Euro style

The 'European-style' waterfall is gaining traction in North America, but US general partners need not fear this trend.

Many private equity firms are already facing the reality that they’ll owe their LPs money at the end of one or more of their funds’ lives. Some of their LPs are even said to be demanding interim clawbacks as a prerequisite for commitments to the next funds.

Market sources say some LPs in the US have taken their precautions – and their newfound bargaining power – to the next level and are asking for “European” style waterfall distribution formulas. US private equity funds tend to calculate their preferred return, catch-up and carried interest on a deal-by-deal basis, while European funds tend to calculate them based on the total capital called over the life of the fund.

The advantage of the “US-style” system to the GP is clear: they're more likely to get paid big carry bucks sooner. The disadvantage is that this “early carry” formula more often needs adjustment at the end of the fund's life in the form of a clawback – a painful true-up that no one enjoys, and which often is impossible to fully execute.

Currently, as much as 70 to 80 percent of existing US have negotiated deal-by-deal payouts. Those with a whole-fund waterfall mechanism tended to be new teams without a substantial track record. But the even fundraisings for experienced GPs could be veering towards the waterfall terms used on the other side of the pond.

“Certainly limited partners are in the driver’s seat right now, and they’ve always liked the aggregate distribution waterfall method,” says Kevin Scanlan, a partner at law firm Dechert. But he cautions that it’s difficult to discern market trends just yet given the relative dearth in capital raising by fund groups.  “It’s not like 2006 or 2007 where a large number of funds came to market.”

And while different waterfall structures are certainly among the the changes LPs would like to see in funds going forward, says Louis Singer of law firm Morgan, Lewis & Bockius, it’s just one of many items on their wish lists.

“That would be a dramatic shift in partnership agreements as previously done, so therefore it’s harder to achieve,” he says. “So while it’s very high on the list for many limited partners, there are other items on the list that they recognise would have less dramatic modifications to previous arrangements.”

Many major GPs are contemplating fundraisings in 2010 and 2011, and the waterall question is a big one, because it could alter the culture and competitive dynamics of the individual firms.

Clearly, the whole-fund waterfall distribution formula has obvious benefits for the LPs: it avoids the risk of the GP not having the cash to pay back a clawback. This could happen for any number of reasons – a principle at the firm may have retired, passed away, or entered into personal bankruptcy as a result of the recession.

Even if the principles can repay the carry they’ve taken out of the fund, they’ve likely already paid taxes on it. Most clawback provisions stipulate that the GP need only return the capital net of taxes, says Raj Marphatia, a partner at law firm Ropes & Gray. Obviously LPs are less than pleased to be getting just over 60 percent of what is owed to them. Some specify that if a partner receives a tax benefit from returning the capital, he must compensate the LP with the amount that he saved from carrying the loss forward to offset future capital gains. But this won’t make up the full amount lost for the LP.

But the European waterfall has advantages for the GP as well. Roger Singer, a partner at Clifford Chance, says his firm recommends the structure to clients.

“It actually reduces the total amount that the LPs get paid,” he says. “There’s likely to be more carry at the end [of the fund’s life], because the sponsor has used the early carry to pay off the investors on their capital or on their preferred return. If the GPs are confident that their investments are performing well, it’s a way to lower the overall the cost of capital, while the LPs are getting their money back sooner which in this environment they love.”

For example, if a GP makes two investments at $100 million, and it sells the first one for $200 million. Under the US model the GP should receive $20 million in carry, and still owes the LP $100 million for the second investment plus a preferred return. If the GP takes that $20 million and pays back a portion of the capital it owes to the LPs, the LPs’ preferred return is no longer accruing on the remaining $100 million owed, but on $80 million.

Of course, for this strategy to work, the GP needs to be able to keep the lights on during the early years before carry starts coming its way. This reveals a fund structuring catch-22: those who need the money most are young teams, and young teams are the least “creditworthy” in the eyes of the LPs, Singer says.

Dan Vene, a vice president at placement agent CP Eaton, says his firm advises all of its clients to offer European style waterfalls. This is largely because the firm tends to work with teams that have spun out of large institutions, and subsequently have to compete with those institutions for capital. CP Eaton also likes to offer LPs “plain vanilla” terms, so that the decision to commit capital is ultimately based entirely on the calibre of the manager and not impeded by above market fees.

“Out of the 12 funds we have on our platform right now, every single one of them is fully pooled economics,” he says. “Now clearly in earlier years there is less income for the partners, but we also advise people that if they’re not ready to go through a couple of years of just getting by on their base salary they’re probably not ready to run their own fund.”

But even if the top people are able to get by for those first few years, a European waterfall could make it difficult to attract new talent, Scanlan says.

While there is momentum in the US towards whole-fund carry payment structures, new dynamics could always pop up to reverse this trend.

“One reason private equity firms moved away from the aggregate return of capital to a deal-by-deal structure was to enhance their ability to compete for qualified professionals with hedge funds and investment banks, both of which provided their employees with the potential to receive a large annual bonus,” Scanlan says. “This allowed them to compete on a little bit more of a level playing field, because they didn’t have to wait until all of the capital and costs had been returned [which could take 7 years or longer in some cases] to pay a large bonus to their employees. If the market comes back and there are a lot of opportunities for private equity professionals at banks or hedge funds, it will put pressure on private equity fund organisations to find creative ways to pay their employees.”