Waterfall Distribution in a Leveraged Buyout Model (Or Any Other Investment)

($ in Millions)

Lesson Outline:

Concept: In many cases, the private equity firm - or any other investment firm - will end up owning close to 100%
of a company, but will give a small percentage of it to the management team to incentivize them to perform.

Sometimes, it ends there and that's the only performance incentive the team has.

But other times, the firm actually gives the management team MORE ownership if the investment performs
very well, i.e. the internal rate of return or IRR (sort of like the "effective compounded interest rate") hits a certain level.

Here's a Concrete Example:

A new leveraged buyout takes place, and the PE firm is cautiously optimistic because the success of the deal depends
heavily on the management team's performance… so they decide to structure the deal to incentivize the team.

For an IRR up to 10%, PE firm gets 95% and management team gets 5%.

Then, for the portion of the IRR between 10% and 15%, the PE firm gets 90% and the management team gets 10%.

For the portion of IRR between 15% and 20%, the PE firm gets 85% and the management team gets 15%.

Then for the IRR above 20%, the PE firm gets 80% and the management team gets 20%.

Why would a private equity firm do this? Why should they voluntarily give up some of their returns?

Because it may encourage the management team to perform even better and create a win-win scenario for everyone.

Think about it: Which of the following scenarios is better…

Scenario 1: Management team only gets 5% and the overall investment's IRR is 13%, just barely beating the long-term st

Scenario 2: Management team gets up to 20% following the schedule above, and the investment IRR is 23% - more than

Scenario 2 is better for everyone! It's a win-win. Only issue is that it doesn't always happen this way since tons of other f

How Do You Model This Type of Scenario?

Can get very complicated, especially with real estate investments or anything else where cash is always being injected or

But in this case, we're going to look at a simplified example to illustrate the concept and show you the ropes of how it w

Step-by-Step Process for Calculating Waterfall Returns:

 1. First, you need to know the initial amount invested, and how much comes back at the very end.

We're assuming no dividends or cash flows in between here - would complicate the calculation and make it harder to illu

2. Also need to know how much the management team vs. the PE firm owns, and how that changes at different IRRs.

For example, 5% / 95% at under 10% IRR, and 10% / 90% above 10%? More levels than that?

3. Then, take the initial investment and calculate what amount of net proceeds at the end would correspond to a 10%

Have to do this for each "level" or "tier" of IRR in the deal.

Just multiply initial amount invested by (1 + IRR Percentage), and compound that amount over the entire period - just lik

4. Next, figure out how much of the proceeds to split within that tier.

Should be either the amount that corresponds to that IRR, or just the total net proceeds… take the minimum of those tw

For example: If the proceeds at the end are $3,000 and a 10% IRR corresponds to proceeds of $1,611, you'd just distribu
PE firm and management team at the percentages in that level (e.g., 95% and 5%)…

And then you have to figure out what to do with the ($3,000 - $1,611) as the next step.

On the other hand, if you only have $1,500 left at the end, that's not even a 10% IRR - so you'd just distribute that $1,50
the management team (at 95% and 5%) and you're done.

5. Calculate how much is left over for the next IRR level above this one.

In the first example above, it's just $3,000 minus $1,611 - that amount corresponds to the IRR portion ABOVE 10%, and w
differently for the next levels.

But in the second example, it's $0! We only got $1,500 in proceeds, so nothing left to distribute there.

Can handle both cases with a MAX(0 function around this formula. Changes slightly as you move up through the tiers.

6. And keep going up to each level beyond the first one, splitting the proceeds as necessary.

Must be very careful with the "Amount to distribute and split in this tier" - need to modify the MIN function and keep su
whatever has been distributed in previous tiers - so that formula has to change in each tier. The rest, less so.

Waterfall Returns Distribution - Assumptions:

Initial Amount Invested (Investor Equity): $ 1,000

Initial Management Ownership %: 5%
Net Proceeds at End (After repaying all debt): $ 3,000 <-- Normally, the management team would get 5%

Level 1 of Waterfall Distribution Calculation:

 IRR Through: 10%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

PE Firm %: 95%
Management %: 5%

Level 2 of Waterfall Distribution Calculation:

IRR Through: 15%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

PE Firm %: 90%
Management %: 10%

Level 3 of Waterfall Distribution Calculation:

IRR Through: 20%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

PE Firm %: 85%
Management %: 15%

Level 4 of Waterfall Distribution Calculation:

IRR Above: 20%

PE Firm %: 80%
Management %: 20%
IRR Calculations:

Overall Deal IRR:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$ (1,000) $ - $ - $ - $ - $ 3,000

5-Year IRR: 24.6%

IRR Only to PE Firm:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$ (950) $ - $ - $ - $ -

5-Year IRR:

IRR Only to Management Team:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$ (50) $ - $ - $ - $ -

5-Year IRR:

End Result: In most cases, the IRR to the PE firm is slightly less than the overall deal's IRR… but it's MUCH greater for the

That's because the PE firm owns 95% in the beginning, so giving away a percentage of the company makes less of an imp

95% to 90% ownership isn't much of a difference, but if you go from 5% ownership to 10% ownership, you've doubled yo

That's why this type of "waterfall structure" and "management promote" can be such a powerful way to incentivize man
end up owning close to 100%
ntivize them to perform.

he investment performs
d interest rate") hits a certain level.

the success of the deal depends

eal to incentivize the team.

e management team gets 10%.

ment team gets 15%.

e of their returns?

a win-win scenario for everyone.

just barely beating the long-term stock market average.

e investment IRR is 23% - more than 2x the long-term stock market average.

appen this way since tons of other factors come into play.

here cash is always being injected or taken out of the business…

and show you the ropes of how it works.

at the very end.

calculation and make it harder to illustrate.

ow that changes at different IRRs.

he end would correspond to a 10% IRR, 15% IRR, 20% IRR, and so on…

ount over the entire period - just like compounding interest.

eds… take the minimum of those two.

oceeds of $1,611, you'd just distribute that $1,611 between the

- so you'd just distribute that $1,500 between the PE firm and

o the IRR portion ABOVE 10%, and we need to distribute it

o distribute there.

as you move up through the tiers.

modify the MIN function and keep subtracting out

ch tier. The rest, less so.

But in reality, the split might be more like…

he management team would get 5% of this: Mgmt: $ 150 Mgmt: $ 200

PE Firm: 2,850 PE Firm: 2,800
<-- Distribute and Split This Amount for IRR in This Tier
<-- Amount of IRR Left to Distribute

<-- Distribute and Split This Amount for IRR in This Tier
<-- Amount of IRR Left to Distribute

<-- Distribute and Split This Amount for IRR in This Tier
<-- Amount of IRR Left to Distribute

<-- Distribute and Split This Amount for IRR in This Tier
<-- Amount of IRR Left to Distribute
s IRR… but it's MUCH greater for the management team as the % ownership increases!

of the company makes less of an impact for it.

o 10% ownership, you've doubled your stake!

h a powerful way to incentivize management teams… if implemented properly.

plit might be more like… Or even:

Mgmt: $ 300
PE Firm: 2,700