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
What does it mean by 20% of 2?
ReplyDeleteIn the line "GP receives 100% of Distributions until the GP has received..."
This is with reference to the examples mentioned in prior posts where the carry comes out to be 2. Hence the reference to 20% of 2.
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