For some investors, the most crucial provisions of any fund documentation are the ones that set out how it receives its returns on investment. As ever, the detailed terms of the fund's constitution need to be studied to ensure that the reality matches the terms detailed in the information memorandum of the fund, which entices investors to part with their money in the first instance.
In this paper, we will look at the different ways in which profits are distributed and the circumstances in which they might be returned by the general partner.
The investment waterfall
The term "waterfall" refers to the method used to allocate an investment’s income and profits.
The "waterfall" language in the fund constitution describes how money is split between the general partner and investors. Typically, there will be a return "hurdle" and an income "split". For example, it may be stated that the investors are entitled to a 10% preferred return on their invested capital – this is the "hurdle". Once it has been met (i.e. received by them), any profits above the hurdle are "split" with, for example, 20% allocated to the general partner and 80% to the investor. This extra share of returns for the general partner is known as the "carried interest" and is designed to incentivise elevated levels of return.
The "whole fund" waterfall
With a "whole fund" waterfall model, 100% of profits available for distribution (i.e. after setting aside sums required for expenses or reserves) is paid to investors on a pro rata basis until the preferred return hurdle is met and 100% of investor capital is returned. Above the hurdle, the general partner’s portion of the profits rises. The level of the hurdle is a commercial matter – but usually it will be an annual rate of return of around 8-12% compounded annually and calculated daily on the capital contributions made by the investor, calculated from the date of receipt of each such capital contribution by the fund and ceasing on the date of distribution by the fund to such investor in repayment of such capital contribution.
From an investor's standpoint, the biggest advantage of the "whole fund" model is that the general partner does not receive any profits until the investor has received its capital, plus its preferred return. The general partner is incentivised to create a strong return in order to receive its share of profits.
The drawback is that it may take a significant period for the general partner to return investor capital and to receive its own returns. As such, it may seek short-term profits to reduce the period until they get paid, rather than focusing on creating value for the longer term.
Top Tip for investors: Seek a "whole fund" waterfall model over the alternative "deal by deal" model so as to maximise long-term alignment between the general partner and investors and minimise the need to invoke clawback provisions (see below).
The catch-up provision is designed to compensate the general partner based on total return, not just the return in excess of the hurdle. The investors receive 100% income and profits until their preferred return hurdle is reached. Above the hurdle, the general partner receives a percentage of the distributable profits until they are "caught up". For example, if investors are entitled to a 10% preferred return and the general partner is entitled to a 20% "carry", with a partial catch-up provision, the income and profits available for distribution would be allocated as follows:
- First, the investors would get all of the income/profits until they have received back their capital commitment and the 10% return hurdle has been reached.
- Second, the general partner would get, say, 80% of the income/profits available for distribution and the investor would get 20% until the general partner has received 20% of the cumulative distributions made to the investor above the amount of the investor's capital contributions and the amount distributed to the general partner (the catch-up).
- Last, any remaining funds available for distribution are split between the general partner (as to 20%) and the investors (as to 80%).
Top Tip for investors: Seek annual auditor confirmation that distributions have been made in accordance with the fund documents. This could either be enshrined in the fund constitution or set out in a side letter.
To give investors comfort that carried interest payments are not paid and retained by the general partner in excess of their entitlement, it is common to see a clawback provision that entitles the investors to be repaid sums which should not have been paid to the general partner. However, the general partner will typically be a special purpose vehicle with limited liability and it may have already distributed such proceeds to its members, lessening the impact of the provision.
Top Tip for investors: As well as having a clawback provision, investors could seek a term that requires a percentage of the sum payable to the general partner to be paid into an escrow account until such time as the sums distributed to the general partner have been verified. A possible alternative to escrow of general partner distributions is for personal guarantees to be given by the individual recipients of the carried interest on a joint and several basis of 100% of the obligation.