Problems persist in automating waterfalls

While technology has been able to automate certain aspects of investor reporting, fund accounting and other back-office functions, CFOs continue to wait for a push-button solution to calculate distribution waterfalls, delegates heard at the PEI CFOs and COOs Forum last week in New York.

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,” said at the conference 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, delegates heard at the conference. “There are some software packages out there that can do it, but it has to be highly customized for each separate fund under management,” said Pride.

CFOs desire a software solution that will allow 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 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 conference.

Hearing those wants, service providers, including BNY Mellon, Koger and eFront, have created platforms that have been able to unravel some of the complexities in automating waterfall distributions.

“The problem of extracting the right data and performing a calculation has been answered but going forward finding the right balance between automation, auditability and flexibility is key,” said during the panel, Eric Bernstein, head of North America operations for software service provider eFront.

Moreover a risk in fully automating the waterfall distribution is creating a “blackbox” that may hide any calculation errors, said Pride. “Using excel gives you a record of the waterfall. Calculations can be more easily traced back and shown to auditors or investors.”