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This episode aired on BloombergTV on Apr 9, 2012


Waterfall is a term related to PE and VC fee structures and specifically describe the timing of payouts to investors and managers. Ther are two types of waterfalls, European and American, with slight differences between them. European waterfalls pay investors all of their invested capita plus a preffered return before the manager can be paid. American waterfalls pay investors and managers proportionately on a deal by deal basis, as the fund exits its investments.

Q. So this term relates to fees that investors pay in various kinds of private equity funds, right?

A. Yes, classic PE, VC, distressed, lots of kinds of funds that are holding illiquid assets. Usually, managers get 20% of the upside… but the question is: how do the profits “flow” for purposes of making this calculation.

Q. OK, so how do they flow? How does the “waterfall” work?

A. Remember that these kinds of funds makes a series of investments at different times, and then dispose of them at different times. So, the question, again, is how and when does the manager start getting his fee? In a “European” waterfall, the investor gets all their invested capital back, plus a preferred return on all that capital, before the manager takes his fee.

Q. Well, that sounds pretty fair to the investors. What other models are out there?

A. The “American” waterfall. In that system, you look at the dollars back to the investors on a per-investment basis. To compare the two, say a fund has invested in 10 items at $10mm each, $100mm total. It then sells the first one for $15mm. In the European waterfall, we’re not talking about any fees being paid to the manager yet, because the $100mm hasn’t been returned. In an American waterfall, however, there’s $5mm of profit on that first deal, and the manager will collect a fee.

Q. Interesting. But you also said that in both systems there is a preferred return paid to the investors before the manager gets his 20% of profits?

A. Right. Say there’s an 8% preferred return and the disposition occurred a year after the investment. Then, of the $15mm, the American investors would get back: the $10mm invested; an 8% return on that, or $800k. Now, there another 4.2mm of profit on which the manager gets 20%, or 840k.

Q. But… what if the other investments don’t do so well? What if they lose money?

A. That’s why the European system is cleaner, of course; that issue never comes up. In the American waterfall, you have to devise complex “clawback” provisions so the manager has to give back the early profits if the later deals don’t do as well.