At Niagara Falls on the border between Canada and the United States, a tradition among intrepid daredevils developed in the early 1900s to go over the waterfalls in a wooden barrel. People became celebrities for doing so (and living to tell the tale), and the act has become shorthand for daring escapades that one would be lucky to survive.
While negotiating limited partner agreements can bring private equity players into choppy waters, no one needs feel they are tempting fate taking on the waterfalls issue today. There doesn't have to be a winner or loser. Times and agreement structures have evolved. And there is a concerted effort on both sides of the fund ledger to seek common ground and ensure everyone can mutually benefit and assuage risk as much as possible.
Traditionally, the waterfalls — how profits flow to investors and managers — have fallen into two specific styles. The deal-by-deal approach allows general partners to collect carried interest from individual deals as they achieve exits, without any immediate giveback for losses on less-successful investments. This provides an incentive to individual GPs to make specific deals profitable; however, many LPs would only usually find this acceptable when coupled with a clawback mechanism, which could be impractical to operate at the end of a fund's life. By contrast, the whole-of-fund model — historically more common in Europe — emphasizes returning all limited partners' contributions before GPs see carried interest from a fund. This minimizes the risk of LPs having to claw back carried interest paid if the GPs have taken profits while their investors are left short.
Over the past decade, a clear preference has developed for the whole-of-fund model among LPs. Many of the new private equity funds raised, especially from first-time managers, have this feature, although exceptions remain for long-established players.
While the industry's direction of travel might be clear, issues related to waterfalls persist, and forward-thinking investors and fund managers continue to try to improve on the model. The whole-of-fund waterfall approach might create greater accountability on the part of the general partner, but it can also serve to undercut the motivation of GPs, particularly for junior members of a firm's deal team who bemoan the years needed to reap the rewards from their efforts. And after all, keeping young talent happy and engaged is in everyone's best interest.
So hybrid models have been developing, seeking to satisfy the LPs' need for security and the GPs' need for profitable dealmaking. Such developments in limited partner agreements illustrate the ongoing effort of both GPs and LPs to find common ground on the waterfalls issue. They allow GPs to reap some reward for good deals made earlier in the life of the fund but continue to offer traditional whole-of-fund-style model protections that make sure LPs will see cash returned with deliberate speed.
In the hybrid waterfall model, the GPs will need to deliver a return hurdle only on aggregate realized investments (together with, in most cases, written off/written down investments) as well as some or all of management fees and expenses. It mandates that cash is distributed earlier in the life of the fund to the GPs compared to a typical whole-of-fund arrangement.
With a hybrid model, the finer details of clawback or escrow of allocated carry become even more important, because profits are being paid to the GPs earlier. The hybrid waterfall option is also more likely to contain an interim clawback feature, because clawback risk is higher in deal-by-deal models. The end-of-term clawback model is still the most common, but interim clawback under deal-by-deal arrangements are popping up more and more as private equity players consider hybrid waterfall structures.
The traditional models likely will remain, but elements of each are cherry-picked and used together in a wider variety of bespoke structures that address changing market conditions and the evolving needs of investors. The blended model offers an alternate route to satisfaction for both sides negotiating a balanced incentive structure. Whichever template is adopted, it is clear from recent trends that one-size-fits-all is no longer the solution for incentive arrangements as a whole range of variations have been noted in recent years, including multitier hurdles, carry rates, phased GP catch-up, etc.
The more general partners choose to move toward a heavily tailored incentive structure, the greater the complexity of the fund documentation that needs to be put in place. Implementing the desired commercial terms can have consequences that need to be thought through, as some are more obvious than others. For example, it's clear the fund administration, accounting or audit processes can become more burdensome when using complex waterfalls. But advice might be needed to establish the practical impact of tax cost in cases where GP members are allocated early carry — on which they pay tax — yet the investors expect to claw back as much cash as possible to help them meet a later interim distribution hurdle.
The evolution of waterfall payout structures are to be expected in a dynamic industry such as private equity, as limited partners seek greater clarity and transparency in all aspects of their relationship with general partners. Under both political and regulatory pressure, LPs need to account for every penny up-front to show stakeholders that all investments are being handled properly and the partnership with the GP is beneficial for the long term.
Gaurav Marwah is technical director and Hugh Stacey is executive director, investor solutions, for Augentius Group, based in London. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.