Distribution

Now comes the time when the invested amount is sold off and money is to be returned to the investors (LP's). The most common method used for that is the waterfall model. A waterfall is the priority in which money is returned on an investment. The most basic version of waterfall model for distribution of capital back to the investors is as follows:

Invested Capital to LP

|

PR (interest on the capital) to LP

|

Catch up to GP

|

Profits (Carry)

|

---------------------

|                               |

80% to LP              20% to GP

Hence the GP generates any of profits only if the value of capital is more than the invested amount and preferred return (sometimes also referred to as hurdle rate or interest) which is first returned to the investor (LP).

An example of a very simple waterfall would be:

- LP's receive all distributions until they have been returned their capital (GP also gets capital returned for its contribution, but no carry at this point)

- LP's receive 80% of distributions and GPs receive 20% of remaining distributions,

Often fund will offer LP's a guaranteed return before they take their carry, though they get a catchup after the guaranteed return. So this is a common waterfall:

- LP's receive all their capital.

- LP's receive distributions until the return they have is 10% of contributed capital. (this is known as the hurdle or PR)

- GP receives 100% of distributions until the GP has received an amount equal to 20% of 2 (this is known as the catch up).

- LP's receive 80% of distributions and GP receives 20% of distributions

If a privat equity fund is like a venture capital fund or a buy out fund, then over many many small plays they make 8 to 10 large plays. Then the question is whether capital is returned on a case by case basis or on an overall basis. Some private equity funds ask for multiple hurdles (i.e., it won't collect anything until you get 10% but after you get more than 20% on your money it wants more than 20% carry).

The PPM (Private Placement Memorandum) should outline the waterfall and the LP agreement section on distributions should cover the waterfall

Complexities in Distribution

Distribution appears simple in the waterfall model shown in the above post. But it is not always so simple and straight forward, especially when its a retail private equity fund, i.e. a private equity fund with retail investors. With retail investors investing in the fund, the minimum amount that is committed by each investor is less and the number of investors are many. Handing data of so many investors becomes a problem because every information of their late fees, contribution dates, PR to be paid to them based on the date they deposited, etc etc. come into picture.

If the investor had contributed for a draw down later than the due date for that draw down, the interest on his contribution will start accruing from the date that he contributed. So the interest for this one single investor will be different as compared to all other investors. With funds over 200 investors, this becomes a tedious task. Various softwares, websites or huge excel files with numerous sheets are used to capture such data and calculate the distribution amount based on these combinations.

Also for various contributions, the date from when the interest or PR amount will be calculated will be different. So for every investor, interest will be calculated on various contributions for different amounts and different periods. Let us make it simpler with the help of an example.
We will understand this with the help of just one investor

Mr. A commits 200 in fund XYZ.
For the 1st draw down for 30% he contributes 60 on 01 Jan 2011.
For the 2nd draw down that was for 20% he contributes 40 on 01 April 2011.
For the 3rd draw down that was for 40% he contributed 80 on 01 July 2011.

The value of his invested capital (180) became 300 and was all realized on 01 Jan 2013.

If the PR is at 10%, it will be calculated as follows.
PR = 10% of 60 for 2 years + 10% of 40 for 1 year and 9 months and 10% of 80 for 1 and a half year.

It also depends if the cumulative quarterly, half yearly or annually, on how the PR will be calculated.

This was just the PR calculation for one investor. Imagine the calculation of PR for the whole fund. And this is just the second stage of the distribution waterfall.

It also depends on how the funds are invested and are meant to be distributed, for example the funds from 2 draw downs can be invested into 2 different portfolio companies or the 2nd draw down can be a follow up investment into the same portfolio company where the first draw down money was invested.  There are also costs associated in it which are over the invested amount and are taken out from the contributed capital. It also depends on the type of distribution, whether it is a case by case (also known as deal by deal) distribution or non deal by deal distribution. We will understand the details of these two types of distributions in detail in further blogs.

Disbursement or Investment in a Portfolio Company

Now that the money is drawn down from the LP's, the fund will invest in the company. As per our numbers, the fund had to invest 15 in a portfolio company. Investment in a company is also referred to as disbursement.

There might be some deal and indirect expenses that might have happened.

Deal expenses are those that can be directly associated against a deal, and indirect expenses are those that cannot be associated against a deal.

For Example: If there has been some due diligence activity for the company to be invested in, or travelling expenses as a part of finalizing the deal, those charges can be associated directly against the deal. These are classified as deal expenses and these are allocated to LP's in a ratio in which they are participating in the deal.

Expenses like electricity bill of the AMC, salaries of employees of AMC, cannot be allocated against a single deal. These must be spread across all the deals and must be allocated to all deals in their invested amount proportion. Such expenses are hence referred to as indirect Expenses.

Drawn Down Money:	20
Investment Amount:	15
Management Fees:	2
Deal Expenses:	1
Indirect Expenses:	1
Cash Balance:	1

Let us see how all these expenses and investments are allocated to each LP.

Management Fees and Classes of LP's

Management Fee's is charged by the AMC to the LP's (investors) as a fees for managing their fund.

There can be different ways in which the management fees is charged. To understand that, let us first understand the commitment period and post commitment period of the fund life cycle.

The fund life cycle is divided into commitment period and post commitment period.

In most cases, Commitment period is defined as the time before which the AMC is allowed to drawdown money from LP's and invest them. After the post commitment period, no money can be drawn down from LP's and no further investments (disbursements) can be made into any portfolio company. Based on the contribution agreement, small modifications in the handling of these definitions are seen in the case of some funds.

In most common scenarios, AMC charges some percentage of management fees on Capital Commitment during the investment period and later on Capital Contributed or Remaining Invested Capital.
Remaining Invested Capital can have all or few components out of the following-->

• Invested amounts to portfolio companies
• Deal Expenses incurred towards portfolio companies
• Indirect fund expenses incurred
• Management fees charged to the fund
• Cash balance if any

Now let us understand with the same set of numbers, how management fees can be charges in commitment as well as post commitment period. Let us assume that the management fees charged is 2% of to total capital commitment during Commitment Period.

Management Fees (2%) charged during Commitment Period on total Capital Commitment

	CC	Management Fees (2%)
LP 1	10	0.2
LP 2	20	0.4
LP 3	30	0.6
LP 4	25	0.5
LP 5	15	0.3
	100

This is the annual management fees taken from each LP. In most cases, the AMC charges management fees on a quarterly basis in advance, at the start of every quarter.

An overview of the complete life cycle of a fund

The Asset Management Company (AMC) finalizes the Contribution agreement and PPM which will have all the clauses and defined terms which are to be followed throughout the life of the fund for carrying our various operations.

Investors or Limited Partners (LP's) would commit to invest in one or more of the funds floated by the AMC.

By committing towards the fund means that they have promised to pay a defined sum of amount towards that fund, which they might not have paid upfront. The AMC company has the right to ask for that amount in parts by sending out draw down (or capital call) notices to investors till the total committed amount has been drawn down.

For a fund, there will be many Investors (LP's - Limited Partners). In case of a fund with Institutional Investors, there are generally 10-20 investors contributing towards the total fund size while in case of Retail Investors, there have been cases with more than 2000 investors investing in the same fund.

From hereon, let us understand these terms with the help of numbers.

Suppose a private equity company XYZ plans to start a fund with a fund size of 100.

5 LP's commit 10, 20, 30, 25, 15 for that fund.

So their capital commitment ratio will be calculated based on the amounts.

	CC	CC Ratio
LP 1	10	10%
LP 2	20	20%
LP 3	30	30%
LP 4	25	25%
LP 5	15	15%
	100

In most cases, all drawdowns, investments, expenses and incomes arising are allocated against each LP on the basis of their capital commitment ratio.

To understand that better, Assume that the fund find a very good investment opportunity. It plans to invest 15 into a portfolio company. It decides to ask for 20% of the capital commitment amount (or 20 in amount) from all investors considering the extra expenses that might be incurred by the fund and some extra cash balance for meeting regular expenses like management fees, etc.

In that case the amounts drawn down from each LP will be calculated as follows:

	CC	CC Ratio	Drawdown / Capital Call	Drawdown for LP's
LP 1	10	10%	20 % of 100 = 20	20% * 10 = 2
LP 2	20	20%		20% * 20 = 4
LP 3	30	30%		20% * 30 = 6
LP 4	25	25%		20% * 25 = 5
LP 5	15	15%		20% * 15 = 3
	100			20