizes professionals and attracts talent to the fund sponsor.
This method is also called the whole fund waterfall. The steps involved in this method are as follows:
- Step one, hundred percent of the cash inflows from a realized investment is paid to the fund’s investors until they have received an amount equal to the total drawn down commitments.
- In the next step, any cash flows from a realized investment more than the amount paid in step 1 is paid to the fund’s investors until they have received an amount equal to the preferred return on the total drawn down commitments, typically expressed as a percentage thereon (eight percent compounded annually).
- Next, any cash inflows from realized more than the amount paid in steps 1 and two are paid to the fund sponsor until it has received an amount equal to 20 percent of the amount paid to the investors in step 2 and step 3.
- In the last step, any cash inflows from a realized investment more than the amount paid in steps 1, 2, and three are split between the fund sponsor (20 percent) and the investors (80 percent).
This method is usually preferred by institutional investors. The reason is that the return of the contributed capital earlier in the life of the fund is advantageous from a time value of money perspective.
It is not that advantageous from the perspective of the fund sponsor though as there is a delay in receiving carried interest and it a disadvantage if seen from the time value perspective.
The applicability of the methods depends on various factors. The preference changes with these factors.
Firstly, it depends on the incentive structure one wants to adopt. Secondly, the operational capabilities form a major role; the American waterfall has operational complexities that are usually dealt with by the fund administrator. Thirdly, the place or location influences the distribution waterfall to be obtained. Often when local norms are not followed it is to be negotiated and bringing in a new format against the conventional norms becomes difficult.
Thus we understand that several factors influence choosing the mechanism that has to be adhered to. However, it is interesting to note that the most competent fund administrators usually do not have any problem handling both European and American waterfall.