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Editor’s Letter: More GPs take dive into European waterfall

One of the wish-list items held dear by most limited partners is for GPs to offer European-style waterfall distribution models on their funds. Traditionally, this has not been something offered by most U.S.-based buyout shops. Instead, they prefer to collect carried interest after each exit (after meeting a return hurdle).

That appears to be changing. In the 2016/2017 “PE/VC Partnership Agreements Study,” produced by Buyouts publisher Buyouts Insider, a majority of North American buyout firms (53.3 percent) said they use the European-style distribution model — returning all contributed capital before the GP starts to collect carry. That is a dramatic increase from when the same study was done two years ago. At that time, 38.8 percent of GPs said they used waterfall distribution.

Some 33.3 percent of North American buyout GPs said they use the deal-by-deal carry model, while 13.3 percent said they return all committed capital (instead of contributed capital) before starting to collect carry, the study found.

The study polled 172 firms located around the world, including in North America.

Looking outside of North America, 61.8 percent of international buyout shops use the waterfall method, 29.4 percent use deal-by-deal carry, and 5.9 percent return all committed capital before collecting carry, the study said.

This is good news for LPs. The Institutional Limited Partners Association’s Private Equity Principles state that “alignment of interest between LPs and GPs is best achieved … when GPs receive a percentage of profits after LP return requirements are met. We continue to believe that an all-contributions-plus-preferred-return-back-first waterfall is best practice.”

What accounts for the move to waterfall distributions? Partly, it has to do with funds getting bigger, said Kelly DePonte, managing director at placement agency Probitas Partners. Larger funds ($1.5 billion and up) tend to have larger LPs, which have more leverage with terms due to their size and “are more likely to subscribe to the ILPA principles,” DePonte said. Also, funds looking to raise capital from Europe might have a better chance using the European-style waterfall model.

Smaller North American funds ($500 million or less) are more likely to use deal-by-deal carry simply because they don’t have as much cash beyond the operating budget. These smaller GPs use early distributions from exits to pay bonuses to strong performers and retain talent, DePonte said.

Apax Partners, a European-based firm, recognized this issue in its latest fund, which is set to hit the market soon. Apax is out talking to LPs about its ninth fund with a target of between $7 billion and $8 billion. The fund features a European-style waterfall distribution structure, but Apax is offering a deal-by-deal carry option to all LPs on a first come, first served basis, up to $2 billion of commitments. LPs that choose that option will get a reduction of 5 basis points on the 1.5 percent management fee during the investment period, an LP told Buyouts in a previous interview.

Apax would use the carried interest collected early on in the fund life to compensate younger executives at the firm, the LP said. Equity partners at Apax would still collect carry on a European-style basis.

“When you have to give back all capital first, that really pushes out carry dollars to years between six and eight on average on a particular fund before any of those guys get any carry,” the LP said.

The fact that more North American GPs are using the European-style waterfall structure in today’s bull market for fundraising environment says to me that the Euro-centric version of carry is here to stay.

Photo: A competitor takes part in the first international waterfall jumping competition held in the old town of Jajce August 9, 2014. REUTERS/Dado Ruvic