[IMGCAP(1)]Investors want to understand the waterfall calculation being used within a private equity fund because it determines the order in which investors and managers receive their returns.
Fund administrators should be able to explain the waterfall calculation for each fund so that the CFOs within each fund can then accurately relay the information to their investors. The waterfall calculations clarify how returned capital will be divided between the investors and the fund manager, and in what order.
Administrators can walk CFOs through waterfall calculations, as well as provide a thorough explanation of an LP agreement, but CFOs will still want to know how to do it themselves.
When launching a private equity fund, CFOs should be given the pros and cons for both the American and European types of waterfall calculations. CFOs will be able to determine which calculation they would like to use based on their preference. Once the administrator provides the CFO with the tools they need to succeed, the CFO will be able to run the calculations, see that it was done correctly, and verify that information to investors. Here’s how that process would work:
The European waterfall is more favorable toward the investor as they are repaid their entire drawn down capital, as well as the preferred hurdle rate, which is typically an 8 percent internal rate of return.
In other words, this calculation uses a whole-of-fund model, so investors see returns faster. Once investors have been paid their capital, it is only then that the manager can receive their return as well.
The American waterfall benefits the fund manager as it is more gross profit friendly. Managers receive a share of the profits after the capital associated with a realized deal is returned. In other words, managers receive a share on a deal-by-deal basis, for only those investments that have been sold. The American waterfall is more appealing to emerging markets as it is advantageous in helping to retain and incentivize younger professionals with fewer assets.
Understanding the LP Agreement
An LP agreement lists how much money the limited partner, or investor, will receive in comparison to the manager. Fund administrators should also be able to provide CFOs with a simple outline of what such an agreement actually entails. Administrators will go step-by-step through the waterfall calculation as it is articulated in the LP agreement, which will, therefore, be an important point of reference for the fund’s CFO to validate and reiterate to investors.
It is important to understand the cash flow distribution between managers and investors, as well as any fees, unpaid interest and investor loans that may apply. Once the CFO understands the LP agreement, he or she is in a better position to make decisions for the company.
How the Cash Flow Works
No matter what their knowledge level is, CFOs will typically have a general understanding of cash flows, but will most likely still need a brief explanation. Once administrators explain the cash flows and direct the CFOs to where they can obtain the answers for future questions posed by investors, they are essentially given all the tools they need to succeed. This approach achieves better results than flow charts and spread sheets because it prevents misunderstandings that may arise when documents are illustrated in such forms.
Since cash flow is the essential driver behind hedge funds in the first place, having a knowledgeable and trustworthy fund administrator is key to a seamless workflow and risk management.
In order to fully understand how the waterfall calculation affects a fund, it is crucial for CFOs to understand how each calculation runs and who benefits from which type of calculation. By explaining why the waterfall calculation is so important for CFOs, they are then in turn able to explain to their investors and ensure them with transparency throughout the entire process.
Once the investor and manager understand the flow of cash within the organization and how they will move forward, both parties will be able to accurately see where the money is going.
Joe Holman is CEO of Orangefield Columbus, a fund administrator.
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