A waterfall provision is a type of distribution provision that specifies the priority of distribution of cash and other assets to equity holders and management in partnership agreements and limited liability company operating agreements. They are most commonly found in entities that act as investment vehicles where there is an active manager and passive investors such as a private equity investment fund or an investment holding company created for buyouts that typically take the form of an LLC.
One of the advantages of using a partnership or LLC is that state partnership and LLC statutes usually defer to the entity’s partnership/operating agreement to determine distribution obligations, which allows the partners/members flexibility to structure economic arrangements in a variety of ways. In addition, waterfall provisions allow these entities to incentivize the general partner or manager with special profits distributions, also known as “carried interest.” Carried interest gives the general partner or manager the right to receive a percentage of future profits unrelated to any capital interest it may have in the entity. The timing and terms of the carried interest is set forth in the waterfall provision, which usually provides that the carried interest distribution is lower in priority to distributions to the investor partners or members.
For purposes of this article, the term “sponsor” refers to the general partner, manager or other party that is responsible for the formation, capital raising, investment and operating decisions of the partnership or LLC, as the case may be. The term “investor” or “investors” shall refer to the equity partners or members who invest in the partnership or LLC, as the case may be, on a passive basis.
I. Typical Waterfall Tiers
The layering of waterfall tiers, and the allocation of the distribution among the investors and sponsor, is a matter of negotiation and there exists a wide variety of options, with certain approaches that are more common than others. The following describes a common distribution waterfall used in a typical private investment:
- First Tier (Return of Capital Contribution) – 100% to the investors until they have received all of their capital contributions.
- Second Tier (Preferred Return) – 100% to the investors until they have received a preferred return on their capital contribution (also called the “hurdle”).
- Third Tier (Catch-up) – 100% to the sponsor until it receives X% of the distributions of profits (known as the “catch-up” tranche).
- Fourth Tier (Carried Interest) – X% to the sponsor as carried interest (note, X% in this fourth tier should match X% of the third tier) and 100%-X% to the partners/members.
a. Preferred Return
A typical rate of preferred return is often between 7-9% and is typically a compounded rate of return depending on the subject entity’s investment. The rate can accrue from the date the capital contributions are made or in some instances, the entity will negotiate that the return accrues on invested capital only or excludes any return on contributed capital used for fund expenses.
The carried interest concept actually kicks in at the third tier, the catch-up tier. After investors receive their return of capital contribution and the entity clears the hurdle, the entity will, by and large, provide for carried interest through catch-up distributions in the catch-up tier to the sponsor. In this tier, usually 100% (or some other agreed-upon fixed percentage) is allocated to the sponsor until the preferred return distributions, along with the sponsor catch-up distribution, results in a ratio of distributions between the parties that is equal to the carried interest split (usually 20%/80%).
c. Carried Interest
After the catch-up distributions are dispersed, the distribution waterfall divides any remaining profits in accordance with the same agreed upon carried interest split that was used in the catch-up tier. It should be noted by sponsors and investors, that the concept of carried interest is not as straight forward as it appears at first glance. There are different methodologies used for calculating carried interest, with the three most common being the following:
- Deal by Deal without Loss Carry Forward – Using this methodology, the parties agree that the sponsor will receive carried interest on profitable investments irrespective of losses on unsuccessful investments. Not surprisingly, this type of arrangement is not commonly used today due to investor concerns that such arrangement forces the investors to bear a disproportionate share of the risk. The thought is that this arrangement may encourage the sponsor to entertain riskier investments than they otherwise would knowing that potential gains on certain investments will not be offset by losses on others when calculating carried interest.
- Deal by Deal Carry with Loss Carry Forward – This methodology, which is more common, accounts for previously realized losses on investments and unrealized losses or write-downs/permanent impairment of value on unliquidated investments. In the event there are losses on investments liquidated after the carried interest has been distributed, the sponsor must return the excess amount through a clawback payment (discussed below). Carried interest distributions are usually distributed after liquidation of a particular investment or at other specified times negotiated by the parties and set forth in the partnership/operating agreement.
- Back-ended Carry – The back-ended carry requires the investors to receive their total capital contribution in addition to their preferred return before the sponsor receives any distribution of carried interest substantially delaying the sponsor’s profit participation until near the end of the life of the fund when most investments have already been liquidated. The benefit to this method is that clawback payments are rarely needed since the sponsor does not receive carried interest on an interim basis.
Under certain circumstances and depending on the methodology used to calculate the carried interest, the sponsor may receive distributions in excess of the agreed upon carried interest or distributions that should have otherwise gone to the investors to clear the hurdle and allow investors their preferred return. To address this scenario, the partnership/operating agreement typically provides for a “clawback” provision. A clawback is a payment from the sponsor, net of the sponsor’s liabilities, to the entity for distribution to the investor. The payment can be made on an interim basis or when the last of the investments are liquidated depending on what is negotiated by the parties and provided for in the partnership/operating agreement.
III. Certain Funds Cannot Charge Carried Interest
It is important to note that not all funds are allowed to charge carried interest. Section 205(a)(1) of the Investment Advisers Act of 1940 (“Advisers Act”) forbids a registered investment adviser subject to the Advisers Act from entering into an investment advisory agreement (which could take the form of a partnership/operating agreement) that provides for compensation to the adviser based on capital appreciation of the funds of a client which includes carried interest arrangements. There is an exception under Section 205(b)(4) of the Advisers Act, which provides, in part, that a registered investment adviser can charge carried interest to a fund formed under Section 3(c)(7) of the Investment Company Act of 1940. Additionally, Rule 205-3 of the Advisers Act allows a registered investment adviser to charge carried interest to investors in a fund, provided that the investors meet certain high net worth tests. Lastly, Section 205(a)(1) also does not apply to investment advisers who are not subject to the Advisers Act nor to investment advisory contracts with investors who are not residents of the U.S.
About Klinedinst PC’s Corporate Transactional and Securities Department
Klinedinst PC’s Corporate, Transactional and Securities Department through its Private Funds Group represents clients in the formation of a wide variety of domestic and international private funds, from start-up funds to established high value funds. In addition, we work closely with our clients to provide counseling and advice in general fund matters after the formation stage. The opinions expressed in this newsletter are general in nature, and are not meant to provide specific legal advice. For more information, please contact Christian Fonss or Mariel Estigarribia. No attorney/client privilege is created or assumed by reading this article.