GPs experiment with waterfalls

Recent fund launches have seen general partners tinker with the distribution waterfall, writes Proskauer’s Andy Shore

The most recent vintages of funds in European private equity have seen a dramatic increase in the number of GPs experimenting with one of the most stable fund terms: the distribution waterfall.

Historically, almost all distribution waterfalls were either whole fund (requiring the return of all investor contributions before paying carried interest) or deal-by-deal (requiring the return of only a portion of contributions relating to realised investments prior to paying carried interest).

GPs are now using the favourable fundraising environment to vary and innovate on the economics.

In 2017 and 2018, many European funds offered investors the choice between a whole fund distribution waterfall and a deal-by-deal waterfall, with those opting for a deal-by-deal waterfall getting a discounted management fee or a reduced carried interest percentage. In Proskauer’s recent survey of 20 pan-European funds raised in 2017 or 2018 with commitments in excess of €750 million, four had introduced optionality into their distribution waterfall.

These options do result in a level of uncertainty for the GP as it sets about fundraising, and add an additional layer of complexity for the fund accountants tasked with implementing the offering. For these reasons, they tend to be the reserve of the large-cap market or for GPs operating multiple products.However, the optionality does not need to be limited to the type of distribution waterfall, with other GPs offering LPs the choice between a simple 20 percent flat carried interest rate and either a flat carried interest rate above 20 percent, or a ratchet carried interest mechanism (where the carried interest rate increases above 20 percent once a certain return threshold is met), in each case in return for a discounted management fee.

Away from the optional distribution waterfalls, some GPs have also sought to incorporate a fixed ‘hybrid’ model or carried interest ratchet into their offering.

Broadly, two types of hybrid waterfall have emerged. The first puts a fixed portion of an LPs commitment through a whole fund distribution waterfall, with the remaining portion being run through a deal-by-deal waterfall. The second operates initially as a deal-by-deal distribution waterfall with a reduced carried interest rate (ie, between 5-15 percent), with an increase in the carried interest rate to 20 percent once LPs have received back an amount equal to their drawn commitments. Both models allow GPs to generate carried interest distributions quicker, without offering a fee discount. They are more prevalent in the lower mid-market and mid-market European private equity funds. Only one of the pan-European funds surveyed above included a fixed hybrid waterfall.

Carried interest ratchets offer a simpler solution for the fund accountants, but are focused on increasing the quantum of carried interest. They don’t offer the benefits of accelerated carried interest flows. As with the hybrid model, these typically appear in the lower mid-market and mid-market, with carried interest rates increasing to as high as 30 percent.

Among all of the variation set out above, there is one consistent theme: that LPs, in a fundraising cycle where GPs have been able to agree more favourable terms, are more willing to entertain innovation and have demonstrated flexibility in their approach.