What is a Waterfall Structure?
A waterfall structure in private equity or real estate deals or similar investment funds is a mechanism of distribution of cash flows between the General Partners (‘GP’) and Limited Partners (‘LP’). The details of the step-by-step distribution and various terms are incorporated as a part of the Partnership Agreement between the GP and the LP.
Why do we have a Waterfall Structure?
In a typical partnership arrangement, the GPs are the active managers who are involved in the day-to-day operations of the partnership, while the LPs mostly provide majority of the capital in exchange for a certain return.
In such an arrangement, a GP is rewarded for their work by having a higher share of distributions in comparison to their contributions in a deal.
The waterfall structure aims to strike a balance between the higher allocation of cash flows received by the GP while also protecting the capital and some level of minimum returns to the LP
Terms used in a Waterfall
Preferred Return/Hurdle – The minimum rate of return expected by the LP before the GP gets a disproportionate share of distributions
Carried Interest (or Promote) – This refers to the share of GP’s profits once the LP has received their Capital and the minimum preferred Return.
Tiers – In more complex waterfalls, there can be multiple tiers of hurdle rates, where each hurdle rate would reflect a different split between GPs and LPs
Pari Passu – Meaning ‘on equal footing’. Until the Pref Return is reached, the distributions between the LP and GP are pari passu i.e. based on their initial % of investment.
Clauses – Some Waterfall structures may be additional clauses which impact the distribution schedule between GPs and LPs
Catch-Up Clause –
The catch-up clause allows the GP to “catch up” and receive a larger share of profits after the LPs have received their return of capital and a preferred return/minimum hurdle rate.
Once LPs get their principal plus the preferred return, 100% of additional profits may be allocated to the GP until they reach their agreed percentage of the total profits (in most cases it is around – 20%), at which point further profits are split according to the carried interest arrangement (eg – 80% to LP and 20% to GP)
Claw-Back Clause –
A clawback clause is a protective measure for LPs, which allows the LP to recover promote from GPs in case the LP have not received their Capital or Minimum Preferred Return at the end of the fund.
A scenario where this may be triggered – The GP overperformed in the early stages of the fund and generated excess returns but significantly underperformed in the later part of the fund cycle. In such a case, the GP might have charged promote for over-performance in the initial stages, but this must be returned to the LPs in case they don’t receive their capital/minimum return at the end.
Basic Waterfall Example
In a very example, we will make a waterfall with the following terms:
Limited Partner’s Contribution: 95%
General Partner’s Contribution: 5%
Preferred Return Hurdle – 10% (not compounded)
Post Preferred Return, Contributed Capital is Returned
Above Preferred Return, GP to get a 20% Promote.
Deal Metrics and Excel Model
The excel model for this waterfall structure is attached below. There are two tabs – One to show the calculations on a monthly basis as well as annual basis.
In the attached example, you’ll notice that the LP IRR is slightly lower than the Project IRR due to the 20% Promote. However, GP’s IRR increases significantly – as they get a disproportionately large share of cash flow v/s their initial investments (24% above the hurdle, for 5% of investment)
In the next article, we’ll cover Waterfalls with Multiple Hurdle Rates, Subdivisions between multiple investor classes and fees.
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