Paul Gajer is the head of Dentons’ private equity and investment funds practices. Dentons is the sixth largest law firm in the world in terms of revenue and the largest in terms of the number of lawyers. We asked Gajer about waterfall trends in private equity, hybrid waterfalls and how the waterfall gets into limited partnership agreements.

Is there a certain type of waterfall that is trending more in the PE space currently?

I would say the trend has been a broader and broader acceptance of American-style waterfalls. There was a bit of a reversal around the financial crisis, around 2007-10, where investors got a lot more conservative and European-style waterfalls became a lot more common in that period. But in the last six, seven, eight years, I think the trend has been strongly towards American-style waterfalls again. And you’re starting to see more and more European funds and European institutional investors accepting them.

It’s very rare to see a European-style waterfall in a US fund unless it’s a first-time fund. When you have first-time fund managers, a lot of times the investors are naturally more conservative and have the negotiating power to demand a waterfall which they would view as more protective of the downsides.

How much does the size of your firm play into what type of waterfalls you implement?

It’s interesting: the size of your firm is usually directly correlated to the size of the fund that you raise as well as where are you in terms of your life fund cycle.

So, typically, first funds are smaller and they are more likely to have a European-style waterfall, whereas a fund three, four, five – each fundraise tends to incrementally get bigger, and usually there’ll be a break with fund two where you’ll firmly move to an American-style waterfall.

What’s the process by which GPs and LPs come to a waterfall agreement in the LPA?

So we do a lot of fund formation work at Dentons and the typical process is that the general partner will start a fundraising process and we’ll certainly advise our clients, especially first-time fund managers, to do what I’ll call pre-marketing with a PowerPoint deck that talks about “This is who we are, this is our investment philosophy,” etc. And that is distributed with a detailed term sheet, which says, “and this is going to be what our fund terms are.” And that term sheet will set forth the waterfall, the proposed waterfall. So you’re upfront in marketing to people and saying “this is what we’re proposing to do.”

At that point in time no one’s signing on the dotted line, but you’re getting feedback from the investors that you’re talking to. You’re gauging market reaction and you’re getting what is referred to in the industry as soft-circle commitments where people say, “I’m interested, send me the PPM and the definitive agreement.” Our job is to then take that detailed term sheet and turn it into a detailed LPA with the detail of the waterfall in there and present it to the investors with a form of subscription agreement and a PPM and say, “OK, here are the definitive agreements. This is our targeted closing date. The LPA follows the term sheet, which you previously saw.” So there should be no surprises.

You’ll always have some negotiation around that LPA up to that first closing date. You may have some revisions and tweaks, but you usually won’t have a dramatic change in the nature of the waterfall once you’ve gone through that sort of pre-marketing process. However, there’s a lot of different kinds of comments you can get. After you get past your first close, which typically you will have at ideally half of what your target fund size is, then you’re just telling other people down the road that “OK, these are the terms. We’re raising a $500 million fund, we already closed a $250 million, we’re not changing the waterfall anymore. This is what it is.”

How long does that negotiation process usually last?

It lasts months. It’s definitely a marketing process. And up until the time when you announce that you’re raising a fund to the time you get to your first close can easily be four months or more.

Is the hybrid waterfall common in the PE space? Are you seeing it more often?

We’ve definitely seen them, but I wouldn’t say it’s common.

In my experience you see them more with non-US investors. Especially with large sovereign wealth funds, foreign pension funds, foreign institutions, who may be looking to sort of bridge that distinction between European- and American-style waterfalls because they’re trying to hold on to the European style, but they realize the market has moved so they negotiate for these hybrid structures.

And what are some challenges that that could pose? Is there a structural challenge or a management challenge that comes with that?

I guess it depends on how it’s designed. Maybe it has certain unintended consequences, such as incentivizing the management team to be focusing their efforts more on those investments that, when sold, would lead to a current distribution of carry rather than one that is just going to return all invested capital. I don’t think anyone would consciously think that way, but I guess human nature is what it is.

In the next five years or so, taking into account the economic climate, do you see American-style waterfalls continuing to proliferate?

If the economy remains generally strong and debt capital continues to remain available to PE fund sponsors – that’s a huge factor in the robustness of M&A in the middle market – then yes, funds will continue to be trending towards American-style.

But there’s a lot of chatter about a downturn. I would not be surprised to see if there is a significant downturn and that resulted in banks and non-bank lenders that are actively supporting PE funds today, pulling back, causing credit to become tighter. That would result in challenges at the funds and their ability to support their portfolio companies and, in turn, an erosion of returns. That clearly would cause a shift and investors to take a more conservative stance.