In private equity, "waterfall calculations" refer to the distribution of profits among different stakeholders in a fund. The waterfall structure outlines how profits from an investment are distributed among limited partners (LPs) and general partners (GPs) based on certain criteria, often in a hierarchical manner. This structure ensures that distributions are made in a specific sequence, typically following these main steps:
Waterfall calculations can have various tiers or levels depending on the terms of the fund. For example, there might be different hurdle rates (minimum rates of return) or multiple tiers of carried interest based on the fund's performance.
Different funds might have different waterfall structures, each designed to align the interests of LPs and GPs while incentivizing GPs to maximize returns. These structures are typically outlined in the Limited Partnership Agreement (LPA) at the inception of the fund.
Types of water fall provisions
In private equity, American and European waterfalls are two common structures used to distribute profits among fund stakeholders, primarily limited partners (LPs) and general partners (GPs). These structures outline how profits are allocated and when different parties receive distributions.
The American waterfall, also known as the deal-by-deal waterfall, is more commonly used in the United States. It distributes profits on a deal-by-deal basis, meaning that each investment or deal's profits are distributed separately. In this structure:
Preferred Return: LPs receive their preferred return (if applicable) on each deal before GPs receive any share of profits. The preferred return is calculated based on the invested capital for that specific deal.
Catch-Up Provision: After the preferred return is met, GPs might be entitled to a catch-up provision. This provision allows GPs to 'catch up' and receive a larger share of profits until they reach a predetermined share, usually around 20%, before LPs and GPs share profits equally thereafter.
Split of Remaining Profits: Any profits beyond the preferred return and catch-up provision are then split between LPs and GPs based on a pre-agreed-upon percentage (e.g., 80% to LPs, 20% to GPs).
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2. European Waterfall:
The European waterfall, also known as the whole fund or aggregate approach, operates differently:
Preferred Return and Cumulative Profits: LPs receive their preferred return on the aggregate or total profits of the entire fund, rather than on each deal separately. This means that profits are not distributed until the entire fund has generated enough returns to meet the preferred return hurdle.
Catch-Up Provision: After the preferred return is met, GPs might be entitled to a catch-up provision. Usually around 20%, before LPs and GPs share profits equally thereafter.
Carried Interest Allocation: Once the preferred return hurdle and catch up are met on the total fund profits, GPs become eligible for carried interest. The carried interest is often a fixed percentage (e.g., 20%) of the entire fund's profits, not tied to specific deals.
The key difference between American and European waterfalls lies in their timing of profit distributions. American waterfalls distribute profits on a deal-by-deal basis, while European waterfalls distribute profits after the entire fund meets the preferred return threshold.
Example :
Let's consider an example illustrating how American and European waterfalls might distribute profits in a hypothetical private equity fund.
Scenario:
Fund Size: $100 million
Preferred Return: 8% preferred return for LPs
Catch up : 20%
Carried Interest: GPs entitled to 20% after meeting the preferred return
American Waterfall Example:
Deal 1:
Investment: $30 million
Profit Generated: $15 million
Preferred Return: 8% of $30 million = $2.4 million
LPs receive $2.4 million first.
Catch-Up Provision: 2.4(20/80) = $ 0.6 Million
Remaining Profit: $15 million - $2.4 million -$0.6 million = $12 million
Split of Remaining Profits: Assuming a 80/20 split after preferred return.
LPs receive 80% of $12 million = $9.6 million
GPs receive 20% of $12 million = $2.4 million
Deal 2:
Investment: $40 million
Profit Generated: $25 million
The process repeats for each deal separately, following the same steps within the American waterfall structure.
European Waterfall Example:
In the European waterfall, profits are accumulated across all deals until the entire fund meets the preferred return before distributions occur.
Total Profit Generated from all Deals: $40 million
Preferred Return on Total Fund: 8% of $100 million = $8 million
LPs receive $8 million first.
Catch up Provision: 8(20/80) = $2 million
Remaining Profits Available for Carried Interest: $40 million - $8 million - $2 million = $30 million
Carried Interest (GPs): GPs are entitled to 20% of the total fund's profits after the preferred return.
GPs receive 20% of $30 million = $6 million