Going over waterfalls in a better barrel

The debate over waterfalls has always been presented as a choice between two opposing styles, but it doesn’t have to be that way. Augentius’s Gaurav Marwah and Hugh Stacey tell us why.

At Niagara Falls, a tradition among intrepid daredevils developed in the early 1900s to go over the falls in a barrel. People became celebrities for doing so (and living to tell the tale), and the act has become shorthand for daring escapades one would be lucky to survive.

While negotiating LP agreements can bring private equity players into choppy waters, no one needs feel they are tempting fate by taking on the waterfalls issue today. There doesn’t have to be a ‘winner’ or ‘loser’. Both sides of the fund ledger can work to seek common ground and ensure that everyone can mutually benefit and assuage risk as much as possible.

Traditionally, waterfalls – or how profits flow to investors and managers – have fallen into two specific styles. The deal-by-deal approach allows GPs to collect carried interest from individual deals as they achieve exits without any immediate giveback for losses on less-successful investments. This incentivises individual GP members to make their 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 emphasises returning all LPs’ contributions before GPs see carried interest from a fund. This minimises 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 last decade, a clear preference has developed for the whole-of-fund model among LPs. Yet, issues related to waterfalls persist and forward-thinking investors and fund managers continue improve on the model. The whole-of-fund approach may create greater accountability for the GP, but it can also serve to undercut their motivation, particularly for junior members of a firm’s deal team who bemoan the years needed to reap the rewards from their efforts.


And so hybrid models have been developed to satisfy the LPs’ need for security and the GPs’ need for profitable dealmaking. 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 realised investments (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 paid to the GPs earlier. The hybrid waterfall option is also more likely to contain an interim clawback feature, since that 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 will likely remain, but elements of each of them are used together in a wider variety of bespoke structures that address changing market conditions and the evolving needs of investors. 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—such as multi-tier hurdles and carry rates, phased GP catch-up and so on.

The more GPs choose to deviate from the simplistic whole-of-fund or deal-by-deal models, the greater the complexity of the fund documentation that needs to be put in place. Implementing the desired commercial terms can have consequences which need to be thought through. For example, it is clear that the fund administration, accounting or audit processes can become more burdensome when using complex waterfalls. But advice may need to be sought to establish the practical impact of tax cost in cases where GP members are allocated early carry, on which they suffer 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 LPs seek greater clarity and transparency in all aspects of their relationship with GPs. Under both political and regulatory pressure, LPs need to account for every penny up-front to show their stakeholders that all investments are being handled properly and their 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.