The idea of waterfall distribution represents one of the core and critical concepts pertaining to private equity and real estate investment, exactly as the way made profits out of an investment will be distributed between investors and fund managers. It is therefore called in equity investing the “distribution waterfall” because it describes how capital gains of the fund trickle down between the participants of an investment, normally among the limited partners and the general partner.
The capital of limited partners in a private equity fund is managed by the general partner himself. The general partner contributes only a relatively small proportion of the total investment, structures for distribution waterfalls are primarily set up in order to ensure that profits are allocated to the manager only after the agreed return on their investment has been received by the limited partners. The structures are found in the distribution part of the private placement memorandum (PPM).
Concept is founded on a fixed sequence wherein the distribution of profits is provided. Here, the limited partners and general partners interests are well-balanced and held in equilibrium.
This prescriptive sequence determines the economic relationship between equity participants and defines the allocation of revenues and profits that, in turn, sets the interest of general partners (GPs) vis-a-vis the interests of limited partners (LPs) in a profit-distribution order.
The operating agreement defines the steps of the process in distributing the profit that dictates how the cash flows is among the investors. The first step in the process has been returning capital from the limited partners to ensure that their capital precedence in the process of distribution.
IMPORTANCE OF THE DISTRIBUTION WATERFALL
A waterfall defines rules and processes over the distribution of profits in a private equity investment agreement. The primary function of a waterfall is to harmonize incentives for the general partner and to clearly indicate a pay structure of the limited partners.
This structure can be thought of in the image of buckets stacked upon each other. Each bucket contains an allocation of profits, and when one bucket is full to the brim with profits, the excess fills up the next bucket, and so on.
In this respect, the capital flows from limited partners (favored by the initial buckets) to the general partner (favored by buckets further away from the source). Such an allocation structure protects the interests of the investors and, at the same time, incentivizes the general partner to maximize the return of the fund.
There are two types of equity waterfall arrangements-
1.American Equity Waterfall –
2. European Equity Waterfall
American Equity Waterfall: This waterfall is also called deal-by-deal model by some people. The basic difference between the American waterfall and the European waterfall is in the treatment of carried interest, in an American waterfall, the sponsors first receive their carried interest from individual investments in the fund before limited partners can get whole. In other words, the sponsors receive carried interest from individual deals rather than from the entire fund.
This model benefits the sponsor because they often have to wait much less time to receive carried interest from the fund. They can start collecting carried interest on day one in some cases. The limited partners also bear more risks because they may not achieve their hurdle rate before the sponsors. Since the American waterfall is less attractive to limited partners, sponsors often include a claw back (or look-back) clause.
European Equity Waterfall: In a European equity waterfall, the sponsors are entitled to carried interest only after recovery and achievement of the preferred rate of return of all contributions made by limited partners, including unrealized investments. The pro-rata distribution is applied, and thus, the initial investment proportions determine the allocation for the limited partners. In other words, the investor who possesses 20% of the equity in the fund will receive 20% of the distributions until he recovers all of his initial capital and achieves the desired rate of return. Sponsors do not get paid until all of the limited partners have been satisfied.
The European model is relatively more favorable to the limited partners. Sponsors may have to wait years before being granted a share of the profits. It increases the risk of a sponsor and encourages the sponsors to sell investments early.
The waterfall models have been adopted around the world, although use of the American model is more typical in the United States and use of the European model far more typical in Europe. Hybrid waterfall models that partially distribute carried interest on a deal-by-deal basis are becoming increasingly popular with some sponsors.
There is a four-tier structure within a waterfall distribution:
ROC (return of capital): Return of Capital ROC Return of capital is the return of the invested capital back to the investors. The first characteristic that predominates in a private equity waterfall to ensure priority on the limited partner is the return of the paid first on their capital invested and return of capital. The Return of Capital tier ensures that all distributions made to the limited partners are up to the original investment recovered.
The ROC remains unreported as long as the adjusted cost base of the original investment maintains an amount above zero. A return of the principal amount, it can impact the cost basis of the investment.
Preferred Return: Preferred return is a cornerstone concept of waterfall distribution, a set, say 8% rate of return is paid to the limited partners on their investment. Any amount left after paying this percentage is termed as extra profits and distributed amongst the other partners. In private equity waterfalls, preferred return means predefined percentage profit distributions made to a bank of limited partners before making any kind of distributions to the general partners.
The Preferred Return tier ensures that the surplus from the investment goes to the limited partners before it is shared with the rest of the investors. In other words, it ensures that there is a minimum level of income for any investor in the project. This aligns the interest between the limited and general partners because it ensures that there is a minimum return as generated from the investment made by the limited partners. This structure ensures a fair division of the profits between limited partners and general partners, because any surplus should be returned as invested capital or preferred returns before it is distributed as profits to GPs.
Catch-Up Tranche: The catch-up tranche is that level of the waterfall distribution whereby the GP can benefit from an increased percentage of profits after the LP has acquired the preferred return. With the catch-up tranche, general partners will be able to attain a fixed percentage of the profits through the receipt of a higher proportion of such profits.
The important thing about the catch-up tranche is that it allows the GPs to achieve a higher percentage of profit till they reach a predefined percentage level, and, while doing so, allow a GP to realize its share of profit in preference over other investors. It can be handy for both the GP and investors.
Carried Interest and Residual Split: It simply refer to the remaining allocations of profit between limited partners and general partners, which is susceptible to Capital Gains Tax. This tier of distribution between the limited partner and the general partner holds an advantage, in that the remaining profits are shared between both parties quite fairly due to the income derived from investment, this carried interest and residual split tier is taxed on capital gains; therefore, this impacts the total return of the partners as well as the general partners. Understanding the tax imposition on this tier is significant in the crafting of an effective waterfall distribution agreement.
CONCLUSION:
Lastly, one must know how the waterfall distribution works as well as all the subtleties associated with it. In doing so, this knowledge will also help construct better deals in private equity and real estate investment. Thus, the four-tiered structure involves return of capital, preferred return, catch-up tranche, and carried interest/residual split to ensure the equitable sharing of profits amongst investors and fund managers. It is well to compare both American and European structures for waterfall that will best suit your current needs of distribution. This concludes by stating that interests must be aligned, along with the legal aspects of the waterfall distribution agreement.