Is my waterfall too complicated to automate?

Al Bauer, managing director of Citco makes the case for waterfall automation even for complicated LP-GP agreements.

While private equity fund managers have historically expressed skepticism in regards to the possibility of automating the waterfall process, we see the potential in a flexible technology offering which can make waterfall automation a viable solution.

The primary arguments against the possibility of waterfall automation are twofold:

1) Terms are contractually negotiated between limited partners and the general partners, and thus, by definition, bespoke and non-standard; and

2) Calculations are complex and nuanced, with no one system able to account for the multitude of unique provisions that complicate individual waterfalls.

Although there is validity to both arguments, an automated waterfall calculation engine that pre-supposes a “macro view” of waterfall calculations (i.e., all waterfall calculations involve a series of proceeds being allocated between participants across a series of hurdles or tiers) can provide an “out of the box” design environment requiring only minimal customization to account for individual waterfall provisions. The key is to design an automated system with the flexibility to account for not only various waterfall tier structures, but the ability to customize calculation methodologies within each tier.

As an example, the majority of waterfall calculations follow some variation on the following tier structure:

1) Return of Investment Capital

2) Return of Allocable Expenses

3) Preferred Return

4) GP Catch-Up

5) Full Promote / Carried Interest

However, the order of priority in which proceeds are allocated across these tiers varies widely, with some waterfalls excluding certain hurdles entirely, and others requiring multiple iterations of the same tier within one waterfall definition. An automated waterfall system should provide standardization in the way of offering a “menu” of tier options with which to structure a waterfall, but with minimal requirements as to the order in which those tiers are structured.

Furthermore, variations of calculation methodologies exist within the above tier definitions. For example, a “Preferred Return” may be calculated as an IRR, simple interest, monthly compounding interest, multiple on contributed capital, etc. “Full Promote” may be calculated as a set percentage allocation between the LP and GP, or may involve a dynamic allocation dependent on fund performance. “Return of Capital” may be defined as a return of aggregate contributed capital, a return of realized contributed capital, or some variation of the above. An automated waterfall system should come with a pre-set menu of customization options within each tier definition, and an intuitive interface with which to apply such options.

An increasing volume of capital flowing into closed-ended fund structures has led to an increasing level of complexity in regards to waterfall calculations. Deferred carry mandates, multiple preferred return hurdles, post-carry fair value tests, and interim claw-back provisions are becoming the rule rather than the exception  and waterfall automation must keep pace with changing industry standards. However, if designed and implemented correctly, an automated waterfall system should be able to provide the standardization, transparency, and auditability necessary to reduce or eliminate the significant risk of carried interest miscalculation inherent in spreadsheet-based waterfall calculation models.

While it is true that not all waterfall calculations may be immediately automated today, increased focus on flexible technology development can ensure that the future of waterfall calculations is one in which automation will play an important role to support these fund structures.