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)...A few reasons underscore its significance:
Alignment of Interests: A clear and agreed-upon distribution waterfall ensures that the interests of both LPs and the GP are aligned. It establishes how and when the GP earns carried interest, thus motivating the GP to achieve performance targets.
In conclusion, fully understanding the distribution waterfall at the fund's outset is crucial for aligning interests, setting investor expectations, ensuring operational accuracy, maintaining compliance, and fostering trust.
It is extremely important to fully understand the distribution waterfall at the outset of a fund. The distribution waterfall is a legal document that sets out the order in which profits from the fund will be distributed to the limited partners (LPs) and the general partner (GP). It is important to understand the waterfall because it can have a significant impact on the returns that you receive as an LP...
The waterfall typically has four tiers:
The specific terms of the waterfall can vary, so it is important to read the fund's investment agreement carefully. However, all waterfalls have the same basic goal: to ensure that the LPs get their money back before the GP starts to make a profit.
Here are some additional reasons why it is important to understand the distribution waterfall:
By understanding the distribution waterfall, you can make sure that you are making an informed investment decision and that you are getting the best possible return on your money
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 Bard 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.
Bard 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.