In private investing, waterfalls, clawbacks, and catch-ups are phrases used to explain how distributions flow from the investment to the partners, what happens if things don’t go as expected, and the manager’s performance fee concept. Knowing how an investment’s waterfall works is critical because an unfavorable one might tip risk in the investor’s favor.
The waterfall shows how the sponsor and investor are compensated in cash distributions. Most waterfalls reward sponsors with a disproportionate share of the overall earnings compared to the amount of money invested. An example is a case where a sponsor contributes just 5% of the investment money but is entitled to 20% returns. Subject to a chosen return threshold, the regular performance fee ranges from 20% to 30%. The recommended return on invested capital is between 7% and 10% per year, but this is not always the case.
In particular, the private placement memorandum (PPM) defines investment cascades in considerable depth, and investors should pay close attention to this part. Waterfall structures come in two flavors: American and European, used to build a single deal or an entire fund.
The Benefits and Drawbacks:
- European Waterfalls
As long as the preferred return and 100% of the invested capital are met, investors receive 100% of all investment cash flow on a pro-rata basis. Distributions are given out according to the amount of money invested in a pro-rata fashion. Investing 10% of the required capital would enable the investor to receive 10% of the distributions until they have received 100% of their investment plus the chosen return. The manager’s share of the earnings will rise in line with the satisfaction of these distributions. Equity funds often use this structure when an investor’s money is distributed over 20 different investments. Once the investor’s requirements for capital and preferred return have been met, the manager won’t be able to get any of the returns.
The manager’s compensation is the major problem with this system. Most gains may not be seen until six to eight years after the first investment. Undercapitalized management may be motivated to sell properties fast instead of maximizing investment profits over the long term. However, taking chips off the table can be beneficial and reduce risk.
- American Waterfall
Unlike the European waterfall, which requires managers to wait six to eight years before receiving their incentive payment, the American waterfall structure is more immediate. Managers can be compensated in advance of investors’ achieving their desired return and receiving their entire investment. With this setup, a manager may start with a considerable portion of the company’s cash flow. Both of these arrangements are identical and one in which the manager receives payment before the investor does.
A fund manager can collect an incentive fee on each deal regardless of whether the investor’s preferred return and capital have been repaid in full if they use the American waterfall. Smaller fund managers can benefit from this structure because it helps to increase their income over time. Fund documentation typically contains a disclaimer to protect investors, stating that the manager may only charge this fee if the other assets in the fund are performing well. Also, if the manager reasonably expects the fund to earn a return more significant than the preferred return. It is something a potential investor should check for in the PPM’s distribution section.
This waterfall strategy may be more appropriate for certain investment products, such as debt or income, because the ultimate objective of these products is to hold the asset for generating revenue, and there is minimal risk to the leading investment. It is not uncommon for managers of income funds to begin participating in the flow of money from the very first day the fund is open for business. On the other hand, investors need to be aware of what occurs if the management accepts a performance fee, but the deal ends up underperforming. When dealing with an American waterfall, having a feature known as a “clawback,” which is crucial in any trade involving a waterfall, becomes relevant at this point.
The Significance of Clawback
The PPM outlines the clawback feature, which entitles investors to refund any incentive fees paid to the manager during the life of the investment. Investors will be protected if a manager obtains an incentive charge for which they are not eligible. So, if you want to use this provision effectively, you need to work with a management team that has a strong balance sheet.
The Catch-Up Clause
The distribution part of the PPM contains the catch-up clause that is included in most private equity funds. This phrase is intended to make the manager whole so that their incentive fee is a factor of the whole return and not merely on the return that is more than the preferred return alone. For example, if the desired return was 8% and the manager was entitled to a 20% performance fee that was subject to catch-up, the distributions would go as follows:
The investor would get a preferred return of 8% per year, plus their initial investment back.
After that, the manager would earn 100% of all payouts until they received 20% of total annualized profits (aka the catch-up clause).
On an 80/20 basis, the remaining funds would be divided among investors, with the majority going to them.
The manager will receive 20% of the overall profits if the sale succeeds. A 15% annualized internal rate of return (IRR) means that the manager will receive 20% of that 15%, or 3% of total annualized profits. The manager will receive a $1 million incentive fee if a deal achieves $5 million in profits and a 15% IRR. There would be a catch-up clause in this scenario, which means that the manager would only be entitled to 20% of earnings over the preferred return of 8%, or 1.4 percent of annualized profits [.2 X (.15-.08) =.0014]. Management cannot be charged an incentive fee even if an investment fails to return the entire capital plus an 8 percent preferred return. This investment protects investors in this case.
Waterfalls are concerned with the distribution of funds and can either align or misalign the participants. You can limit risk by ensuring you engage in the correct charge structure. There are too many deals where the sponsor comes out on top, and you come out on the losing end, so it’s a “heads they win” and “tails you lose” situation. Waterfall structures can influence investing behavior, so make sure the sponsor is interested in the investment return. When a transaction doesn’t go according to plan, ensure the sponsor doesn’t get a performance fee or is subject to a clawback option. Setting up a framework where everyone’s interests are aligned is the key to investing well.
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