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Why LPs are diving into waterfalls
The complexity of distribution waterfalls can often deter Limited Partners ( LPs ) from engaging in the calculation process , but as Delphine Jones , solutions consultant executive at PEF Services LLC explains , understanding the methods and arming yourself with a bit of knowledge can be a valuable thing .
Why have distribution waterfalls traditionally been an area that LPs have avoided engaging in ? This is an area where LPs don ’ t feel comfortable , mainly because the calculations can be very complex and the data they have got in the past from the GPs has been very inconsistent . This hasn ’ t helped them when formulating how the waterfall works so it becomes way out of their comfort zone . It ’ s important for them to understand it though , because it determines how the revenue of fund is going to be divided out over the span of the fund ’ s life . For that to be ignored is very surprising . There have been several high-profile cases where LPs have been overcharged by the GPs , resulting in a barrage of press around the process of the waterfalls and carry distributions . This is something they can get insight on with a little bit more effort on their part . After all , they are sophisticated and smart , and will be able to grasp it without redoing the waterfall in its entirety .
Given the complexity and time that would go into a full in-depth review , are there any standout ‘ red flags ’ LPs can look out for ? We ’ re not advocating that an LP creates their own waterfall calculation , but there are a few things that they can look at on a quarterly basis . Firstly , their inception-to-date numbers : they want to determine whether they are greater than the distribution they have received – that ’ s inception to date plus their ending capital account balance . If inception-to-date contributions are greater than the distribution in your capital account balance , then there should be no carry . The second thing we ask them to take a look at is the inception-to-date contribution compared to the combination of their preferred return and the distributions they received plus the capital account balances . If that is less than your distributions , than your capital balance , then there should be an allocation of carry , typically that is somewhere around 20 %. It ’ s about getting to an approximation of what the carry should be . The third thing we suggest is that if there is a net operating loss for those funds for the year , you want to go back and see if they are reallocating a portion of the prior year carry because this year you have a loss . So the carry should be reversed . Those type of analysis don ’ t take long at all , less than half an hour to ensure the carry is going in the right direction .
Are there any advantages in an even deeper look into the calculations ? I ’ ve seen a lot of articles recently about LPs buying software to do calculations for waterfalls , but there seems not to be just one system that can do that . If you have more than one fund , the waterfall for one could be completely different to another . Or there could be enough differences between waterfalls where one size does not fit all . So you would need a system to customise a waterfall for each fund and that takes a lot of effort , so I wouldn ’ t encourage LPs to go that route , but the assessment points I mentioned before are certain things they can do to get an overall feel for whether the carry is overall correct and going in the right direction .
Delphine Jones , solutions consultant executive , PEF Services LLC
What are the questions they should be asking their GPs around distribution waterfalls and are most happy and welcoming in answering these ? They should ask questions about any area of the LP agreement that they didn ’ t quite understand or parts that are subject to interpretation . They want to make sure they are using the same interpretation that the GP is using so that the calculations can be much more in-line . LPs should also question anything they ’ ve seen in the allocation of profit and loss that doesn ’ t make sense to them .
18 Global Custodian Spring 2021