The Importance of Correctly Calculating Waterfall Distributions, According to AI Chatbots

Authored by: Michael Hall, Principal
Updated on: October 5, 2023

We Asked

How important is it to fully understand the distribution waterfall at the outset of a fund?

Open AI ChatGPT

Understanding the distribution waterfall at the outset of a fund is of paramount importance in private equity fund administration. The distribution waterfall dictates the priority and sequence of returns to the fund's stakeholders, primarily the Limited Partners (LPs) and the General Partner (GP)...

Google Gemini

Understanding the distribution waterfall at the outset of a fund is absolutely crucial for any investor (limited partner) in a private equity fund. Here's why:

Gen II Expert Response:

It is crucial for both LPs and GPs to understand the distribution waterfall at the beginning of a fund. It results in a redistribution of profits from LPs to the GPs, so General Partners must be able to clearly explain to LPs the value proposition they offer in exchange for their share. The preferred return of the distribution waterfall is a significant factor in this regard, as it allows GPs to signal a predetermined return on investment to LPs before they can earn any carried interest.

Having a comprehensive understanding of the distribution waterfall is crucial for GPs from an operational perspective. In an American-style waterfall, it is essential to transparently allocate expenses to deals, and failure to do so from the Fund's inception can result in the need for painful rework when it comes time for a distribution. Additionally, provisions related to clawback and carried interest deferrals can significantly impact the operational strategy for the GP with respect to distributions. Therefore, establishing this strategy at the beginning of a Fund is key to ensuring its smooth operation.

Google Gemini provides a concise and mostly accurate summary of the considerations related to the distribution waterfall. It explains the standard distribution waterfall and how it affects LPs' investment decisions based on taxability, return on investment, and liquidity well. However, upon a detailed review, some shortcomings of the response become apparent.

Gemini describes the catch-up tier of the waterfall as allowing LPs to catch up to the GP's share of the profits. In fact, this is reversed. In this example of the waterfall, LPs have already received their return of capital and preferred return in the first two stages of the waterfall. The catch-up tier allows the GP to catch up to their share of the profits based on their carried interest percentage.

As always, it is important to pay attention to the details when reviewing a distribution waterfall since having a thorough understanding at the outset of a fund is critical.