Waterfalls, clawbacks and catch-ups are terms used in private investing that define how distributions flow from the investment to the partners, what happens when things don’t go as planned and dictate the terms of the manager’s performance fee. Every investment has a defined waterfall and it’s important to understand how it works because an unfavorable waterfall can tilt risk towards an investor.
The waterfall defines the way in which cash distributions will be allocated between the sponsor and the investor. In most waterfalls, a sponsor receives a disproportionate amount of the total profits relative to their co-investment. For example, a sponsor may only put in 5% of the investment capital but be entitled to 20% of the profits. The typical performance fee is between 20% and 30%, subject to a preferred return hurdle. The preferred return ranges from 7% to 10% annually and can be viewed as an interest rate on invested capital, but it is not guaranteed.
Investment waterfalls are described in great detail in the distribution section of the private placement memorandum (“PPM”) and investors should pay close attention to this area. There are two common types of waterfall structures, American and European, and they can exist in either an individual deal or fund structure.
European Waterfall Pros and Cons
In a European waterfall, 100% of all investment cash flow is paid out to investors on a pro rata basis until the preferred return and 100% of invested capital is paid back. Pro rata means that all capital is treated equally and distributions are paid out in proportion to the amount of capital invested. An individual who invested 10% of the required capital would be entitled to 10% of the distributions until they’ve received 100% of their investment back plus the preferred return. Once these distributions have been satisfied, then the manager’s portion of the profits will increase accordingly. This is both a common and appropriate structure in equity funds where an investor’s capital might be spread across 20 different investments. All distributions will go to investors and the manager won’t participate in any profits until the investor’s capital and preferred return have been fully satisfied.
Watch Michael Episcope explain the European waterfall and how it benefits investors.
The biggest drawback to this structure is in the way the manager gets paid. The majority of the manager’s profits may not be realized for six to eight years after the initial investment, and that’s a long time to wait to get paid. An undercapitalized manager may be incentivized to sell properties quickly, rather than maximizing investment returns for the long run. On the other hand, taking chips off the table can be a good thing and certainly helps minimize risk. At Origin, we adhere to the European waterfall structure because we believe it’s the best structure for our investors.
American Waterfall Pros and Cons
The American waterfall structure is similar to the European waterfall, but addresses the issue of waiting six to eight years for the manager to unlock their incentive fee. This structure allows for managers to get paid prior to investors receiving their preferred return and 100% of invested capital. In this structure, a manager could receive a disproportionate share of cash flow on day one. To be clear, the investor is still entitled to a preferred return and their return of capital, but this structure allows the manager to get paid prior.
Watch Michael Episcope explain the American waterfall and importance of a clawback feature.
If a fund manager utilizes the American waterfall, the manager will be entitled to receive an incentive fee on each deal, regardless of whether the investor’s preferred return and capital have been paid back in full. This structure can help a smaller manager smooth out their income over the life of the fund. To protect investors, there is usually a caveat in the documents that states the manager is only entitled to take this fee so long as the other assets are performing well and the manager reasonably expects the fund to generate a return in excess of the preferred return. This is something investors should look for in the distribution section of the PPM.
In certain investment products, such as debt or income, this waterfall may actually be more suitable, as the end goal is to hold the asset for income and there is very little risk to principal. In the case of income funds, it’s not uncommon for managers to participate in the income stream from day one. However, investors need to be aware of what happens if the manager takes a performance fee and then the deal underperforms. This is where a clawback feature comes into play, which is an important feature to have in any deal with an American waterfall.
The Importance of a Clawback
The clawback feature is detailed in the PPM and entitles investors to get paid back any incentive fees taken by the manager during the life of the investment. This is meant to protect investors in the event a manager takes an incentive fee they should not have received. This clause is really only as good as the manager’s ability to pay it back, though, so it’s important to invest with a manager who has a strong balance sheet.
Most private equity funds also have a catch-up clause that can be found in the distribution section of the PPM. This clause is meant to make the manager whole so that their incentive fee is a function of the total return and not solely on the return in excess of the preferred return. For example, if the preferred return were 8% and the manager had a 20% performance fee subject to a catch up, the distributions would flow as follows:
- The investor would receive an annualized 8% preferred return and their capital back.
- The manager would then receive 100% of distributions until they receive 20% of all annualized profits (aka the catch up clause).
- All remaining dollars would be split on an 80%/20% basis, with the majority going to investors.
This clause makes it so the manager receives 20% of the total profits if the deal does well. To further illustrate, if the deal returns a 15% annualized internal rate of return (IRR), the manager will receive 20% of 15%, or 3% of total annualized profits. If a deal generates $5 million in profits and a 15% IRR, the manager will receive a $1 million incentive fee. In the absence of a catch-up clause in this example, the manager would only be entitled to 20% of the profits above the 8% preferred return, which equates to 1.4% of annualized profits [.2 X (.15-.08) =.014)]. The investor is still protected in this situation because the manager is not entitled to an incentive fee if the investment doesn’t meet the hurdle of paying all of the capital back plus the 8% preferred return.
In summary, waterfalls are all about how capital is distributed and can either align or misalign interests. Making sure you are entering into the right fee structure is an easy way to mitigate risk. All too often, deals are structured in favor of the sponsor so it’s a ‘heads they win’ and ‘tails you lose’ situation. Waterfall structures can impact investment behavior and you want to make sure the sponsor is motivated by the investment return. If the deal doesn’t perform as planned, make sure the sponsor either doesn’t take a performance fee or is subject to the clawback provision. Getting into a structure where everyone’s interest are aligned from day one is the key to successful investing.