Don’t go chasing automated waterfalls

Having the ability to calculate waterfall distributions at the touch of a button is something all private equity chief financial officers agree would make their lives easier. But whether the technology exists to make it happen, or would even be embraced by GPs, has been another matter.

Waterfall calculations are governed by delicate language found in the partnership agreement that determines how money from realized investments will be divided between LPs and the fund manager.

“If you’ve worked on more than one fund, you know each fund waterfall process is defined totally different in the partnership agreement,” says EY private equity principal Shawn Pride.

Factors such as clawback provisions, multilayered tiers of carried interest rights and whether carry is paid on a whole fund or deal by deal basis all complicate the waterfall distribution process.

The challenge then is writing software code that could account for all the nuances within each partnership agreement’s waterfall model. “There are some software packages out there that can do it, but it has to be highly customized for each separate fund under management,” says Pride.

Nonetheless, CFOs say that having to manually figure out the order in which a private equity fund makes distributions is a time-intensive process begging for efficiencies to be made.

Ultimately what CFOs would like is a software solution that allows them to forecast carried interest payment streams by playing with a fund’s IRR – moving it up and down to see what kind of carry figures partners could expect under various distribution scenarios.

“The deal team will ask me what IRR we need to hit for X amount of carry in 2014, and I’ll just have to rely on manual methods to figure it out,” said one CFO delegate at the PEI CFOs and COOs Forum held earlier this year in New York.

But even though CFOs complain that Excel isn’t exactly a perfect tool to handle the large volumes of nuanced data that come with waterfall calculations, they are reluctant to try something else because the program is familiar, says Eric Bernstein, head of North America operations for software service provider eFront.

THE CHALLENGES IN CODES

Aware of the market’s needs and concerns, service providers say they’ve developed products that can reduce some of the manual processes in calculating waterfall distributions.

One way this is being done is via a code-driven “black box”. Under this approach, a programmer takes into account all the intricacies that go into the partnership agreement and various other client needs and writes software code that can automate that particular fund’s unique waterfall distribution method. As a result, the CFO no longer has to manually input formulas into Excel each time a waterfall distribution needs to be determined.

But having a specialist programmer work out all these details to write software code is a significant challenge, according to sources. And although these solutions have much to offer once implemented, they are only workable as long as the GP doesn’t change how the waterfall is fundamentally calculated, says Bernstein.

Some CFOs browsing different software packages able to automate the waterfall distribution have been put off after realizing any change in their LP base for instance, or new allocation of carry amongst the partners, meant the software was no longer tailored perfectly to their needs. “This was a route people were going down but they have now seen the problem – that every time they want to change [the waterfall] it’s code development, not configuration on Excel,” says Bernstein.

Another potential pitfall in automated waterfalls is the traceability of the calculations. CFOs say they need the ability to easily show investors, auditors and even regulators how the numbers were crunched when distributing proceeds. But the black box system may only be able to provide the inputs and outputs.

ALTERNATIVE SOLUTIONS

However, the code-based approach is not the only option available for CFOs who want their waterfalls automated. Service providers, such as US-based Relevant, BNY Mellon and Koger, offer automated solutions as add-ons for their fund administration clients.

These systems have the potential to be far more efficient than Excel, says Ray Haarstick, Relevant’s founder and chief executive. Arguably the most time consuming aspect of the waterfall calculation process is figuring out which LPs have reduced fees, taking into account clawback provisions and all the other nuances that go into the process. But Haarstick says some software providers that double as fund administrators have already worked out these details during the LP intake process and other services they provide.

A more automated solution also has the potential to reduce human error, note service providers. “There are so many things that can go wrong if you are modeling the waterfall yourself,” says Haarstick. “If you are using a spreadsheet, you’re more prone to keyboard and link updating errors.”

But critics of these systems argue they require the software provider to have intimate knowledge of a firm’s legal and account documents. “What is cumbersome is you need to get all of the data out of a firm’s accounting system,” says Bernstein. “Although these systems look pretty cool and work well, it is a monumental effort to put them in place.”

There’s also a cost argument to consider here. Recent EY research conducted with PEI found that GPs typically allocate less than 5 percent of their annual budget to technology spend – making every dollar count when investing in technology. And some say automating the waterfall, while seen as an area of improving back-office efficiency, is not something that requires the CFO’s immediate attention; rather it is “a nice-to-have”, says Bernstein. “If I were to invest dollars to solve a problem at my firm, [automating the waterfall] wouldn’t make the top five.”

Still, CFOs are clear in their desire for a push-button solution to calculate distribution waterfalls on the cheap. Service providers are no doubt listening.