April 25, 2019
IEA has seen an increase in hybrid waterfall structures in private equity firms’ Limited Partnership Agreements (“LPAs”). These fund structures are seeking to bridge the alignment gap between General Partners (“GPs”) and Limited Partners (“LPs”). Specifically, GPs are trying to receive some benefits found in deal-by-deal waterfall structures, while maintaining LP protections that the investor community receives in total-return structured funds.
Deal-by-deal waterfall structures (also known as American-style waterfalls) are considered GP favorable as they allow members to receive carry from the sale of a specific deal, and before all contributed capital is returned to its Limited Partners. However, many LPs have required new funds to be structured as total-return funds to help protect their investment. Total-return funds (also known as European-style waterfalls) require LPs to receive all of their contributed capital, plus a preferred return, before a GP can participate in carried interest.
In this strong fundraising environment, some GPs have pushed back on the European-style structure, not wanting to wait 5-8+ years for the first carry payment. LPs have become amenable to these discussions because, among other reasons, they understand the importance of carry payments in recruiting and retaining top talent and want access to top performing funds1. To bridge this timing divide, hybrid waterfall structures have emerged. The intent of these structures is to give LPs most of the protections they receive in a total-return fund, while also allowing for GPs to receive carry sooner. Some hybrid waterfall features that IEA has seen recently in LPAs include:
- Minimum Return Threshold: GP can only take carry once a certain percentage of capital is returned to its LPs (i.e. 70%).
- Carry Holdback: If the GP is eligible for carry, only a certain percentage of that carry can be distributed (i.e. 75%). The non-distributed carry is held back until all LP principal and preferred return is returned.
- Minimum Value Tests: The value of the realized and unrealized investments must be greater than a certain percentage (i.e. 130%) before GP can take carry.
- Interim Clawbacks: Clawback calculations run semi-annually or annually.
- Sector/Class Based Waterfall: The fund is a deal-by-deal waterfall, but investments in certain sectors within the fund are run through a total return waterfall calculation.
- Carried-Interest Ratchet: A deal-by-deal waterfall structure, but with reduced carry (i.e. 5%-10%) until LPs receive their contributed capital and preferred return. Carry payments to the GP rachet up to an agreed upon level (i.e. 20%) once LPs have received their required distribution amounts.
IEA thinks hybrid funds will continue to be a prominent waterfall structure as capital continues to flow into the alternative investment sector. Only the strongest private equity funds will continue to raise traditional deal-by-deal waterfall structures. The majority of private equity firms’ fundraising will have to negotiate LP protections in the waterfall. IEA expects hybrid fund structures as the solution for many LP/GP negotiations.
1Interestingly, a recent study suggests that LPs in deal-by-deal structures actually perform better. Part of the explanation for this trend is that better performing private equity firms can command better terms than newer or below average funds that can’t negotiate away from the European style structure. “Paying for Performance in Private Equity: Evidence from VC Partnerships”, David T. Robinson. January 13th, 2018