1 Excel still excels
The waterfall is the most complex calculation in the private equity industry – and the most important. Within several general models for calculating carried interest, firms use an infinite variety of different adaptations – sometimes operating different structures across funds and even within funds themselves.
“We see firms that may have multiple variations of already complex waterfalls across 80-100 different funds,” says Scott Pearson from EWM Global.
The fact waterfall calculations are so bespoke means it’s hardly surprising that firms are cautious about moving away from internal systems, which are almost always based on Excel. Our annual survey of CFOs shows just 6 percent have automated their waterfall calculations. There is widespread trepidation about whether automated systems can account for the nuances contained in firms’ spreadsheets. CFOs are also concerned by the cost, particularly at smaller firms. Even so, 10 percent of firms in our survey plan to automate – and automation is likely to cascade if concerns over functionality and cost can be addressed.
2 Key person, key problem
Studies show Excel spreadsheets are not as reliable as CFOs might think. “Excel has the advantage of familiarity,” says Joe Hayward, tax and financial manager at ECI Partners. “But it does have limitations in that it can be difficult to prevent errors creeping in.”
Small mistakes in entering data, formulas or formatting cells can mean disaster for a firm’s reputation.
A growing number of CFOs appear willing to consider automated alternatives. In particular, firms might need to consider automation due to auditing requirements and succession planning. At many firms, a single “key person” has knowledge and control over critical waterfall calculation methods.
“The administration of our carry and co-invest plans has been highly manual and owned by one person for a number of years,?”says Seth Berger, chief financial officer at AEW Capital Management, which has recently automated carry plans. “As our business has grown over the years with additional plans, the ability to maintain clean, consistent record-keeping has been outlived.”
3 Team members want transparency
As well as creating a business continuity risk, the tendency for Excel systems to be controlled by gatekeepers means that team members cannot easily work out the status of their own carry allocations.
Equally, automated systems are built with collaboration in mind. Unlike Excel, LPs can easily dive into waterfall calculations, without fund managers needing to share their entire model. And the actual process of automating – though sometimes painful – ultimately offers potential benefits for firms.
“They are forced to reassess LPAs and the way waterfalls have traditionally been calculated,” says Riyaz Gadiwalla, head of product management at EWM Global. “Sometimes complacency has crept in and things are being done in a certain way, simply because that is the way they have always been done.”
Firms that use Excel for their waterfall calculations value the familiarity and relative simplicity. But in simplifying their models, to make them easier to repeat in Excel, they may be missing out on carry. “Simplifications end up overstating the preferred return, when compared to an automated system that is carrying out a far more detailed and complicated calculation,” warns Pearson.
EWM Global’s Robert Hagmeier illustrates this point with a mathematical comparison of two ways to calculate carried interest. The fixed date compounding method, where firms compound all their fund?s outstanding capital on a certain date, is simpler to operate in Excel. But using an automated system to calculate separate preferred return accruals for each capital call on their respective anniversary date is more accurate and results in a lower hurdle value. This avoids a time-value loss and means partners can be paid on their carry earlier. And for a marginally profitable fund, writes Hagmeier, it can ?prove the difference between partners receiving a small amount of carry or none at all.?
5 Slicing the pie
Regardless of which waterfall method is used, deciding how to split carry between team members is often contentious. Private equity recruiter Gail McManus has compiled data showing how founding partners tend to take the vast majority of the carry pool in first-time funds. Although their share is naturally diluted as their firms grow and they promote more partners and directors, the problem of how to allocate carry only gets more difficult.
“Resentment can sometimes build up among the cohort that feels it is delivering the bulk of the workload in a fund,” writes McManus. But “founders may well feel that they are only just getting the rewards of their years of effort in funds three and four.”
Firms typically use complex formulas to allocate the carry share of executives who leave the firm before the end of a fund, distinguishing between ‘good’ and ‘bad’ leavers. Unsurprisingly, “the consequences for being a bad leaver (or being downgraded from a good to a bad leaver) are uniformly bad,” notes Christopher Good, a partner at Macfarlanes. But even ‘good leavers are unlikely to be fully satisfied with their package, since allocation rules are “written so as to incentivize the executive to stay for the duration of the fund?s investment period.”