Distribution Waterfalls: Three Nuances | Vinson & Elkins LLP

Distribution waterfalls are ubiquitous within the non-public funding world. They decide participation in money flows or earnings that’s not in proportion to invested capital akin to the motivation aspect (aka “promote” or “carry”) of fairness preparations. Whereas the fundamental idea stays the identical throughout funding funds and portfolio corporations, the implementation and particulars regularly fluctuate broadly. The ensuing complexity might merely mirror the underlying enterprise understanding, however typically additionally completely different drafting approaches. This Perception explores the nuances of three drafting options with respect to the return of capital and the precedence return within the context of a distribution waterfall of a portfolio firm structured as a restricted legal responsibility firm (“LLC”). These nuances have the potential to shift economics between investor and administration.

In its easiest kind, a distribution waterfall appears like this:

Tier 1: Return of Invested Capital
Tier 2: Precedence Return on Invested Capital
Tier 3: Cut up between Invested Capital and Incentive Fairness

The time period precedence return is right here used broadly – completely different strategies of expressing it are addressed beneath.

For functions of the next illustrations, assume that the investor holds its capital curiosity within the type of Class A Models (and is thus a Class A Member) and administration holds its revenue pursuits (incentive fairness) within the type of Class B Models (and is thus a Class B Member).

1. Return of Capital

Take into account the next variations of the primary tier of the waterfall:

Assume that two Class A Models have been issued at completely different occasions to 2 separate members, initially one Class A Unit at $100 to Member 1 and subsequently one other Class A Unit at $200 to Member 2 to mirror a rise within the portfolio firm’s valuation. What are the quantities that have to be distributed to pay the primary tier in full?

In impact, the primary tier of Model 2 returns greater than invested capital, as a result of it distributes proceeds at that tier professional rata to all Class A Models till the Class A Unit with the best value has acquired its invested capital. Model 1 distributes proceeds to the members in accordance with their unreturned capital quite than the variety of Class A Models held by them, such that combination distributions within the first tier is not going to exceed invested capital. Model 3 prorates proceeds in accordance with Class A Models (like Model 2), however then distributes them to every Class A Unit solely as long as it has unreturned capital. Proceeds are initially distributed to Member 1 and Member 2 equally as a result of every investor holds one Class A Unit, however as soon as Member 1 receives $100 (at which level it not holds a Class A Unit “with Unreturned Capital”), all subsequent proceeds will go to Member 2 till the unreturned capital of Member 2 is decreased to zero. Model 3 seems at first to be similar to Model 1, nevertheless it differs within the tempo of distributions, which issues in a draw back situation, as we’ll illustrate beneath.

Whereas Model 2, which may return greater than invested capital, might seem unfair at first, there are different situations the place the result’s extra intuitive. Assume {that a} Class A Unit is issued at $200, and subsequently the issuer incurs leverage and distributes $100 to the Class A Unit, lowering its unreturned capital to $100. Then one other Class A Unit is issued at $200. At that time, a complete of $400 have to be distributed to pay the primary tier in full, regardless of the $100 beforehand distributed. However this could be precisely the end in a customary company capital construction, which requires that every share of the identical class receives the identical value per share in a liquidity occasion.

Assume the identical info as above, however now take into account what quantities every investor will obtain within the first tier in a draw back, break even and upside situation.

The desk above illustrates that the tempo (or price) at which capital is returned to the 2 traders within the first tier might affect their returns in numerous exit situations. In Model 1, capital is returned based mostly on unreturned capital contributions, such that each greenback is cut up 1/3 to Member 1 and a couple of/3 to Member 2. In Model 2 and Model 3, capital is returned based mostly on Class A Models held, such that each greenback is cut up 50/50 between Member 1 and Member 2. In a draw back situation in Model 1, the 2 Members obtain completely different quantities though they maintain the identical variety of Class A Models. The completely different return quantities between Model 2 and Model 3 within the break-even and upside situations are, as indicated above, as a consequence of Model 3 stopping distributions to the Class A Unit held by Member 1 as soon as the capital contributed for this Class A Unit has been returned.

2. Order of Return of Capital and Precedence Return

Take into account the next variations of the order of the primary two tiers of the waterfall:

Assume {that a} Class A Unit was issued at $100 with an 8% most well-liked return, compounding yearly. After six months, $100 will get distributed, and after one 12 months, one other $20. The distribution for every tier is as follows:

What is going on right here? Compounding accrues most well-liked return on beforehand accrued most well-liked return (in debt phrases: accrues curiosity on beforehand accrued curiosity) and, thus, in impact provides accrued most well-liked return to invested capital (accrued curiosity to principal). Nevertheless, it does so solely on the compounding date, whereas the underlying invested capital (principal) accrues most well-liked return (curiosity) constantly.

In Model 1, after the primary distribution, the invested capital has been returned in full, so it not accrues most well-liked return, whereas the unpaid most well-liked return is just not but compounding. In Model 2, after the primary distribution, the popular return has been paid in full, whereas the invested capital has not been returned and continues to accrue most well-liked return each day.

Does that imply traders ought to favor Model 2? Not essentially. The variations, if any, are sometimes marginal, will be minimized by using shorter compounding intervals, and are irrelevant if there is just one, last distribution. Distribution waterfalls that return invested capital on the first tier have the benefit of readability and keep away from confusion if the waterfall has extra advanced or a number of precedence return and carry tiers.

3. Most popular Return v. IRR

The precedence return will be expressed as a most well-liked return on unreturned capital, calculated like curiosity on excellent principal, or as an inside price return (“IRR”) threshold.

IRR thresholds in distribution waterfalls sometimes use the next definition for the IRR itself:

“IRR means the low cost price, expressed as an annual proportion, at which the online current worth of all capital contributions made by any Class A Member equals the online current worth of all distributions made to such Class A Member, calculating by utilizing the X-IRR perform of Microsoft Excel.”

The IRR calculation captures all money flows, i.e., all capital contributions and all distributions (no matter whether or not they represent a return of or a return on capital), and so far as the system itself is anxious, a separate tier for the return of capital is just not obligatory. Thus, a waterfall together with an IRR threshold can take certainly one of two primary kinds:

In opposition to this background, take into account these variations:

The definition of IRR quoted above, which has develop into standard in authorized paperwork that use an IRR threshold, defines IRR by reference to the X-IRR perform of Excel. The X-IRR perform has a singular compounding function that’s inflexible and can’t be modified. The X-IRR perform makes use of each day compounding to reach at an efficient annual price of return. Over the course of a 12-month interval, it slopes upwards, whereas a most well-liked return accrues in equal increments alongside a straight line. If the popular return makes use of annual compounding, the outcome is identical on every anniversary, however differs inside every annual interval. Let’s examine a $100 funding with an 8% most well-liked return, compounded yearly, with the identical funding with an 8% IRR. After one 12 months, return of capital plus precedence return equals $108 in every case. At six months, nonetheless, a return of capital plus a most well-liked return equals $104 whereas a return of capital plus an IRR threshold equals $103.90.

Extra considerably, the IRR calculation, whether or not based mostly on the X-IRR perform or a distinct IRR system, may end up in unintended overpayments to administration if extra capital is contributed after a distribution by the portfolio firm. The underlying motive is that the IRR calculation captures all money flows going again to the unique funding and doesn’t reset the clock for later contributions, whereas in the popular return calculation each new contribution has to earn its personal return, identical to curiosity on borrowings below a revolving credit score facility.

Assume an investor makes a dedication to a improvement firm. The investor contributes capital to Venture I, which will get bought after completion a 12 months later. The investor then contributes capital to Venture II, which additionally will get bought after completion a 12 months later. Money flows are:

The waterfall options are:

The next desk exhibits the distributions below every waterfall model:

What is going on right here? The essential facet is that even after the second capital contribution of $25 million, the IRR stays above 10%, so the clock doesn’t reset because of the second capital contribution. In Model 2, which applies the IRR threshold after the return of capital, the IRR desire was beforehand happy by the primary distribution, so the acquire remaining after the return of capital goes on to the carry cut up. Extra dramatically, in Model 3, which solely makes use of an IRR threshold, your entire distribution goes on to the carry cut up.

Traders ought to concentrate on the distinction between most well-liked return and IRR calculations, significantly for portfolio corporations that will name capital after exits of initiatives or belongings. As well as, attorneys drafting waterfalls mustn’t method most well-liked return and IRR thresholds as interchangeable.

Conclusion

Distribution waterfalls can mirror numerous enterprise understandings and drafting approaches. What they need to not do is trigger any person who applies the waterfall to cite HAL from 2001: A House Odyssey: “It might solely be attributable to human error.”