SEC official warns GPs to pay close attention to waterfall calculations

  • LPs concerned with “leakage” around complex distribution models
  • SEC examiner sees “errors in spreadsheets, errors in calculation” of waterfalls
  • Others say waterfalls leave little wriggle room for misinterpretation

A Securities and Exchange Commission official has some advice for GPs: Pay close attention to your waterfall calculations.

In an April 6 keynote interview at PartnerConnect East in Boston, SEC Examiner and Private Funds Unit Co-Head Jennifer Duggins described seeing “errors in spreadsheets, errors in calculations” in the context of waterfall distribution structures.

“Make sure you understand your process,” Duggins said. Firms should account for oversight of their waterfall calculations “because of the complexity, because of what the audit might show. Care and focus are important in that regard.”

How LPs and GPs get paid through private equity funds is one of the most heavily negotiated, and one of the most complicated, aspects of the business. Misinterpretations of how these distribution structures work could expose general partners to regulatory risk, according to multiple sources interviewed by Buyouts.

“They’re really mathematical formulas, and trying to write out mathematical formulas is really hard,” said one fund attorney. Some are so complex, certain investors could “have no understanding of what the damn thing means.”

While virtually every source Buyouts spoke with acknowledged the complexity of waterfall structures, it’s unclear what steps the industry could take to simplify its fund distribution models.

Some larger LPs have already started to ask firms to provide them with Microsoft Excel algorithms to calculate cash flows more efficiently.

The Institutional Limited Partners Association will try its hand at simplifying things later this year with an effort to harmonize certain components of limited partner agreements and side letters, including waterfalls, said ILPA Managing Director Jennifer Choi.

“These should be comprehensible documents, after all, when it comes to how the economics are split,” she said.

Devil’s in the details

The waterfall distribution structure determines how cash and stock, including any carried interest, gets paid out to limited partners, GPs and other shareholders following an exit.

At a high level, there are two waterfall structures: one, known as deal-by-deal (or North American carry), allows GPs to take their profit-share on profitable deals, provided certain hurdles are met, before investors have gotten all their contributed capital back.

The other, known as the European-style waterfall, guarantees that investors get paid back at least all contributed capital (if not all committed capital) before the GPs receive any carry.

Within these two models are all kinds of details on exactly how they pay out and it’s in these details where things get complex.

Complicating the situation is the different methods used by fund formation attorneys to disclose waterfalls in fund agreements. “I’ve actually been interested why [the SEC doesn’t] focus on waterfalls,” said one fund compliance attorney. “They’re written by lawyers and implemented by CFOs. And words can be misinterpreted.”

Jack Rader of ACA Compliance, which helps private equity firms develop compliance programs, said he has not seen any specific instances of the SEC focusing on waterfall structures. But “certainly that’s an area where there’s less oversight and it’s more complicated. So there’s a higher risk for issues.”

Two sources, an LP advisor and a private equity CFO, said fund agreements leave little wiggle room for firms to misinterpret or miscalculate distributions. “If you were to look at the LPAs [written] across law firms, you will see that every single scenario is accounted for,” said the CFO. “It doesn’t mean they’re unintelligible; it means they’re complicated.”

Still, two fund compliance officials said that auditors from the “big four” accounting firms — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers — have grown wary of the increasing complexity of waterfalls, particularly as more LPs demand side letters delineating separate and distinct terms.

“They realize, as much as everyone else, that there are a lot of judgment calls in the numbers, and they don’t want the liability for those judgment calls,” said a second fund attorney.

Private equity professionals from major accounting firms did not respond to requests for comment.

In the meantime, LPs should be certain they understand every aspect of their fund managers’ distribution models.

“When you invest, you’re investing in that contract,” said one public pension investment official. “That’s why we all need to be so careful in those contracts.”

Action Item: For a California Public School Employees’ Retirement System presentation on distribution models, visit

Photo: A general exterior view of the U.S. Securities and Exchange Commission (SEC) headquarters in Washington, June 24, 2011. REUTERS/Jonathan Ernst