U.S. private equity fund distributions waterfalls generally fall within one of two broad types: return-all-capital (sometimes referred to as European-style waterfalls) and cumulative deal-by-deal (sometimes referred to as American-style waterfalls) waterfalls. Generally, the latter type of waterfall only requires capital contributions in respect of deals that have actually been disposed of, and a corresponding portion of expenses, to be returned to investors before profits distributions are made. Because capital contributions for deals that have not been disposed of do not have to be returned prior to profits distributions, these waterfalls generally permit general partners to receive carried interest distributions sooner than do return-all-capital waterfalls.
The ability of the general partner to get to the carry more quickly can be good for both investors and the general partner. For example, it might assist the general partner in recruiting young talent, or it might lower the amount of management fees the general partner needs to charge. But with these benefits come the costs of potentially lower investor IRRs (based on the timing of investor distributions) and a greater risk of the fund getting into a clawback situation.
Fortunately, the private equity industry is not limited to the choice between a simple return-all-capital waterfall and a classic cumulative deal-by-deal waterfall. Instead, we increasingly see various “twists” on the classic deal-by-deal waterfall that make it a little closer to the return-all-capital model, but while hopefully retaining the potential advantages of the deal-by-deal model to some extent.
Below are five examples of these modifications that we see frequently:
1. Treatment of Written Off and Written Down Investments. Almost all deal-by-deal waterfalls treat investments that have actually been written off the same as those that have been disposed. But we increasingly see that investments that are written down by a significant amount – e.g., 90% – are treated as if they had been written off. Aside from the obvious benefits, this might also reduce the incentive of the general partner to avoid writing off worthless investments. Much less frequently, some waterfalls require all write downs to be returned prior to profits distributions.
2. Return of Expenses. Classically, deal-by-deal waterfalls only required the return of a pro rata portion of fund expenses, equaling the portion of the fund’s investments that had been realized, before profits distributions could be made. Investors are increasingly asking that instead 100% of expenses be required to be returned prior to profits distributions.
3. Catch-Up to the Preferred. Most typically, a deal-by-deal waterfall provides for 100% of profits distributions after the return of capital and preferred return to be made to the general partner until it has received in the aggregate 20% of the total distributions in excess of the return of capital – i.e., until it has been “caught up” to the preferred return. However, the catch-up “works” – in the sense of eventually getting the general partner to its correct percentage of profits distribution – as long as the general partner receives in excess of 20% of the catch-up distributions. Accordingly, some waterfalls provide for the general partner to receive only 80%, or sometimes even only 50%, of catch-up distributions, with the remainder going to investors.
4. Portfolio Value Test. One of the more straightforward ways of guarding against clawbacks with a deal-by-deal waterfall is to include in the investment documents a rule that only permits carry distributions to be made if either investors have received aggregate distributions exceeding their aggregate contributions or if the fair value of the remaining portfolio is at least equal to the amount of unreturned contributions.
5. Interim Clawback Application. A final example of a way that the clawback risk of a deal-by-deal waterfall can be lowered is by requiring interim applications of the clawback, such as at the end of the investment period. The interim clawback is based on the clawback that would be payable on a hypothetical liquidation of the fund at that time. This is similar in many ways to a portfolio value test, but applied retroactively instead of prior to the carry being paid.
These are all ways that investors can lower the risk of clawback and improve the timing of investor cash flows without requiring a return-all-capital waterfall. A fund with a deal-by-deal waterfall that, for example, requires capital invested in any investment which has been written off or written down by more than 90% to be returned prior to profits distributions, requires the return of all amounts contributed by investors for the management fee and other fund expenses before profits distributions, has a 50/50 catch-up on the preferred, and requires the clawback to be applied at the end of the investment period, is still a deal-by-deal waterfall, and still has some of the benefits to both investors and the general partner of a deal-by-deal waterfall. But it is one that has been moved materially in the direction of the return-all-capital model. In some cases these types of waterfalls can make good business sense for both investors and general partners.
Henry Riffe practices corporate and commercial law at Robinson Bradshaw with an emphasis on private equity and venture capital transactions and mergers and acquisitions.