Get someone to go over the waterfall

Tim Eberle, vice-president at fund services business Citco, makes the case for third-party verification of waterfall calculations.

Tim Eberle

As LP capital allocations into real estate, private equity and private debt funds have continued to increase, so have the demands for transparency in regards to GP incentive fee calculations. This fact, coupled with the industry trend towards increasingly complex and bespoke incentive fee calculations, presents new opportunities for third-party service providers in the area of “waterfall verification”.

Under a waterfall verification/waterfall recalculation service model, a third-party service provider (including, but not limited to, a private equity fund administrator) would be engaged to independently verify a fund’s waterfall calculations – ensuring that methodologies and results align with the fund’s governing documents.

This service would be of benefit to the limited partner and the general partner: limited partners would have the benefit of independent review in regards to the incentive fees they are being charged on positive performance, and general partners would have the benefit of outsourcing a complicated accounting function to a third party, one with both the expertise and the technology in place to ensure that waterfalls are being calculated accurately, in a timely manner and in accordance with best industry standards and practices.

Additionally, independent waterfall calculation and review would reduce the increasing administrative burden placed on limited partners and general partners. Outsourcing the waterfall review function would allow large institutional investors to focus primarily on their core competency of capital allocation, while third-party verification would provide the limited partners with the due diligence necessary to reduce investor queries to the GP, the majority of whom have seen an increasing number of investor requests for bespoke reporting and transparency.

An added benefit to both parties lies in the ability of a dedicated third party to not only verify waterfall calculations, but to also advise as to industry best practices. While the majority of legal language underlying waterfall calculations is similar across funds, the actual application of that language varies widely across the industry, leading to confusion, miscalculation and difficulties in comparing performance across a limited partner’s investment portfolio.

Under a verification/recalculation model, third-party service providers would play a significant role in the standardization of accounting and calculation practices (including, but not limited to, standardized data templates, standardized output reporting and possible integration with external GP accounting platforms.) While a push towards standardization yields obvious benefits to the limited partner, the onus for providing standardized output has fallen disproportionately on fund managers. Incorporating a third party into the process would help to ease the increasing administrative burden placed on the GP, as well as reduce the redundancy associated with the varying requirements of a fund’s client base.

While private equity as an industry has been largely resistant to the idea of outsourcing its administrative and accounting function (especially when compared to other alternative asset classes, such as hedge funds,) a waterfall verification model would afford these private equity funds the benefit of tapping into third-party expertise, while allowing them to continue to maintain primary control of the fund’s data, branding, and relationships. And while the adoption of this service will almost certainly be LP driven, a successful application of this model will bring palpable benefit to the GP as well.