How Well Do You Know Your Waterfall?

Too few investors understand the math behind profit distributions — here are some ways to ease the pain.

Profit distribution from PE funds is the most important element of the GP-LP relationship, so why is the process so often misunderstood?

The answer, of course, is the language surrounding the so-called waterfall, the terms under which funds flow to the members of the partnership. In the long march toward complete transparency and alignment of interest between GPs and LPs, the language surrounding waterfalls largely remains Byzantine. Not only do many fund documents not completely spell out exactly how the waterfall is calculated, but too many investors, including funds-of-funds, struggle to get their hands on the right data and heads around the right math.

A friend who recently departed from a prominent gatekeeper/fund of funds told me that the least desirable task among the firm’s investment staff was waterfall work, especially when a change in fortunes such as a deal write-down or clawback required the entire distribution formula be backed up and recalculated. If some funds-of-funds professionals are having a hard time with this, imagine the issues at under-resourced LPs such as state pension funds.

Waterfall distribution calculations can make a material difference. Katita Palamar, co-founder of investment consultant LP Analyst, says that her review of many limited partnership agreements (LPAs) makes clear that terms around waterfall calculation are often left deliberately opaque, allowing GPs to choose methodologies that tilt in their favor.

The best example is the calculation of the preferred return, the threshold above which GPs start to get paid carried interest. It is in the best interest of the GP to use a calculation methodology that gets them to the typical eight percent hurdle the quickest.

Using a favorable waterfall calculation is one tried-and-true method. Here is one key aspect of a waterfall that an LP should know, and which is not always spelled out in the LPA—the start and end points for calculating the preferred return. In other words, does the “clock start ticking” as soon as capital is drawn down from LPs, or as soon as the capital is invested in the underlying companies?

Time is the enemy of the IRR, and so a GP has an incentive to use the typically shorter “cash in ground/out of ground” time markers. But from an LP’s point of view, opportunity costs accrue as soon as capital goes out the door. And as participants in the private capital asset classes can attest, there is often a big time lag between a capital call and the capital actually being injected into the deal. An LP might be justified in requiring that the preferred return be calculated with the capital call as the “born on” date, since this is when LPs actually send money to a private partnership.

Another term not always specified in the LPA is how regularly the preferred return is compounded. Here again the GP has an incentive to choose a method that gets them over the hurdle rate sooner and more easily, and GPs would tend to favor less-frequent compounding. As noted in a commentary last year by Cesar Estrada of JP Morgan and Jonathan Karen of Simpson Thacher, “In a several-hundred-million-dollar fund with a term of over ten years, the resolution of this particular question can literally become a million-dollar question, and result in a meaningful difference in outcomes in the amount and timing of distributions.”

Estrada and Karen also note that “finance and accounting people are not often found on the front lines of the drafting of waterfall provisions,” and hence the language used to describe actual methodologies is often either missing or vague.

Waterfalls calculations become especially challenging when you need to push the water back up the cliff, as it were. In the case of private funds, unexpected turns of events can mean that distributions made and values baked in to the model need to be revisited. Here again the LPA language around waterfall calculations might not be clear enough. For example, it is important for all parties to understand what happens in the event of a portfolio company write-down. What happens to a prior distribution to GPs? Do they just keep it and take a wait-and-see attitude toward future performance, or do LPs need to be immediately “made whole” on the revised performance?

A more perfect alignment on the waterfall issue will come with clearer language in LPAs, more (and standardized) cash-flow and valuation information shared with LPs, as well as do-it-yourself calculation tools so LPs are not entirely dependent on intermediaries and the GPs to understand their positions. A DIY tool was recently unveiled by BNY Mellon, but, of course, the ability to crank out a waterfall calculation is only as good as the specificity of the data used to auto-generate a result.