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HONEYGUIDE IN THE NEWS

Supply Crunch Might Be Looming

7/29/2018

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Crude across the globe is being used up faster than it is being replaced, raising the prospect of even higher oil prices in the coming years.  The world isn’t running out of oil.  Rather, energy companies...
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What Are Waterfalls?

7/28/2018

 
Ok, let me rephrase that.  What are waterfalls in the realm of private equity?  In this article, we’ll review waterfalls, clawbacks, and catch-up clauses and how they pertain to investors. Each have their own unique importance in private investing and define how distributions flow from the investment to the partners and the terms of the manager’s performance fee.
 
When investments provide a return and cash needs to be distributed, the waterfall defines how these funds are allocated.  The preferred return can range usually between 6-9%, and is defined as 100% of funds going to investors until this return is reached.  It is after this return hurdle is reached that funds are distributed between investors and the manager – usually at 80% to investors and 20% to the manager.  Usually there will be another higher return hurdle that needs to be reached in order for cash distributions to split even further.  Waterfalls are useful for aligning interests amongst investors and managers.  By incorporating a preferred return, it ensures that managers must find appropriate investments that will bring a robust return in order to get paid.  Meaning, only once investors make their return, then managers can participate in profits.  Honeyguide utilizes a preferred return.
 
Honeyguide also uses a European waterfall vs. an American waterfall.  In European waterfalls, 100% of the investment cash flow is paid out to the investors on a pro rata basis until the preferred return is reached.  Pro rate means that all capital is treated equally, and distributions are paid out proportionately to the amount of capital invested. Once the return hurdles have been satisfied, then the manager’s portion of the profits is realized.
 
In an American waterfall, the manager can receive an incentive fee on each deal, even if the investor’s preferred return and capital have not been paid back in full.  The intent here is to help a smaller manager with their income over the life of the fund.  When looking at private investments, this is something that should be looked for in the Private Placement Memorandum (PPM). At times, this kind of waterfall may be more suitable when the end goal is to hold the asset for income and there is little risk to the principal.  In these instances, however, managers participate in the income stream from the first day. 
 
With American waterfalls, it’s important to have a feature called a clawback clause.  This entitles investors to get paid back any incentive fees taken by the manager in an instance where the investment underperforms.  Because Honeyguide uses a European waterfall, no incentive fees are taken upfront.
 
A catch-up clause is meant to make the manager whole so that their incentive fee is a function of the total return and not just on the return in excess of the preferred return. 
For example:
 
Without Catch-up Clause
The investor would receive an annualized preferred return and their capital back.
Then all remaining distributions would be split 80% to investors and 20% to the manager.
 
With Catch-up Clause
The investor would receive an annualized preferred return and their capital back.
The manager would then receive 100% of distributions until they get 20% of all annualized profits (catch-up clause).
Then all remaining distributions would be split 80% to investors and 20% to the manager.
 
You can now see how each of these tie together starting with the waterfall. The waterfall will tell you where you stand in the allocation order. From there, you’ll want to know if there is a catch-up in place. The catch-up will dictate whether the fund manager is made whole prior to a profit split. Lastly, understand if there is a clawback clause. Having one in place can help investors recoup additional funds in the event the fund manager gets a deal by deal incentive fee found in American waterfalls.

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Sources: Origin Investments; origininvestments.com

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