Topic 2.13: Distribution Waterfall

Importance of the Waterfall DistributionGeneral Partner Incentive Structure

Profits and Carried InterestDistribution of Profits

General Waterfall DistributionBreakeven IRR

Preferred Return as a Free OptionClawbacks

186

Importance of the Waterfall DistributionPrivate equity investments require numerous critical decisions over a long investment horizon Decisions are largely unobservable by limited partnersNeed to align incentives and pay structure to protect limited partners and maximize returnsDistribution waterfall sets the rules and procedures for the distribution of profits

LO 2.48

187

General Partner Incentive StructureCarried interest – Key incentive aligning device; percentage profit split after meeting hurdle rate; typically 80/20Management fees – 1.0%–2.5% of committed capital; used for operating costsGeneral partner contribution – 1.0% of committed capital; aligns interests of the managers and investorsVesting – Legal transfer of incentive payments to managersDistribution provisions – Specific timing and provisions of profit distribution

LO 2.49

188

Profits and Carried InterestHurdle rate (preferred return) – Must be distributed to investors before managers earn carried interestClawback – Managers must return funds to investors from overpayment of carried interestCarried Interest:

Deal-by-deal – General partner receives profits on each investment; manager receives profits sooner; limited partners have exposure to future lossesFund-as-a-whole – Calculates carried interest on the performance of the entire fund; more likely to align the interests of managers and investors

LO 2.50, 2.51, 2.55

Hurdle rate (h%) will be specified in the distribution provisions for the fund Must estimate value (ah) that must be achieved before general partners participate in carried interest

Managers are entitled to a u% catch-up under the distribution provisions and will accrue u% of the next amount, c, earned by the fund

189

Distribution of Profits

LO 2.52

h ? uIRR with full carried interest = u ? c

T ? th na = C (1 + h)∑

t < T

n = 1

190

Example: Distribution of ProfitsInvestors contribute $100M to a private equity fundHurdle rate is 10% and the fund is worth $150M at the end of the year Catch-up rate is 100%Carried interest split is 80/20

Calculate the distribution of profits and the full carried interest IRR

LO 2.52

191

Example: Distribution of Profits (continued)

Investors: receive principal plus preferred return of $110M = 100M × (1 + 0.10)10M / 12.5M = 0.80 = 80%General partner: receives 100% of the next $2.5M earned2.5M / 12.5M = 0.20 = 20%80/20 split is achieved; remainder of profits are split

LO 2.52

×= =

−10% 100%IRR with full carried interest 12.5%100% 20%

193

General Waterfall Distribution

LO 2.52

LP GP Total

Return of capital d d

Preferred return to LP ah – d ah – d

Catch-up for GP (1 – u)x u(x) x80/20 split or

residual (1 – c)y c(y) y

Closing balance Sum of above

Sum of above a – d

194

General Waterfall Distribution (continued)

LO 2.52

Investors contribute $100M to a private equity fundHurdle rate is 10% and the fund is worth $150M at the end of the year Catch-up rate is 50%Carried interest split is 80/20

Determine the waterfall distribution

195

General Waterfall Distribution (continued)

LO 2.52

LP GP Total

Return of capital 100 $100M

Preferred return to LP 110 – 100 = 10 $10M

Catch-up for GP (1 – 0.5)(6.67) = 3.335 0.5(6.67) = 3.335 $6.67M

80/20 split or residual

0.80(50 – 16.67) = 26.66

0.20(50 – 16.67) = 6.67 $33.33M

Closing balance $140M $10M $150M

196

Breakeven IRRFund A: 100% catch-up, 20% carried interest, and hurdle rate of 8% Fund B: 40% catch-up, 20% carried interest, and hurdle rate of 6%

LO 2.53

8% 100%Fund A 10%100% 20%

×= =

−6% 40%Fund B 12%

40% 20%×

= =−

IRR Return Fund A(hurdle rate = 8%)

Return Fund B(hurdle rate = 10%)

6% 0% 20%8% 20% 20%

10% 20% (caught up) 20%12% 20% 20% (caught up)

197

Preferred Return as a Free OptionDistribution of the preferred return is similar to a call option Strike price = contributed capital + preferred returnGeneral partner earns high returns if the option is deep in-the-moneyIf returns do not exceed the hurdle rate, the option is out-of-the-moneyAssumes general partner contributed little or no personal capital

LO 2.54

198

ClawbacksProvisions in partnership agreementEnsures equitable final distribution (carried interest split)

LO 2.56

Example:Asset X (purchased for $170M) is sold for $200M in Year 1. Asset Y (purchased for $30M) is sold for $10M in Year 2. 80/20 carried interest split with 10% hurdle rate. Determine the carried interest at the end of Year 1 and 2 and the clawback, if any

199

Clawbacks (continued)

LO 2.56

End of Year 1 (carried interest):(20%) × ($30M) = $6M to managers$30M – $6M = $24M to investors

End of Year 2 (no carried interest):$20M loss accrues to limited partners

Termination of the fund:Hurdle rate: $200M × 1.12 = $242M

Limited partners: $170M + $24M + $10M = $204MClawback: $242M – $204M = $38M

200

Clawback LimitationsUnenforceable if the fund does not contain liquid assets Payment is based on the general partner’s creditworthiness General partner may extend the life of the fund to delayPractical limitations of litigation

LO 2.57

Which of the following statements correctly compares the preferred returns of a private equity fund to the returns of a long call option?

A) For returns above the hurdle rate, the fund managers are out-of-the-money.

B) For returns below the hurdle rate, the fund managers are at-the-money.

C) For returns below the hurdle rate, the fund managers are in-the-money.

D) For returns above the hurdle rate, the fund managers are in-the-money

Which of the following statements correctly compares the preferred returns of a private equity fund to the returns of a long call option?

A) For returns above the hurdle rate, the fund managers are out-of-the-money.

B) For returns below the hurdle rate, the fund managers are at-the-money.

C) For returns below the hurdle rate, the fund managers are in-the-money.

D) For returns above the hurdle rate, the fund managers are in-the-money

Assume that limited partners contribute $100M in the first year of a private equity fund. The fund has a hurdle rate of 10%, an 80/20 carried interest split, and a 100% catch-up provision. If all investments doubled over a two-year period before liquidation, what is the fund’s distribution of profits over the investment horizon?

A) $20M for general partners; $80M for limited partners. B) $10M for general partners; $90M for limited partners. C) $16M for general partners; $84M for limited partners. D) $20M for general partners; $180M for limited partners

Assume that limited partners contribute $100M in the first year of a private equity fund. The fund has a hurdle rate of 10%, an 80/20carried interest split, and a 100% catch-up provision. If all investments doubled over a two-year period before liquidation, what is the fund’s distribution of profits over the investment horizon?

A) $20M for general partners; $80M for limited partners.B) $10M for general partners; $90M for limited partners. C) $16M for general partners; $84M for limited partners. D) $20M for general partners; $180M for limited partners

The limited partners are entitled to $121M (= $100M × 1.12) before any distributions to the general partner. Since the fund liquidated at $200M there will be a distribution to the managers. Further, since the rate of return on the fund is significantly above the hurdle rate, the catch-up zone can be ignored. Managers will receive 20% of the $100M profit (i.e., $20M). The limited partners will receive$80m.