What is Private Equity Waterfall Modeling?
When private equity does well, the value of an investment can grow substantially. The next question would be what to do with the proceeds realized? This is where the waterfall distribution comes into play. In this context, we will take a deep dive into how does private equity waterfall modeling works?
What is Waterfall Distribution
In private equity investments, a partnership is formed between a general partner who manages the investment and a limited partner who contributes the most in the partnership. The waterfall structure describes the distributions' flow between the partners. It has also provision for the claw back and catch-up clauses that aim to protect both the investor and managers. Ideally, the limited partner receives all the cash flows from the investments until it reaches the preferred return rate before satisfying provision for claw back and catch-up clauses. The general partner or manager will receive a profit based on the level of investment and agreed incentive or management fee.
Types of Waterfall Distribution
The European Waterfall pays 100% of the investment proceeds to the limited partner until it reaches the required return and 100% investment. After that, the proceeds will be distributed on a pro-rata basis. The manager could only share profits after the capital is returned, and the preferred return has been satisfied. However, as part of managing the fund, the manager may receive an asset management fee. This waterfall is aligned with the interest of both managers and investors. However, it could take years before the fund manager could share in investment profits.
The American Waterfall pays 100% of distributions to limited partner up to the preferred return, but does not require the full repayment of his capital before the general partner participates in the profits. For the manager to qualify in this share of distribution, the deal must consistently satisfy or surpass the expected level of performance. It aims to encourage the manager to maximize the return on investment.
The claw back clause intends to protect the limited partner or investor. It takes into effect when the fund manager takes a performance fee while the deal is under performing. It requires the manager to repay any fees collected to make up for deficits.
The catch-up clause intends to protect the general partner or manager. It comes into play when there is a delay in the participation of profits. The fund manager is entitled to a retroactive payment of share in the net proceeds once the investment reaches a predetermined milestone.
Waterfall Modeling in Excel
In Waterfall Modeling, the profits are distributed between the general partner and limited that follow an uneven distribution. A multi-tier waterfall model can be designed according to the partnership agreement in which all equity investors will receive a preferred annual return of their invested capital. IRR models could be a three-tier waterfall with all hurdle rates measured at the project level. Suppose the distribution fall below the preferred return on the first tier, the deficiency will be carried forward to the following year and compounded annually at the preferred return rate. On the other hand, the cash flow required to meet the preferred hurdle must be determined before calculating the profit split on Tier 1. Then, the additional profit will be allocated based on the agreed profit split in this tier. Lastly, the remaining cash available from the investment will flow to the next waterfall tier. This multi-tier waterfall modeling is a bit complicated compared to other models, and for this reason, financial experts built various templates that include waterfall distribution.
Conclusion: Waterfall Model provides for fair distribution of profit between general and limited partner.
Since the investor risks his capital in the partnership, it is just right that his capital contribution and preferred return must be met before additional proceeds are distributed on a pro-rata basis. However, it is also just fair that the general partner received a management fee or other incentive to manage the investor's asset. It is just a matter of agreement and communication between the partners. A Greater profit will be achieved with a great partnership.
