Private Equity Waterfall Notes

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Private Equity Waterfall Notes

  1. 1. Topic 2.13: Distribution Waterfall Importance of the Waterfall Distribution General Partner Incentive Structure Profits and Carried Interest Distribution of Profits General Waterfall Distribution Breakeven IRR Preferred Return as a Free Option Clawbacks LO 2.48Importance of the Waterfall Distribution Private equity investments require numerous critical decisions over a long investment horizon Decisions are largely unobservable by limited partners Need to align incentives and pay structure to protect limited partners and maximize returns Distribution waterfall sets the rules and procedures for the distribution of profits 186
  2. 2. LO 2.49General Partner Incentive Structure Carried interest – Key incentive aligning device; percentage profit split after meeting hurdle rate; typically 80/20 Management fees – 1.0%–2.5% of committed capital; used for operating costs General partner contribution – 1.0% of committed capital; aligns interests of the managers and investors Vesting – Legal transfer of incentive payments to managers Distribution provisions – Specific timing and provisions of profit distribution 187LO 2.50, 2.51, 2.55 Profits and Carried Interest Hurdle rate (preferred return) – Must be distributed to investors before managers earn carried interest Clawback – Managers must return funds to investors from overpayment of carried interest Carried Interest: Deal-by-deal – General partner receives profits on each investment; manager receives profits sooner; limited partners have exposure to future losses Fund-as-a-whole – Calculates carried interest on the performance of the entire fund; more likely to align the interests of managers and investors 188
  3. 3. LO 2.52 Distribution of Profits Hurdle rate (h%) will be specified in the distribution provisions for the fund Must estimate value (ah) that must be achieved before general partners participate in carried interest t<T ah = ∑ n=1 Cn (1 + h)T ? t Managers are entitled to a u% catch-up under the distribution provisions and will accrue u% of the next amount, c, earned by the fund h?u IRR with full carried interest = u?c 189LO 2.52 Example: Distribution of Profits Investors contribute $100M to a private equity fund Hurdle rate is 10% and the fund is worth $150M at the end of the year Catch-up rate is 100% Carried interest split is 80/20 Calculate the distribution of profits and the full carried interest IRR 190
  4. 4. LO 2.52 Example: Distribution of Profits (continued) Investors: receive principal plus preferred return of $110M = 100M × (1 + 0.10) 10M / 12.5M = 0.80 = 80% General partner: receives 100% of the next $2.5M earned 2.5M / 12.5M = 0.20 = 20% 80/20 split is achieved; remainder of profits are split 10% × 100%IRR with full carried interest = = 12.5% 100% − 20% 191
  5. 5. LO 2.52 General Waterfall Distribution LP GP Total Return of capital d d Preferred return ah – d ah – d to LP Catch-up for GP (1 – u)x u(x) x 80/20 split or (1 – c)y c(y) y residual Sum of Sum of Closing balance a–d above above 193 LO 2.52General Waterfall Distribution (continued) Investors contribute $100M to a private equity fund Hurdle rate is 10% and the fund is worth $150M at the end of the year Catch-up rate is 50% Carried interest split is 80/20 Determine the waterfall distribution 194
  6. 6. LO 2.52General Waterfall Distribution (continued) LP GP Total Return of 100 $100M capital Preferred 110 – 100 = 10 $10M return to LP Catch-up for (1 – 0.5)(6.67) = 3.335 0.5(6.67) = 3.335 $6.67M GP 80/20 split or 0.80(50 – 16.67) = 0.20(50 – 16.67) = $33.33M residual 26.66 6.67 Closing $140M $10M $150M balance 195 LO 2.53 Breakeven IRR Fund A: 100% catch-up, 20% carried interest, and hurdle rate of 8% Fund B: 40% catch-up, 20% carried interest, and hurdle rate of 6% 8% × 100% 6% × 40% Fund A = = 10% Fund B = = 12% 100% − 20% 40% − 20% Return Fund A Return Fund B IRR (hurdle rate = 8%) (hurdle rate = 10%) 6% 0% 20% 8% 20% 20% 10% 20% (caught up) 20% 12% 20% 20% (caught up) 196
  7. 7. LO 2.54Preferred Return as a Free Option Distribution of the preferred return is similar to a call option Strike price = contributed capital + preferred return General partner earns high returns if the option is deep in-the-money If returns do not exceed the hurdle rate, the option is out-of-the-money Assumes general partner contributed little or no personal capital 197LO 2.56 Clawbacks Provisions in partnership agreement Ensures equitable final distribution (carried interest split) Example: Asset X (purchased for $170M) is sold for $200M in Year 1. Asset Y (purchased for $30M) is sold for $10M in Year 2. 80/20 carried interest split with 10% hurdle rate. Determine the carried interest at the end of Year 1 and 2 and the clawback, if any 198
  8. 8. LO 2.56 Clawbacks (continued)End of Year 1 (carried interest): (20%) × ($30M) = $6M to managers $30M – $6M = $24M to investorsEnd of Year 2 (no carried interest): $20M loss accrues to limited partnersTermination of the fund:Hurdle rate: $200M × 1.12 = $242M Limited partners: $170M + $24M + $10M = $204M Clawback: $242M – $204M = $38M 199 LO 2.57 Clawback Limitations Unenforceable if the fund does not contain liquid assets Payment is based on the general partner’s creditworthiness General partner may extend the life of the fund to delay Practical limitations of litigation 200
  9. 9. Which of the following statements correctly compares the preferred returns of a private equity fund to the returns of a long call option?A) For returns above the hurdle rate, the fund managers are out-of-the-money.B) For returns below the hurdle rate, the fund managers are at-the-money.C) For returns below the hurdle rate, the fund managers are in-the-money.D) For returns above the hurdle rate, the fund managers are in-the-moneyWhich of the following statements correctly compares the preferred returns of a private equity fund to the returns of a long call option?A) For returns above the hurdle rate, the fund managers are out-of-the-money.B) For returns below the hurdle rate, the fund managers are at-the-money.C) For returns below the hurdle rate, the fund managers are in-the-money.D) For returns above the hurdle rate, the fund managers are in-the-money
  10. 10. Assume that limited partners contribute $100M in the first year of a private equity fund. The fund has a hurdle rate of 10%, an 80/20 carried interest split, and a 100% catch-up provision. If all investments doubled over a two-year period before liquidation, what is the fund’s distribution of profits over the investment horizon?A) $20M for general partners; $80M for limited partners.B) $10M for general partners; $90M for limited partners.C) $16M for general partners; $84M for limited partners.D) $20M for general partners; $180M for limited partnersAssume that limited partners contribute $100M in the first year of a private equity fund. The fund has a hurdle rate of 10%, an 80/20 carried interest split, and a 100% catch-up provision. If all investments doubled over a two-year period before liquidation, what is the fund’s distribution of profits over the investment horizon?A) $20M for general partners; $80M for limited partners.B) $10M for general partners; $90M for limited partners.C) $16M for general partners; $84M for limited partners.D) $20M for general partners; $180M for limited partnersThe limited partners are entitled to $121M (= $100M × 1.12) before any distributions to the general partner. Since the fund liquidated at $200M there will be a distribution to the managers. Further, since the rate of return on the fund is significantly above the hurdle rate, the catch-up zone can be ignored. Managers will receive 20% of the $100M profit (i.e., $20M). The limited partners will receive $80m.

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