Understanding Prefs, Clawbacks, and Waterfalls

Topic: ADVANCED KNOWLEDGE, RETURNS • By: Michael Lewis • 12-20-2018

Equity multiple and IRR describe the forecasted returns. The waterfall describes the order of those distributions. Stated simply: the waterfall describes how everybody gets paid. Every investment has a defined waterfall structure; and it’s important to understand how it works.  It’s less risky to be paid first, and more risky to be paid last because there might not be any money left to distribute if a deal underperforms.

Investment waterfalls are described in great detail in the private placement memorandum (“PPM”) which accompanies each investment opportunity. An investor should pay particular attention to the “distributions” section of these offering materials.

In most waterfalls, the sponsor receives a disproportionate amount of the total profits relative to their co-investment. For example, a sponsor who contributes 5% of the capital investment may be entitled to a range of 10% to 40% of the profits depending on the performance of the investment.

These payments in excess of the amount of capital contributed by the sponsor are called the sponsor’s carry, carried interest, or performance fee.

These are different terms which describe the same thing. We use the term “performance fee” because it most accurately describes the nature of the fee in the context of the various costs and fees a sponsor earns.

The performance fee is earned by the sponsor subject to upstream distributions and based on the profitability of the investment. Some fees may be earned for acquiring, managing, and selling assets; but the majority of the sponsor’s profit is earned at the back-end of a deal based on performance. Experienced sponsors structure investment opportunities which (a) ideally align sponsor incentives with investor returns; and (b) offer competitive risk-adjusted returns.

Generally, there are two waterfall models: the European model and the American model.  The difference is the the return priority of the investor’s capital.

In the European model, the sponsor does not receive any performance fee until all the investors’ capital has been returned. In the American model, repayment of all investor capital is not a separate hurdle which must be overcome before performance fees may be earned. Rather, distributions are allocated among investor and sponsor based on specific profitability hurdles.

Before I explain the upside and drawback each approach, it may be helpful to explain preferred returns, or prefs because preferred returns are the most common way that waterfalls shift risk away from investors.

A preferred return is typically stated as an annual percentage return paid to investors at the top of the distribution waterfall.  Preferred returns generally range from 8% to 10% annually; and a sponsor can also offer a preferred return over the life of the investment.

Think of the preferred return as an interest rate on the invested capital that is paid to investors before a sponsor receives any performance fee.

An “8% pref” means that a $50,000 investment will receive $4,000 per year (an 8% return) before any other distribution (besides capital repayment) is made. Investors get paid first from the distributions of the business.

It is also important to consider that annual preferred returns are not guaranteed; and, in some cases, the sponsor does not forecast that each investor will receive an 8% return every year. What happens when the investor is entitled to an annual preferred return, but there are not sufficient distributions to meet the return rate? It carries over. The amount carried over can be compounded or non-compounded.

What is the purpose of a preferred return?

Like all aspects of the waterfall, it allocates risk.

A preferred return to investors allocates risk of underperformance to sponsors; and oftentimes that risk is balanced by higher performance fees for the sponsor further down the waterfall.

Returning to the differences between the European and American waterfall models, it is important to note that neither is “better” for investors or sponsors. They are simply different ways of allocating risk.

With the European model, investors receive all their capital plus any preferred return before the sponsor receives any performance fee. This lowers the investor’s risk but may misalign investor/sponsor interests and lower upside investor returns. A sponsor may be expected to work six to eight years before getting paid in a pure “European model” waterfall structure. Because the sponsor is largely unpaid until the asset it sold, this can make sale of the asset disproportionately advantageous to the sponsor. In addition, the allocation of greater risk to the sponsor is often counterbalanced with greater upside performance fees for the sponsor. Total investor returns may be lower if the investment is very successful.

The American model, by contrast, allows greater flexibility but also requires that a sponsor appropriately allocate risk. The interests of the sponsor and investors may be more closely aligned because of the greater flexibility. For example, an waterfall may allocate investors a preferred return of 8%, then 80% of distributions up to an IRR of 16%, 75% of distributions up to an IRR of 24%, and 65% of distributions above an IRR of 24%. The sponsor’s incentive is to maximize investor returns. If the investment is paying investors an IRR above 24%, a large performance fee is probably warranted. The downside to the American waterfall model is: what happens when an asset underperforms?  What if the asset makes its preferred return, but fails to return investor capital upon resale?

This is where a clawback clause ​becomes important.

A clawback means that a sponsor has to pay back any performance fee received if the investors would take a loss on the investment but-for his return of the distributions.

Obviously, a clawback shifts risk of underperformance back to the sponsor.

First, risk can be effectively mitigated in a variety of ways; and an experienced sponsor who invests alongside investors is unlikely to underwrite and enter particularly risky deals. Work with people you trust.

Second, if the sponsor takes no performance fee until all investor capital is repaid, plus a preferred return, expect that the sponsor will receive a larger performance fee if the investment meets target returns or over-performs. The general rule, less risky investments offer lower returns, is true here. The difference, however, is that many real estate investments are neither speculative nor particularly risky. Is a low-low-risk investment better than a low-risk investment? Maybe not if the returns are far less.

Third, beware fund managers or offering sponsors who disparage a particular waterfall model. It is too simplistic to say “that opportunity forecasts an 18% IRR compared to our 10% IRR, but you do not want it because they use the American (or European) waterfall model.” It is important to consider where capital is returned in the waterfall; but remember that the defining line between European/American is “all investor capital returned before first dollar distributed to the sponsor.” Does a sponsor receiving a relatively-small performance fee when an asset performs well shift unwarranted risk to the investors? Probably not. The distinction should be understood because it is commonly used to describe opportunities, but it should never be determinative.

The key to successful investing is making sure that everyone’s interests are aligned from start to finish; which means a waterfall structure that correctly allocates risk and reward between investors and the sponsoring private equity firm.