Why US waterfalls are going European

There were plenty of good insights to be found in a new study of fund terms published recently by PEI and law firm Schulte Roth & Zabel.

For instance, one notable finding was that LPs typically allow about six months for firms to find a ‘key man’ replacement before they start to get uncomfortable. Another interesting one was that a partner’s direct involvement in any individual deal tends not to matter to most GPs when distributing carried interest.

But perhaps the most striking finding, at least as far as we were concerned, was about waterfall arrangements. The received wisdom is that there are two models: the US version, where fund managers distribute carry on a deal-by-deal basis, and the (arguably more investor-friendly) European version, where LPs receive all their contributions back plus an agreed hurdle rate before GPs start collecting their share of the carry.

Not surprisingly, the research showed that about 95 percent of European managers use this second ‘fund as a whole’ model. But what’s interesting is that US managers are increasingly moving in this direction too. Only about one in three US managers now employ the deal-by-deal model – a significant departure from what was once the industry standard Stateside.

This shift is largely a consequence of LP pressure. The Institutional Limited Partners Association considers the European waterfall model to be best practice (not least because it reduces the chances of a cumbersome claw-back process). And a sample of US GPs interviewed as part of the research specifically named alignment of interests with investors as their primary rationale for the switch.

But there may be something else going on here. Fund formation lawyers say there’s a growing awareness that the European model can ultimately result in more carry for fund managers – because it reduces the amount of outstanding capital on which LPs’ preferred return is calculated over the course of the fund.

Let’s say a GP calls $200 million from LPs to make two investments for $100 million each. It then sells one of these investments for $200 million, making a $100 million profit. Under the US model (assuming a standard 20 percent carry rate), the GP would first give LPs back their capital – the initial $100 million – and then split the other $100 million 80/20, thus receiving $20 million in carry. That would leave $100 million of outstanding capital committed by LPs (from the other investment).

But under the European model, the GP might use that $20 million to pay down its total capital owed to LPs. So now the outstanding amount of capital would be $80 million, rather than $100 million.

The preferred return is usually (although not always) calculated on the basis of outstanding capital. So in the US model, it’s calculated as a percentage of $100 million; in the European model, it’s calculated as a percentage of $80 million. The result? Over the course of the fund, the GP has to pay out less money to meet the preferred return, and thus ends up keeping more money for itself.

Of course, the caveat is that the GP needs to be able to attract and retain talent during the early years before carry starts coming its way. So delaying carry payments may require the manager to offer higher bonuses pulled from the management fee, making it more difficult to “keep the lights on”. That kind of result can place upward pressure on management fees, says Schulte Roth & Zabel private funds partner Joseph Smith, a co-author of the report. After all, competitors like banks and hedge funds can offer job seekers big performance payouts without the years of waiting.

So it’s likely that the waterfall will continue to be heavily negotiated, depending on the unique characteristics of each fund manager and its LPs; there may never be a uniform industry-wide standard.

On the other hand, it does seem to be the case that the European waterfall model is starting to predominate. In fact, according to Smith, it’s even influencing some of the managers that are ostensibly sticking to the ‘US model’: “There are lots of nuances around catch-up periods, interim claw-backs and other things that make the US model a little more European.”