23/05/2024
Funds And Waterfall Structures
This briefing focuses on the use of distribution waterfalls and carried interest structures in funds. It covers:What is carried interest?What is a distribution waterfall?How does a basic waterfall operate?Hurdle ratesCatch upWhole-fund v deal-by-dealHybrid waterfall structuresOpen-ended fundsESG-linked carried interestFirst loss mechanisms What is carried interest? “Carried interest” is a form of performance-related remuneration, where a fund sponsor or manager is rewarded with a share of fund profits where the fund has outperformed certain performance targets (often referred to as “hurdles”). In order for the sponsor to become entitled to a carried interest, the fund must typically first have provided the investors with a return of their capital invested, plus a return on that capital of an amount equal to the hurdle. As a form of profit share, a carried interest differs from a performance fee, which is often calculated in a similar manner but which is paid to the sponsor as a fee for provision of services (and which may therefore attract VAT and be taxed as income in the hands of the sponsor). In contrast, as of the date of publication of this briefing, carried interest should, if structured correctly and for UK tax purposes, be capable of being treated as a capital (rather than income) return in the hands of UK tax resident individual carried interest holders. For this reason, carried interest has historically been greatly favoured by fund managers as an effective and efficient means of incentivising (and retaining) management team members and providing performance-driven alignment of interest with investors. What is a distribution waterfall? A “distribution waterfall” refers to the ‘cascading’ order of priority by which net profits (income profits and capital gain) are distributed between the investors and sponsor of a fund. The structure of a waterfall will often vary depending on various factors, including the investment strategy, legal form and geography of the fund. This note refers to the use of carried interest and waterfall structures in the context of private funds, but it should be noted that similar mechanisms are often employed in other investment structures outside of funds, such as joint ventures, clubs, co-investments and segregated mandates. How does a basic waterfall operate? The structure and operation of the waterfall will typically be set out in the main fund agreement (such as a limited partnership agreement). In its most basic form, a waterfall might have the following sequential tiers: Hurdle rates The hurdle rate is typically expressed as a specified percentage internal rate of return (“IRR”) on the investors’ invested capital. The hurdle rate may vary depending on the investment strategy and targeted returns of the fund. Strategies which target higher returns typically with higher accompanying risks (such as value-add or opportunistic funds) may adopt a higher hurdle rate than strategies with lower return targets and/or risk profiles. However many private funds investing into alternatives will employ a base hurdle rate of between 7% to 9% IRR. Occasionally, other forms of hurdle may be adopted, such as a specified investment multiple on investors’ invested equity, either instead of or in conjunction with an IRR based hurdle. Other fund waterfalls have adopted tiered hurdle structures with differing carried interest sharing ratios. For example, the sponsor might receive a carried interest equal to 20% of profits over a first hurdle of 8% IRR, increasing to 25% of profits over a second hurdle of 12% IRR. Certain investors have however viewed such arrangements with caution, on the basis it can incentivise the management team to take increased risks in executing investment decisions. Finally, some funds have adopted “floating hurdles”, where the hurdle rate can vary from time to time. Such arrangements are not widespread but can be seen, for example, in private debt funds where the underlying loan investments may be originated at floating interest rates and investment returns will therefore vary accordingly over time. Catch up A catch up mechanism operates to provide the sponsor with an accelerated share of profits with the aim of ensuring the sponsor receives a specified percentage of the total fund profits. Typically, the catch up will apply between tiers 3 and 4 in the above waterfall example, and will apply to “catch up” the sponsor’s share of profits to its specified carried interest sharing percentage. For instance, in the example waterfall shown above, while the sponsor will receive, as a carried interest, 20% of profits above the hurdle, it will not have received 20% of total profits, as investors have already received the preferred return before any distribution of carried interest is made. A catch up might seek to rectify this by providing the sponsor with 100% of profits until it has received 20% of total profit distributions (i.e. excluding return of capital). Only once the sponsor has caught up to that 20% share would distributions then revert to the 80% / 20% split. In practice, the rate at which the sponsor is caught up (if at all) will vary depending on the fund strategy and the bargaining power of the stakeholders. While 100% rates of catch up are not uncommon in certain private equity and venture capital funds, we often see variations and in a private real estate context it is more commonly 50% / 50%. Whole fund vs deal-by-deal There are two main types of waterfall structures: “whole-fund” and “deal-by-deal”. They are often known as “European-style” (whole-fund) and “American-style” (deal-by-deal), by reference to the locations where they had traditionally been pre-eminent. However those geographic distinctions have over the years become increasingly blurred. Whole Fund: Under the whole fund model, the waterfall is applied cumulatively in respect of contributions to, and distributions from, all investments made by the fund. This is generally seen as more favourable to investors, as the sponsor will not participate in carried interest until the investors have received a return of their invested capital plus the preferred return across all investments. This would typically not occur until the late-stage disposals made by the fund (i.e. the sponsor’s carried interest entitlements are back-ended until the end of the fund’s life). Deal-by-deal: Under the deal-by-deal model, the waterfall is applied separately in respect of each investment. This structure generally favours the sponsor, who may (subject to performance of individual investments) become entitled to carried interest, irrespective of the profitability (or losses) made on other investments. Due to this risk, investors into funds adopting the deal-by-deal model will often expect greater protection in the form of escrow, clawback or guarantees in order to mitigate the risk of carried interest overpayments to the sponsor (had the carried interest been calculated on a whole-fund basis). Hybrid waterfall structures Each of the whole-fund and deal-by-deal model, on its own, tends to favour one stakeholder’s interests over the other. Hybrid waterfall variations can however be used to strike a compromise and address specific goals. For example, a reduced carried interest rate can be applied on a deal-by-deal basis but then, once investors have recouped their capital and preferred return on a total return basis, the carried interest rate can be increased and the waterfall converted to a whole fund structure. Alternatively, the waterfall can be applied on a cumulative basis in respect of realised investments (but not from unrealised investments). The effect of this is that the sponsor can be rewarded more quickly for successful investments, but that losses from any subsequent unsuccessful realised investment which brings the fund below the hurdle will need to be made up by future distributions before the manager becomes entitled to further carried interest. Open-ended funds This note generally considers carried interest and waterfalls in the context of closed-ended fund structures. Performance-related remuneration models have typically been less common in open-ended funds, which tend to prioritise long-term income returns over capital appreciation (and where capital proceeds are typically reinvested into the fund portfolio rather than distributed to participants). Where they have been employed, it was often in the form of a performance fee rather than a profit sharing arrangement. That being said, various open-ended funds have adopted performance-related profit sharing structures (and this trend has increased in recent years). However these generally operate differently to closed-ended waterfall models, with the promote often being based on rolling calculation periods, with a notional IRR calculation applied to the starting and ending net asset values and related cashflows in respect of the applicable calculation period. Given the inherent differences between the closed and open-ended models, these promote arrangements are outside the scope of this note. ESG-linked carried interest Carried interest has traditionally been linked to the performance of funds against financial hurdles. However, the increased recent industry focus on ESG considerations, have seen certain stakeholders look to link carried interest and waterfalls to ESG, impact and sustainable investment criteria. This has proved an effective means of investors holding sponsor to account for their ESG performance, and for certain sponsors to differentiate themselves from competitors in a market that has seen a recent proliferation of sustainable investment strategies. There are varying methods of linking carried interest to ESG performance. For example, a portion of the traditional financial return-based carried interest may be held back subject to assessment of performance against impact-related KPIs. Alternatively, the fund’s hurdle rate may be lowered if certain impact-related KPIs are achieved. Other variations exist (e.g. requiring a portion of forfeited carried interest to be donated to charitable causes or to be used to purchase carbon offset credits). The complexity with all such models is in ensuring that impact KPIs are meaningful, measurable and appropriate to the investment strategy (or even individual investments within a strategy). ESG performance is inherently contextual, meaning that it can be difficult to accurately measure impact and outcomes, while as yet there are no clear or defined market standards. To provide greater alignment between sponsors and investors, funds will often rely on external experts, such as impact advisers and auditors, to provide independent guidance, oversight and verification of the process. For the reasons outlined above, ESG-linked carried interests have tended to be seen more commonly in strategies which pursue or promote a specific environmental and/or social objective or outcome, but have yet to become commonplace in the wider private funds industry. First loss mechanisms Last, but not least, there is also the option to use blended finance, where more risk-averse investors are hedged by investors with a higher risk appetite. This not only widens the pool of resources available to the sponsor, but allows investors to diversify their portfolio and enter into transactions outside of their usual risk profile. In a waterfall structure, this can take the form of a first loss mechanism under which an investor with a higher risk / return profile may agree to absorb a portion of losses (if they arise) against their contributions. In exchange, that investor may receive a greater preferred return and/or a preferred return contingent on a lower hurdle rate, meaning that if the overall portfolio performs well (with any losses recovered), that investor recoups higher and/or earlier profits than the more risk‑averse investors. Conclusion In structuring any fund product, it is crucial that the fund terms provide an appropriate alignment of interests between the sponsor and the investors. The distribution waterfall goes to the very heart of the fund (i.e. its performance and returns) and the various permutations (as set out above) provide an effective means of striking a balance between the respective interests of those key stakeholders, having regard to the strategy and purpose of the fund in question. If you would like specific advice on waterfall structures, including which model might be suitable to a particular transaction, please feel free to contact the CMS Funds Group.
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