Some of you may remember the warning from R&B trio TLC about not chasing waterfalls. As the chorus to their song went: “Don’t go chasing waterfalls, please stick to the rivers / And the lakes that you’re used to.”
It’s unlikely that any PERE readers heeded the advice of Tionne ‘T-Boz’ Watkins’, Rozonda ‘Chilli’ Thomas and the late Lisa ‘Left Eye’ Lopes because, frankly, it made absolutely no sense. Until now.
With waterfall provisions in private equity real estate funds specifying that investors must get all their capital back plus a preferred return before the fund manager can start collecting carried interest, such provisions are often very attractive to LPs. After all, they ensure that a GP can’t cash in until its LPs already have been well rewarded for their commitment to a fund. There are, however, challenges to this approach.
A new study released by Connecticut-based secondaries firm Landmark Partners examines the difficulties GPs face when it comes to finding the best time to pay out investors from a commingled fund. “There’s a tension as to when is the best time to distribute,” explains Barry Griffiths, head of quantitative research in Landmark’s alternative investment group and co-author of the study. “There are different factors that play out as to figure out when’s the best time.”
When a GP wants to exit a property or other type of real estate investment made on behalf of a pooled fund, the paper asserts that it “needs to balance several factors.” For instance, if the GP “exits too early before much value has been added, neither the GP nor the LPs will receive much profit for their investment.”
Conversely, if the fund manager waits too long in the hopes of gaining the most profit possible, there’s an increasing chance that some bad event – be it within the company or worldwide – will cause the remaining investments to lose value. “This is something you need to understand if you’re managing your commitments,” adds Griffiths.
The challenges, however, may go a little deeper than mere timing. James Taylor, editor of sister publication Private Equity International, noticed a snag in this practice of deploying waterfall provisions, which is connected to the ‘catch-up’ period that normally happens after a GP has crossed the preferred return hurdle.
During this time, a GP typically will receive 100 percent of the distributions from a fund until such time as it has earned 20 percent of the fund’s profits. After that, distributions are split 80:20 between LP and GP (assuming a standard carried interest rate of 20 percent). During this ‘catch-up’ 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 if the fund holds onto its investments too long and ends up making less money than expected. This means that 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 percent 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,” Griffiths says. “So there’s a tension between what the franchise wants – 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 the report’s other 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 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 ‘catch-up’ threshold is reached as in the period before the threshold.
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’ necessarily damages returns. In fact, Landmark says that all of the funds in its study delivered returns 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.