Have you ever seen a waterfall? It's pretty amazing! Speaking of waterfalls, have you heard of the private equity distribution structure that's also called a waterfall?
Picture this: you and your friend have launched a business together. You're both equal partners, sharing the profits 50/50. Meanwhile, another business has three partners who have agreed to split the profits equally, with each partner entitled to a third of the share. But how much each partner gets really depends on several other factors, which they'll all agree on and write down in a partnership agreement.
Similarly, in the world of Private Equity, there's a term for how profits are divided between General Partners and Limited Partners - it's called Waterfall distribution. The amount each partner gets depends on the percentage of return made on the investment. And just like with the business partnership, they have an agreement called Limited Partnership Agreement (LPA) where all the details are clearly stated.
In a Private Equity Fund, the two main parties are the General Partner (GP) and the Limited Partner (LP). The Limited Partners are the ones who put their money into the fund, while the General Partners are the ones who manage it. Successful General Partners earn a lot of money, and you will understand why.
We all invest our money to make a profit, right? But let's not forget that we also want to protect our capital - we don't want to lose the money we've invested. So, the goal is to not lose money and hopefully make some profit on it.
If you want to understand Waterfall distribution, let's learn about the four tiers in the distribution structure:
- Return of Capital
- Preferred Return
- Catch-up
- Carried Interest
1) Return of Capital
As we previously discussed, the top priority for any investor is to make sure they don't lose any money. Limited Partners are no exception to this rule. After all, who wants to lose money? That's why Limited Partners have certain conditions before they share their money with General Partners. The first and foremost condition is the return of capital.
For instance, if the LP invested $100 million in the fund, then $100 million is the capital. Before the General Partners can start earning any money, they need to make sure the Limited Partner gets their investment back. Basically, before the General Partners can make any profits, they need to recover the amount of money the Limited Partner invested. Until the Funds' proceeds exceed the return of capital and Preferred return, the General Partners will not be eligible to earn any profits from the fund.
In our example, if the fund generates $200 million, the entire $100 million invested by the LP will belong solely to them. The General Partners can't claim any share in the recovered capital. The return of capital always belongs to the Limited Partners. In short, return of capital ensures that investors get their initial investment back.
2) Preferred Return
Preferred return is basically the minimum return that the Limited Partners expect to receive from their investment. For example, if they're hoping for an 8% return on the fund, then 8% is their preferred return. If you're investing in the stock market or mutual funds and you're expecting a 10% return, then your preferred return is 10%. It is only when the return on the fund exceeds the Preferred return that the General Partners are entitled to a portion of the profits. That means 100% of the return of capital and 100% of the Preferred return belongs to the Limited Partner. Preferred Return guarantees investors a certain percentage of profits before General Partners get a cut.
3) Catch-up
This is where things get exciting for the General Partners. If they exceed the expectations of the Limited Partners, they'll be rewarded generously. For example, if the Limited Partners were expecting an 8% return but the General Partners delivered a 10% return, they will receive a payment equivalent to 20% of the cumulative distributions made in the form of return of capital and Preferred return. It's important to note that the total amount paid to the Limited Partners and General Partner must add up to 100% of distributions up until this point. The amount paid to them in step 1 and step 2, combined with the amount paid to the General Partner in this step, will make up 100% of the distributions. So, if we add up the Return of Capital, Preferred return, and Catch-up, the Limited Partners will receive 80% of the total amount, while the General Partners will receive the remaining 20%. This is where the General Partner gets a chance to catch up on their share of profits. It's a win-win situation for everyone involved!
4) Carried Interest
Now, let's talk about the exciting part - the Carried Interest or Carry! So, imagine the fund has done really, really well and has made a whopping 20% return. The remaining profits, which could be anywhere between 10% (Catch-up) to 20% (actual return), will be divided between the General Partner and the Limited Partner. The split will depend on the agreement terms, and it could be either 80:20 or 50:50. Carried Interest is a way for general partners to get rewarded for all their hard work and determination.
I hope you have gained some knowledge about the waterfall distribution!
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