Playing catch-up

On the face of it, waterfall provisions look extremely investor-friendly. After all, by specifying that LPs must get all their capital back plus a preferred return (typically of about 8 percent) before the GP can start collecting carry, they ensure that the GP can’t start cashing in until their LPs have already been well rewarded for their commitment to the fund.

But there’s a snag, according to a new study by secondaries adviser Landmark Partners – and it’s all to do with the ‘catch-up’ period that normally happens after the GP has crossed that 8 percent hurdle. During this time, the GP will typically receive 100 percent of distributions from the fund until such time as they have 20 percent of the fund’s profits to date; after this, distributions are split 80–20 between LP and GP (assuming a standard carried interest rate of 20 percent). 

During this period, the GP’s return goes up very steeply: in the model scenario constructed by Landmark, it jumps from 1.4x to more than 8x when the gross IRR increases from 10 percent to 13 percent, whereas the LP’s return profile barely changes. The GP also loses out to a much greater extent (relatively speaking) if the fund holds onto its investments too long and ends up making less money than expected. 

In other words, according to Landmark, the GP is heavily incentivised to bring exits forward and lock in returns during this period – even though LPs might end up with a better overall return if they hang onto the assets for longer.

“As firms get into the 8 to 9 percent IRR phases, there’s a tremendous impetus to get money out – although if they decide to realise assets then, the overall upside won’t be as much,” explains Landmark’s Barry Griffiths, who co-authored the paper. “So there’s a tension between what the franchise wants – which is a high teens IRR – and what individual partners want, which is to get their personal investment back.” This is particularly evident at the moment, he suggests, because individuals are nervous about the economic climate.

This clearly has consequences for the secondaries market, as his co-author David Robinson points out. “A secondaries investor ideally wants to buy in when the GP is about to hit that 8 percent return. At that point, the GP is incentivised to bring realisations forward. Equally, it makes sense to buy in just as the GP is getting to the end of the catch-up phase because thereafter, as an LP you’ll be getting around 80 percent of any distributions.”

Landmark has some interesting data to support its argument: according to its research, total distributions to LPs are almost three times as high in the period after the threshold as in the period before the threshold.

But although this sounds plausible enough, some caveats remain. For one thing, there’s a great deal of variation in the way GPs set up their waterfall arrangements. What’s more, there’s no definitive evidence that selling assets ‘early’ like this necessarily damages returns; in fact, Landmark says that all of the funds in its study delivered returns of about 20 percent in excess of those from public markets over a similar period. Further study may yet show that although there’s a potential conflict here, the practical consequences are relatively minor.