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Topic 2.

13:
Distribution Waterfall
Importance of the Waterfall Distribution
General Partner Incentive Structure
Profits and Carried Interest
Distribution of Profits
General Waterfall Distribution
Breakeven IRR
Preferred Return as a Free Option
Clawbacks

LO 2.48

Importance of the Waterfall Distribution


Private equity investments require
numerous critical decisions over a long
investment horizon
Decisions are largely unobservable by
limited partners
Need to align incentives and pay structure
to protect limited partners and maximize
returns
Distribution waterfall sets the rules and
procedures for the distribution of profits 186

LO 2.49

General Partner Incentive Structure


Carried interest Key incentive aligning device;
percentage profit split after meeting hurdle rate;
typically 80/20
Management fees 1.0%2.5% of committed
capital; used for operating costs
General partner contribution 1.0% of committed
capital; aligns interests of the managers and
investors
Vesting Legal transfer of incentive payments to
managers
Distribution provisions Specific timing and
187
provisions of profit distribution

LO 2.50, 2.51, 2.55

Profits and Carried Interest


Hurdle rate (preferred return) Must be distributed
to investors before managers earn carried interest
Clawback Managers must return funds to
investors from overpayment of carried interest
Carried Interest:
Deal-by-deal General partner receives profits
on each investment; manager receives profits
sooner; limited partners have exposure to future
losses
Fund-as-a-whole Calculates carried interest
on the performance of the entire fund; more
likely to align the interests of managers and
188
investors

LO 2.52

Distribution of Profits

Hurdle rate (h%) will be specified in the distribution


provisions for the fund
Must estimate value (ah) that must be achieved before
general partners participate in carried interest
t<T

ah =

Cn (1 + h)T ? t

n=1

Managers are entitled to a u% catch-up under the


distribution provisions and will accrue u% of the next
amount, c, earned by the fund

IRR with full carried interest =

h?u
u?c

189

LO 2.52

Example: Distribution of Profits


Investors contribute $100M to a private
equity fund
Hurdle rate is 10% and the fund is worth
$150M at the end of the year
Catch-up rate is 100%
Carried interest split is 80/20
Calculate the distribution of profits and the

full carried interest IRR


190

LO 2.52

Example: Distribution of Profits


(continued)
Investors: receive principal plus preferred
return of $110M = 100M (1 + 0.10)
10M / 12.5M = 0.80 = 80%
General partner: receives 100% of the next
$2.5M earned
2.5M / 12.5M = 0.20 = 20%
80/20 split is achieved; remainder of profits are
split
IRR with full carried interest =

10% 100%
= 12.5%
100% 20%
191

LO 2.52

General Waterfall Distribution


LP

GP

Total

Return of capital

Preferred return
to LP

ah d

ah d

Catch-up for GP

(1 u)x

u(x)

80/20 split or
residual

(1 c)y

c(y)

Closing balance

Sum of
above

Sum of
above

ad
193

LO 2.52

General Waterfall Distribution (continued)


Investors contribute $100M to a private
equity fund
Hurdle rate is 10% and the fund is worth
$150M at the end of the year
Catch-up rate is 50%
Carried interest split is 80/20
Determine the waterfall distribution

194

LO 2.52

General Waterfall Distribution (continued)


LP
Return of
capital
Preferred
return to LP

GP

Total

100

$100M

110 100 = 10

$10M

Catch-up for
(1 0.5)(6.67) = 3.335
GP

0.5(6.67) = 3.335

$6.67M

80/20 split or
residual

0.80(50 16.67) =
26.66

0.20(50 16.67) =
6.67

$33.33M

$140M

$10M

$150M

Closing
balance

195

LO 2.53

Breakeven IRR
Fund A: 100% catch-up, 20% carried
interest, and hurdle rate of 8%
Fund B: 40% catch-up, 20% carried interest,
and hurdle rate of 6%
Fund A =

8% 100%
= 10%
100% 20%

Fund B =

6% 40%
= 12%
40% 20%

IRR

Return Fund A
(hurdle rate = 8%)

Return Fund B
(hurdle rate = 10%)

6%

0%

20%

8%

20%

20%

10%

20% (caught up)

20%

12%

20%

20% (caught up)

196

LO 2.54

Preferred Return as a Free Option


Distribution of the preferred return is similar
to a call option
Strike price = contributed capital + preferred
return
General partner earns high returns if the
option is deep in-the-money
If returns do not exceed the hurdle rate, the
option is out-of-the-money
Assumes general partner contributed little or
no personal capital
197

LO 2.56

Clawbacks
Provisions in partnership agreement
Ensures equitable final distribution (carried
interest split)
Example:
Asset X (purchased for $170M) is sold for
$200M in Year 1. Asset Y (purchased for
$30M) is sold for $10M in Year 2. 80/20
carried interest split with 10% hurdle rate.
Determine the carried interest at the end of
Year 1 and 2 and the clawback, if any
198

LO 2.56

Clawbacks (continued)
End of Year 1 (carried interest):
(20%) ($30M) = $6M to managers
$30M $6M = $24M to investors
End of Year 2 (no carried interest):
$20M loss accrues to limited partners
Termination of the fund:
Hurdle rate: $200M 1.12 = $242M
Limited partners: $170M + $24M + $10M =
$204M
Clawback: $242M $204M = $38M

199

LO 2.57

Clawback Limitations
Unenforceable if the fund does not contain
liquid assets
Payment is based on the general partners
creditworthiness
General partner may extend the life of the
fund to delay
Practical limitations of litigation

200

Which of the following statements correctly


compares the preferred returns of a private
equity fund to the returns of a long call option?
A) For returns above the hurdle rate, the fund
managers are out-of-the-money.
B) For returns below the hurdle rate, the fund
managers are at-the-money.
C) For returns below the hurdle rate, the fund
managers are in-the-money.
D) For returns above the hurdle rate, the fund
managers are in-the-money

Which of the following statements correctly


compares the preferred returns of a private
equity fund to the returns of a long call option?
A) For returns above the hurdle rate, the fund
managers are out-of-the-money.
B) For returns below the hurdle rate, the fund
managers are at-the-money.
C) For returns below the hurdle rate, the fund
managers are in-the-money.
D) For returns above the hurdle rate, the fund
managers are in-the-money

Assume that limited partners contribute $100M in the first year


of a private equity fund. The fund has a hurdle rate of 10%,
an 80/20 carried interest split, and a 100% catch-up
provision. If all investments doubled over a two-year period
before liquidation, what is the funds distribution of profits
over the investment horizon?
A) $20M for general partners; $80M for limited partners.
B) $10M for general partners; $90M for limited partners.
C) $16M for general partners; $84M for limited partners.
D) $20M for general partners; $180M for limited partners

Assume that limited partners contribute $100M in the first year of a


private equity fund. The fund has a hurdle rate of 10%, an 80/20
carried interest split, and a 100% catch-up provision. If all
investments doubled over a two-year period before liquidation,
what is the funds distribution of profits over the investment
horizon?
A) $20M for general partners; $80M for limited partners.
B) $10M for general partners; $90M for limited partners.
C) $16M for general partners; $84M for limited partners.
D) $20M for general partners; $180M for limited partners
The limited partners are entitled to $121M (= $100M 1.12) before any
distributions to the general partner. Since the fund liquidated at
$200M there will be a distribution to the managers. Further, since
the rate of return on the fund is significantly above the hurdle rate,
the catch-up zone can be ignored. Managers will receive 20% of
the $100M profit (i.e., $20M). The limited partners will receive
$80m.