The Waterfall Exercise: B&G II LLC
CPPIB is considering a large commitment to B&G’s new fund, B&G V LLC. This would be CPPIB’s first commitment to a B&G fund. Dudley Dorite, MD at CPPIB, has asked his Associate, Antoine Froid, to assess the performance of B&G’s most recent fully realized fund, the £6.5 billion Fund II, vintage year 2003. Antoine has received the following information from V&W management.
Committed Capital: £6.5 billion, including management fees.
GP commitment: 3%
Investment period: 4 years.
Post Investment Period Fund Life: 6 years.
Management fee during investment period: 1.5% of LP committed capital (GP pays no management fee).
Management fee post investment period: 1% of LP Invested Capital.
Carried Interest: 20% of fund profits after return to LPs of 100% of their capital invested plus management fees paid, subject to an 8% annual compounding hurdle rate (IRR) on capital invested plus management fees paid and 100% catch-up by GP until profit split of 80/20 LP/GP is reached (see priority of distributions below).
Priority of distributions: (1) return of capital invested by LPs and GP, then (2) return of management fees to LPs, then (3) to LPs and GP until hurdle rate is met on the capital they have invested and the fees LPs have paid, then (4) to the GP until the GP has received 20% of the fund profits, and finally (5) 80% to the LPs and GPs pro rata to their capital commitments and 20% to the GP in the form of carried interest.
Arsenal Industries: invested £135 million in 2003 and £75 million in 2005. Realized £50 million through a dividend recap in 2006 and £180 million through a sale of the company in 2008.
Chelsea Brewers: Invested £482 in 2003. Sold the company in 2006 and realized £750 million
Everton Shops: Invested £210 million in 2003. Sold the company in 2008 and realized £580 million.
Liverpool Manufacturing: Invested £750 million in 2004. Wrote-off the investment in its entirety in 2008.
Aston Villa Grocers: Invested £175 in 2004 and realized £650 in 2009 through a sale.
Manchester Markets: Invested £350 in 2004 and £150 in 2005. Realized £3.5 billion in 2009 through a sale.
Newcastle Toys: Invested £432 in 2004 and wrote off the investment in its entirety in 2009.
Tottenham: Invested £130 in 2004 and realized £250 in a sale in 2007.
Sunderland plc: Invested £255 in 2005 and an additional £450 in 2006. Realized £1.31 billion through a sale in 2011.
Stoke Bakeries: Invested £187 in 2005 and wrote-off the investment in its entirety in 2008.
West Ham Cafes: Invested £650 in 2005 and realized £150 through a sale in an IPO in 2007. Sold the remaining stake in 2010 for £400.
QPR plc: Invested £322 in 2005, sold a £300 million stake in 2008 and realized an additional £1.55 billion in 2010.
Swansea Trading: Invested £480 in 2006. Sold the company and realized £1.1 billion in 2011.
Crystal Palace Networks: Invested £225 in 2006 and realized £715 million in a sale in 2012.
Leeds Linoleum Linings: Invested £180 in 2006 and realized £400 million in a sale in 2012.
Dudley has asked Antoine to calculate the IRR for each deal as well as the gross and net IRRs and MoM for this fund and to show how much the GP has collected in fees and carry. Dudley would also like to see annual cumulative management fees as a percentage of committed capital and capital invested. Antoine realizes that this will require him to put together a waterfall analysis for the fund. Since the analysis is due the next day, he will have to make certain simplifying assumptions. After discussing it with Dudley, Antoine has decided to assume that all investments and realizations occurred on the last day of the year, that management fees were collected at the end of each year based on the committed or invested capital at the beginning of the year, and that the reduction in Invested Capital for deals with more than one distribution would occur on a pro rata basis with each distribution.
Committed Capital: the aggregate capital committed by the fund’s LPs and GPs at the formation of the fund.
Investment period: the period in the fund’s life in which B&G is allowed to make investments and draw-down capital from the LPs. Only, follow-on investments for existing portfolio companies can be made outside the investment period.
Post Investment Period Fund Life: the period in the fund’s life in which B&G is expected to harvest its investments. No additional investments can be made except follow-on investments in existing portfolio companies. After this period, the fund must be liquidated unless an extension is granted by the LPs.
Invested Capital: the amount of capital invested by the fund less the cost basis of realizations (distributions and write-offs). Dividend distributions should be assumed not to reduce invested capital for purposes of this calculation. Note: this is different than the term “capital invested” which refers to the capital invested by the relevant parties and remains unchanged despite distributions.
GP commitment: the amount or percentage of Committed Capital committed by the GP.
Fund profits: The excess of aggregate distributions over the capital invested and management fees paid by LPs and the GP.
P r i v a t e E q u i t y
Fu n d
D i s t r i b u t i o n
Wa t e r f a l l
P E F i n a n c e
P r i v a t e
E q u i t y Fu n d
S t r u c t u r e
P E F i n a n c e
Fund Economics- Main Entities
- Full investment discretion
- Responsible for management services
- Determines and reports quarterly fund valuation
- Has fiduciary duty and duty of care to LPs
The investors in the fund are comprised of two entities:
o Limited Partners (vast majority of investors)
o General Partner (entity formed to manage the fund)
General Partner Limited Partner
- No involvement of the daily management of fund
- Limited liability
o Limited to amount committed to fund
- Normally has priority over GP’s in fund
Fund Economics- Main Entities
General Partners must invest their own capital into the funds that they raise
o Expected to put up money to (have “skin in the game”)
o Percentage is variable and market driven.
o The more capital the GP commits the better sign for the LPs
o The GP’s investment is treated as an LP investment with regards to distributions (i.e. if the GP commits 5% of
the capital, it is entitled to 5% of LP distributions)
o However, the GPs commitment is not subject to management fees.
Note: References to LP distributions in this deck include distributions to the LPs and to the GP as an LP
Fund Structure - Main Entities
Private Equity Fund
(LP or LLC)
Pro Rata Net
Carried Interest &
Pro Rata Net
PE Firm Management
Fu n d L i f e
P E F i n a n c e
Fund Life Overview
Fund-Raising Period Drawdown(Investment Period) Post Investment Period Extension
Capital is called from
investors over a time as
investments are made
Distributions: Cash Flows back to
Only occurs with
vote of approval
6-24 months 4-6 years 4-6 years
The period the launch of
the fundraising and final
closing of investor
The GP has the discretion to
draw-down capital and make
The GP may draw-down capital to
invest in existing portfolio companies
but cannot make new investments
GP can request extra
time to exit the final
Note: There are often several closings, but the fund may begin operating after the first closing
R E A L I Z A T I O N S , R E T U R N S & E X I T S
Fund Life: Drawdowns During Investment
The capital that is committed by limited partners to a private equity fund, “Committed Capital”, is not invested
immediately but rather drawn-down and invested over time as investments are identified.
Funds are drawn-down on a “just in time basis” because otherwise this capital would be idle and reduce IRRs
Vintage Year: The first year that the private equity fund draws down or calls committed
Capital Call: The legal right of the fund to demand a portion of the money committed to it
by an investor.
Investors are free to do whatever they want with the committed
capital until they receive a draw-down notice (aka “capital call”),
after which they must send-in a prorated share of the investment,
normally within a 2-week period
GP identifies an
Fund Life: Drawdowns during Investment
What happens to the uninvested committed capital?
Any committed capital that is undrawn by the end of the investment period is released (i.e., capital is never drawn).
o LPs are no longer subject to capital calls on uninvested, committed capital.
o Undrawn committed capital has no impact on IRR.
Fund Life: Post Investment Period
Once the investment period has expired, the fund will be no longer make investments (except follow-on investments) and
will focus on creating value in its portfolio companies and on exiting its investments.
o The fund is a self-liquidating entity: it makes investments and eventually exits them and returns the proceeds to its
investors via distributions
o Some funds have recycling provision that allow them to re-invest distribution proceeds that were generated
(normally) within 18 months of the underlying investment or throughout the investment period generally.
Fund Life: Post Investment Period
Note: If the fund managers don't expect to recover any value from a particular investment, it must be ‘written-off’. Write-off’s have
o Proceeds are distributed to LPs and GPs as determined by the limited partnership agreement (“LPA”), the main
governing document in PE fund.
o By the end of the fund life, the GP must have divested all the deals and returned all proceeds to its investors.
o If the fund requires a timeline extension, they must request it from its LPs
o This is a better alternative than having a “fire sale” based on timing
Fu n d Fe e s
P E F i n a n c e
Fund Fees: Investment Period
The GP is paid for services it provides to the fund
o Management fee
o Used to pay operating expenses of PE fund/firm
o Tends to be circa 1% for large funds and 2% for smaller funds
o During the Investment Period, it is paid as a function of Committed Capital at the start of the fund
o Remains constant throughout the Investment Period.
o Carried Interest
o Success fee (20% of realized fund profit)
o Realized Fund Profits = Cumulative distributions – cumulative management fees – cumulative capital
o M&A fee (for closing a deal)
o Monitoring fee
o Exit fee
Charged to the portfolio companies but eventually returned
to LP via a reduction in the management fee.
Fund Fees: Post Investment Period
o At the expiration of the Investment Period, management fees step down to about .5%-1% and normally become a
function of Invested Capital rather than Committed Capital
o Invested Capital = cost basis of capital contributions
o Invested Capital is reduced by the cost basis of every distribution and write-off
o Every share that is sold has a cost basis attached to it.
o Dividend and interest distributions do not affect Invested Capital because no shares, and therefore no
cost basis, is being sold.
o If an investment is written-off, its cost basis is removed from Invested capital
o Invested Capital should equal zero at the end of the fund-life.
o Therefore, management fees will decline throughout the post-investment period as investments are exited
Management Fee Over the Fund Life
Post Investment Period
Note: Once the fund is past the investment period, the GP’s attention is divided between the current fund and its successor fund and the
management fees from the successor fund will likely make-up for the fee reduction in the current fund.
Note: The step-down is a vertical line
because when the fund flips from the
Investment Period to the Post Investment
Period, the fee % declines AND the basis
flips from Committed Capital to the
(probably) lower Invested Capital
Fee = 0
PE Fund Returns
PE fund returns are shown on a gross and net basis
o Gross returns = returns generated by the fund before deductions for management fees, carried interest, and
o Gross multiple of money (“MoM” or “MoIC”) = (cumulative fund distributions + NAV of remaining
portfolio)/ (cumulative capital contributions)
o Gross IRR = portfolio or fund level IRR = IRR implicit in cash flows above.
PE Fund Returns (Continued)
o Net returns = returns generated to LPs, i.e., gross returns minus management fees, carried interest and fund
o Net MoM or MoIC = (cumulative fund distributions to LP + NAV of remaining portfolio adjusted for carry
payable on NAV)/(capital contributions by LPs)
o Net IRR = IRR to LPs (based on net cash flows above)
o LPs assess fund performance based on net IRR/MoM
o A large gap between gross and net returns signifies large fees collected by GPs
Fund Life: Illustration
Manager “calls” call from
Investments are realized, cash is
returned to investors
The J Curve
Note: In the early stages of a fund life, the management fees may exceed the portfolio value write-ups, putting the fund in
a net loss position. As such, net returns tend to be negative at the very beginning of the fund life.
D i s t r i b u t i o n
Wa t e r f a l l s
P E F i n a n c e
Distribution Waterfall Overview
Once the fund sells a company, what does it do with the proceeds it collects?
o Distribution waterfalls determine the split of each distribution between LPs and the GP.
o The specific terms of the distribution waterfall are documented in the fund’s LPA.
o Waterfall provisions broadly fall into one of two categories: so-called American or European
American Versus European Waterfalls
GPs of the fund may not collect carried interest
until the limited partners have received all
their capital contributions, including
management fees, plus a pre-determined rate
of return (the “Preferred Rate” or “Hurdle
GP’s may collect carried interest from profits
generated by individual investments as these
are exited. The fund need not have returned
the LPs aggregate fund capital contributions
before such carry distributions are made.
GP favorable LP favorable
American Waterfall: Issues
o Carried interest is distributed to the GP on profitable investments regardless of losses that may be incurred on
o This creates the risk of excessive carry payments: i.e., carry payments might ultimately exceed 20% of fund profits
if positive returns from early distributions are subsequently eroded by poor deals.
American Waterfall: Risk of Excess ive Carry
Payments to GP
Example: A fund exits its first deal at a profit but exits its second deal at a loss. By paying carried interest on a deal-by-
deal basis, GP payout might ultimately exceed the 20% of total fund profit.
There are two mechanisms used to mitigate this risk:
o A portion of the carry distribution is placed into an ESCROW account as a reserve for potential future losses
o After the end of the fund life, excessive carry payments can be clawed-back by the GP and returned to the LPs
o It can be difficult to collect claw-backs.
European Waterfall Overview
Note: Hurdle rates are generally 8% because this was the risk-free rate at the time they were introduced. LPs demanded at minimum the
risk-free rate of return before GPs could collect carried interest. The hurdle rate has mostly remained at 8% despite significant reductions in
the risk-free rate.
o GP does not receive carried interest until all the LPs capital contributions including management fees are returned
and the LPs earn a realized net IRR equal to the hurdle rate
o Management fees are repaid to the LPs through portfolio exits distributions. Therefore, management fees
function as non-recourse advances on the carried interest.
European Waterfall Steps
STEP 1: Return of LP Contributed Capital
Distribution of 100% of exit proceeds to LP’s until each of them has received 100% of its aggregate contributed capital for
investments, management fees, and fund expenses
Step 2: Hurdle Rate
Distribution of 100% of exit proceeds to LPs until a they have earned an 8% realized (hurdle rate) IRR. During this phase,
the fund has generated a profit and therefore owes carried interest to the GP.
Step 3: GP Catch Up
Distribution of 100% of exit proceeds to the GP until it receives carried interest equal to 20% of accumulated fund profits (i.e.
the owed but unpaid carry from Step 2)
Step 4: 80/20 Split
Distribution of remaining exit proceeds in the ratio of 80% to the fund’s LP’s and 20% to the GP. As a result, at the end of the
fund life, carried interest will equal 20% of realized fund profit provided the net IRR exceeds the hurdle rate.
European Waterfall: Hurdle Rate
o Realized IRR to LPs (net IRR) the must exceed the hurdle rate before the GP can be paid carried interest
o Each time there is a distribution, the net realized IRR is calculated to assess whether hurdle rate has been
o Only when that net IRR crosses the hurdle rate can the fund pay carry to the GP, initially as a catch-up payment
o Net IRR calculation is based on the amount and timing of capital contributions made and distributions
received by the LPs
Note: Carried interest is calculated based on capital invested, not committed, so it is possible for the fund to temporarily exceed the 8%
hurdle rate and subsequently fall below it if all the committed capital is not yet invested
8% Rate of
Distribution To LP Before Catch Up Distribution To GP to Catch Up
(Carry paid to
European Waterfall: Catchup Period
Note: The GPs will continue collecting management fees after the catch-up has been achieve and will continue to return such management fees to
the LPs with every subsequent distribution.
The catch-up clause is designed to compensate the General Partner on a fund’s total realized profit, not just the profits in excess of the
hurdle rate. Once the hurdle rate has been achieved, the General Partner receives 100% of fund distributions until it has “caught up” to
20% of realized fund profits.
European Waterfall LP Payoff Curve
0 1 2 3 4 5 6 7 8 9 10
Capital Distributed By the Fund
Catch Up Period.
Distributions to LPs
= 0. (Slope = 0)