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LPs urge emerging GPs to use Euro-style waterfall structures

  • LPs more comfortable with carry paid to GPs after they get paid
  • Emerging GPs still use deal-by-deal carry distribution
  • LP touts a yearly management fee review

Emerging managers should structure their early funds so they can’t collect carried interest until limited partners are paid back, a panel of LPs suggested at a Buyoutsconference Tuesday.

This model is known as a European-style distribution waterfall. Under this system, GPs don’t collect carry until LPs’ commitments (or sometimes contributed capital), plus a preferred return, are paid back.

LPs like this type of structure because GPs can’t typically collect carry on early exits, as they can under a deal-by-deal waterfall structure, known as an American-style waterfall model. LPs in this structure must be made whole through a clawback of GPs profits if the fund falls short of providing them with their promised 80 percent of the profits.

GPs who use the American waterfall model argue that it’s necessary to give junior executives incentive, especially in emerging funds that need the management fees to keep running.

Skew toward Europe system

Some emerging managers are coming to market with funds structured with European-style distribution models, but it’s not dominant one way or the other, said Tim Weld, a partner at StepStone Group. Weld spoke on a panel at Buyouts’ Emerging Manager Connect 2016 conference on July 19.

“Coming in with a European waterfall can help a bit,” Weld said about firms having slower fundraisings.

“LPs prefer [the] Euro waterfall system; it’s just a lot cleaner,” said Paul Kwon, a  747 Capital senior associate who also spoke on the panel.

“When it comes to the limited-partner agreement and an emerging manager that has that type of carry, we’ll hammer on those clawback provisions or hammer on those other things we’d want that will ultimately kind of skew toward the European model. So, in my opinion, it’s better to go toward that European system.”

Irwin Loud, chief investment officer at Muller and Monroe Asset Management, said many GPs have stuck with American-style carry models, despite the Institutional Limited Partners Association recommending that firms move to the European model.

Some firms are using hybrid distribution models, like deal-by-deal carry with provisions for early release of capital, Loud said.

Innovation: fee resets

Another terms-and-conditions innovation involves management fees. LPs generally don’t want to pressure young firms to keep fees low. Too-low fees can hurt the firms’ ability to operate, which in turn can distract them from their core efforts to produce returns.

But LPs must also be cognizant of costs, so some funds have established budget-based management fees that reset each year with the approval of the limited-partner advisory committee, Weld said.

“The GP feels good [that] they’ll have enough resources each year to run the firm and invest and grow the business, and have resources to deliver the returns LPs are expecting,” Weld said. “LPs are comfortable that no one is getting rich off management [fees].

“To have that level of granularity reviewing it each year or every few years, that’s a nice feature for LPs that GPs could think of doing.”

Action Item: Buyouts Emerging Managers Conference: http://bit.ly/29nLw8n