What are Private Equity Waterfalls, Clawbacks & Catch-Up Clauses? (2022)

What are Private Equity Waterfalls, Clawbacks & Catch-Up Clauses? (1)

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.

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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.

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(Video) Clawback - Private Equity

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.

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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.

(Video) Real Estate Waterfall Model with Catch Up and Clawback Provisions

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.

Catch-Up Clause

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:

  1. The investor would receive an annualized 8% preferred return and their capital back.
  2. The manager would then receive 100% of distributions until they receive 20% of all annualized profits (aka the catch up clause).
  3. 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.

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(Video) Distribution Waterfall - Catch-Up Calculation Whiteboard - Part 3 of 5
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FAQs

What is a catch-up clause in private equity? ›

A “Catch-up” in the private equity world is commonly used as a means for a fund Man- ager (“Manager”) to earn a fee equal to a per- centage of the profit but only after the investor has received back its investment and earned a preferred return (often expressed as an internal rate of return or “IRR”).

What is a waterfall in private equity? ›

A distribution waterfall is a way to allocate investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall defines the pecking order in which distributions are allocated to limited and general partners.

What is a clawback in private equity? ›

Clawbacks in Private Equity

In private equity, it refers to the limited partners' right to reclaim part of the general partners' carried interest, in cases where subsequent losses mean the general partners received excess compensation. Clawbacks are calculated when a fund is liquidated.

What is a 50/50 catch-up private equity? ›

So, a typical deal might be stated as “20% carry over an 8% pref with a 50% catchup”. This means that the partnership has to earn at least 8% return before the sponsor earns any carry. Above an 8% return, the sponsor gets half the profit (i.e. the catchup is 50%) until the ratio of profit split is 20% to sponsor.

What is catch up in waterfall? ›

Catch-Up Clause

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.

What is a 100% catch up? ›

In practice, in a deal with a GP Catch-Up clause, the LP receives 100% of the property's cash flow until their preferred return hurdle is reached. Above the hurdle, the manager/General Partner receives 100% of the income and profits until they are “caught up” to their performance fee.

What is a catch-up in carried interest? ›

Catch-up takes effect when an investor's returns reach the defined hurdle rate, giving them an agreed level of preferred return. The manager then enters a catch-up period, in which it may receive an agreed percentage of the profits until the profit split determined by the carried interest agreement is reached.

Which waterfall method is better in private equity? ›

The European model is more favorable for limited partners. Sponsors may wait for years to receive a share of the profits. This increases the sponsor's risk and incentivizes them to sell investments early.

What is a promote catch-up? ›

Catch-up Provision

This provision provides that the investor gets 100% of all profit distributions until a predetermined rate of return has been achieved. Then, after the investor achieves the required return, 100% of the profits will go to the sponsor until the sponsor is “caught up”.

What is another word for clawback? ›

What is another word for claw back?
regainretrieve
recouprecover
win backreclaim
repossessretake
recaptureregain possession of
25 more rows

What does 2 and 20 mean in private equity? ›

"Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.

What is a hurdle rate in private equity? ›

The minimum return to investors to be achieved before a carry is permitted. A hurdle rate of 10% means that the private equity fund needs to achieve a return of at least 10% per annum before the profits are shared according to the carried interest arrangement.

How do you calculate waterfall catch up? ›

Distribution Waterfall - Catch-Up Calculation Whiteboard - Part 3 of 5

What is hurdle rate with catch up? ›

The lower the percentage of the catch-up rate, the higher the hurdle rate effectively becomes. For example, with a 100% catch-up rate and a 8% preferred return, the effective hurdle rate is 10%; by comparison, with a 80% catch-up and a 8% preferred hurdle, the effective hurdle rate is 13.3%.

What is deal by deal waterfall? ›

The deal-by-deal waterfall distributes carried interest faster. With a European waterfall, the first distributed amounts are used to return the capital called by other deals. In the deal-by-deal waterfall, the first deal may return some carried interest if the deal IRR is above one of the hurdle rate.

What does waterfall mean in accounting? ›

What Is a Waterfall Payment? Waterfall payment structures require that higher-tiered creditors receive interest and principal payments, while the lower-tiered creditors receive principal payments after the higher-tiered creditors are paid back in full.

What do you mean by waterfall provisions? ›

Waterfall provisions (or, colloquially, “waterfalls”) are provisions that dictate how the distributions from a partnership or limited liability company are allocated among investors.

What is a VC waterfall? ›

“Waterfalls” by TLC. The distribution waterfall is the order in which a venture capital or private equity fund makes distributions to both its limited and general partners.

What is a high water mark in finance? ›

A high-water mark is the highest level in value an investment account or fund has reached. A high-water mark is often used as a demarcation point in determining performance fees that an investor must pay.

How do you calculate preferred return in private equity? ›

Preferred returns for an entire syndication can be calculated by multiplying the equity from the investor class by the preferred rate. For example, if $1 million is raised from investors to purchase a property, and the preferred rate is 6%, the annual preferred return would be $60,000.

What is a good preferred return in private equity? ›

A preferred return in private real estate investing is the minimum return an investor must receive before an investment manager can earn a performance fee. The preferred return is typically between 6% to 9% in real estate investing, depending on the risk of the investment.

How does private equity carry interest work? ›

In the Interest Of. Carried interest is a share of a private equity or hedge fund's profits that is paid to the fund's managers. People often view this money as a performance bonus because the more the fund makes, the more profit there is for the managers to share.

What is an example of carried interest? ›

To understand carried interest, it helps to look at an example. Say an LP invests $5k in a fund that charges 20% carried interest. The fund has a successful exit, and that LP's distribution is worth $100k. The GP will receive 20% of the amount the investor earned after their principal is paid back ($100k - $5k = $95k).

How does a waterfall work? ›

Often, waterfalls form as streams flow from soft rock to hard rock. This happens both laterally (as a stream flows across the earth) and vertically (as the stream drops in a waterfall). In both cases, the soft rock erodes, leaving a hard ledge over which the stream falls.

How does a waterfall structure work? ›

A waterfall structure can be thought of as a series of pools where cash flows from an asset fill a single section, before spilling over into the next one. Each pool represents an agreement on how the asset's cash proceeds will be distributed.

Which waterfall method is better? ›

Agile and Waterfall are two popular methods for organizing projects. Waterfall is a more traditional approach to project management, involving a linear flow. Agile, on the other hand, embraces an iterative process. Waterfall is best for projects with concrete timelines and well-defined deliverables.

Is it claw back or clawback? ›

The term clawback or claw back refers to any money or benefits that have been given out, but are required to be returned (clawed back) due to special circumstances or events, such as the monies having been received as the result of a financial crime, or where there is a clawback provision in the executive compensation ...

How do you explain private equity? ›

Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange. Private equity firms earn money by charging management and performance fees from investors in a fund.

How does private equity make money? ›

Investment bankers make money by advising companies, structuring sales, raising capital, and taking a percentage fee on each transaction. By contrast, private equity firms make money by exiting their investments. They try to sell the companies at a much higher price than what they paid for them.

What is a carry fee in private equity? ›

Also known as carry or a performance fee. In private equity, a share of a fund's profits that the general partner is entitled to receive from the fund. This method of compensation is designed to incentivize the general partner to generate profits for the fund.

What is an 8% hurdle? ›

8% Hurdle Rate means, with respect to any Investment, an amount equal to an annually compounded return of eight percent (8%) per annum (compounded annually) on the Unreturned Investment Cost in respect of such Investment from time to time.

Is IRR same as hurdle rate? ›

Key Takeaways

The hurdle rate is the minimum rate of return on an investment that will offset its costs. The internal rate of return is the amount above the break-even point that an investment may earn.

Is WACC the hurdle rate? ›

Often companies use their weighted average cost of capital (WACC) as the hurdle rate. In the second method, the internal rate of return (IRR) on the project is calculated and compared to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely proceed.

What is waterfall schedule? ›

A waterfall schedule is one where there are overlapping physician shifts. In addition, the model often has physicians changing locations partway through their shifts to be primarily responsible for evaluating different types of patients at different times.

What is no catch up in private equity? ›

No catch-up means that profit share will be applicable only on the incremental return over and above the hurdle rate.

How does a waterfall work? ›

Often, waterfalls form as streams flow from soft rock to hard rock. This happens both laterally (as a stream flows across the earth) and vertically (as the stream drops in a waterfall). In both cases, the soft rock erodes, leaving a hard ledge over which the stream falls.

What is a valuation waterfall? ›

A general 'waterfall' is an analytical tool that visually presents the sequential breakdown of a starting value (ex: revenue) to a final result (ex: profit) by displaying intermediate values and 'leakage' points. This can be used by companies to track data on each step.

What is a financial waterfall? ›

What Is a Waterfall Payment? Waterfall payment structures require that higher-tiered creditors receive interest and principal payments, while the lower-tiered creditors receive principal payments after the higher-tiered creditors are paid back in full.

What is a VC waterfall? ›

“Waterfalls” by TLC. The distribution waterfall is the order in which a venture capital or private equity fund makes distributions to both its limited and general partners.

What are the benefits of waterfalls? ›

Waterfalls provide soothing sights and sounds that help you relax and de-stress in today's busy world. Lower your blood pressure and improve your physical and mental health as you prop your feet up and enjoy the therapeutic effects of Mother Nature.

How many types of waterfalls are there? ›

Waterfalls are classified into 10 different types depending on the way they descend. Some prime examples are Punchbowl Waterfalls, Plunge Waterfalls, Multi-step Waterfalls, Horsetail Waterfalls, Frozen Waterfalls, Fan Waterfalls, Chutes, Cataracts, Cascades, and Block Waterfalls.

What is waterfall model with example? ›

Waterfall model is an example of a Sequential model. In this model, the software development activity is divided into different phases and each phase consists of a series of tasks and has different objectives. In waterfall, the development of one phase starts only when the previous phase is complete.

What is waterfall formula? ›

Waterfall calculations are used to allocate cash flow among two or more partners based on their agreed-upon return parameters. In this course, Excel expert David Ringstrom, CPA, brings his prior commercial real estate experience to the forefront by walking you through assembling a waterfall calculation from scratch.

What is waterfall summary? ›

Definition: The waterfall model is a classical model used in system development life cycle to create a system with a linear and sequential approach. It is termed as waterfall because the model develops systematically from one phase to another in a downward fashion.

What is a waterfall cap table? ›

Waterfall Analysis

The cap table typically indicates the accounting ownership of individual shareholders, which is the actual ownership percentage. Accounting ownership varies from economic ownership, which is the percentage of ownership available to equity.

What does the term waterfall mean in business? ›

Waterfall project management maps out a project into distinct, sequential phases, with each new phase beginning only when the previous one has been completed. The Waterfall system is the most traditional method for managing a project, with team members working linearly towards a set end goal.

What is deal by deal waterfall? ›

The deal-by-deal waterfall distributes carried interest faster. With a European waterfall, the first distributed amounts are used to return the capital called by other deals. In the deal-by-deal waterfall, the first deal may return some carried interest if the deal IRR is above one of the hurdle rate.

Videos

1. Clawbacks in Private Equity Real Estate Explained
(Break Into CRE)
2. American vs European Private Equity Waterfall
(Bridger Pennington)
3. Distribution Waterfall - Private Equity Catch-Up - Part 5 of 5
(A Simple Model)
4. Structure of a Private Equity Waterfall 🤯
(Bridger Pennington)
5. Distribution Waterfall Stages, Commitment & Unfunded Commitment in Private Equity
(FinLens 🔍)
6. Waterfall - Private Equity
(Steve Balaban)

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