US waterfall popularity fading, study finds

The deal-by-deal waterfall model is declining in use, according to PEI and Schulte Roth & Zabel research.

Fund managers are increasingly adopting the EU waterfall model over the US style, further underlining the shift towards more LP-friendly terms in recent years, fresh research reveals.

Only about one in three US funds now employ the US style deal-by-deal waterfall on carried interest payouts, according to a survey of over 130 fund advisors worldwide conducted by parent media company PEI and law firm Schulte Roth & Zabel. The report, released Wednesday, can be found HERE.

Similar research conducted in the past shows as much as half of US funds utilizing the more GP-friendly deal-by-deal model during the post-crisis years up to 2013.

The type of waterfall model used can be a source of significant tension between GPs and LPs while negotiating terms during fundraising. Investors prefer the EU model to reduce the likelihood of a cumbersome clawback process, while GPs may prefer the US style to collect cash proceeds earlier, as that capital can be used to retain and incentivize talent.

The shift may in part be attributed to LP demands. The EU-style waterfall, where investors receive the full return of all their contributions plus an agreed hurdle rate before GPs can begin collecting carry, is considered best practice by the Institutional Limited Partners Association.

In fact, during follow-up interviews with respondents, GPs cited “alignment of interests with investors as the primary rationale for adopting the European model”, said Schulte Roth & Zabel private funds partner Joseph Smith, a co-author of the report. “The LP sees the returns of the fund more quickly in the European model, bringing the added benefit of a higher net IRR,” Smith added.

In situations that require a clawback – where too much carry is paid out to the GP – there is no single preferred method to return cash to investors, the research showed. The largest proportion of GPs secures clawbacks through a personal guarantee of the fund principals, while roughly half of other respondents said they either create an escrow account at the management firm or fund level.

Key man provisions

The research also sheds light on the types of key man provisions being negotiated today – something 86 percent of respondents say is a provision in their latest fund.

Of those respondents, roughly half said their key man provisions are only triggered when two people from the investment team leave. Roughly a quarter said the clause depends on the seniority of the departing partner.

The research further revealed that LPs are “somewhat flexible” about what happens when the key man is triggered. Most funds allow a replacement to be found – usually between three to nine months – subject to the approval of the LP advisory committee. And the most common result of a triggered key man clause – that the fund’s investment period can be suspended – is also “the most lenient”, the report said.

Other highlights from the report include:

• GPs perceive their track record and ability to attract and retain talent as investors two biggest concerns.

• Three quarters of GPs surveyed said that more than 20 percent of their staff compensation is discretionary.

• Over two thirds of GPs have vesting arrangements; though these provisions are most likely to be found in larger firms.

• Direct involvement in individual deals tends not to matter to the majority of GPs when awarding carried interest (though it is something slightly more important to real estate firms compared to buyout firms).