Molding water
30 October 2013
Ras Sipko, COO of Koger explains how to automate your private equity waterfall
Image: Shutterstock
Common feedback from private equity funds when questioned about running pro it/performance allocations is that they have a process that works, mainly driven by the use of spreadsheets. While it is certainly easy enough to build out the required accounting methodologies on an excel spreadsheet is it the best way to handle this critical work? When pressed further on the topic the overwhelming refrain is complex calculations like private equity waterfalls cannot be easily automated and it must be an expensive proposition to not only build these, but provide ongoing support.
Breaking down the complexities of these calculations allows for a high level view into how these can be formulated to be effectively used through automation and allow for a process required to provide unique calculations on a fund by fund basis. However, just looking at the typical layering of private equity waterfall tiers is not enough as there are endless options with regards to not only which are applied but when in the calculation. But first let’s take a look at the primary elements or tranches of these distributions and examine a common distribution model.
The typical order these tranches are applied to a calculation is as follows:
Repayment of investors up to the point where they have received all of their captal contributions.
Repayment of investor’s percentage share (typically pro rata) of fund expenses inclusive of management fees.
Payments to investors that represent their agreed preferred return.
Payment to the fund sponsor or general partner, which represents the first portion of performance allocation by the fund, commonly referred to as the ‘catch up’.
Payments of the carried interest split (typically 80:20). This would be 20 percent of any remaining profits payable to the sponsor or general partner with the remaining 80 percent of profits being paid to the investors.
While this may seem straightforward the complexity underlying this is based on additional elements within the limited partnership agreement. For example, looking at the first tranche, while the intent is to return in full the original capital contributions to investors this could be affected by items such as: the methodology chosen, eg, whole fund or deal by deal basis; additional tiers of carried interest; any clawback provisions; or whether or not opt out clauses are available for investments. While the list above is not exhaustive, any one of these can affect each of the five tranches identified with all tranches having the potential to be affected based on the terms of the fund agreement leading to uniqueness of each fund’s final performance.
In order to automate these fee calculations, you need to not only have a base methodology in place but also a flexible system in which to make specific changes to the base calculations, along with the expertise to implement these formula changes specific to each fund’s documents. This requires a dedicated staff whose role is to support these business needs exclusively. All of this automation exists today in Koger’s PENTAS Private Equity system, which allows Koger’s clients to eliminate spreadsheets and run a fully automated process.
Additionally, the ability to fully report on these at both the fund and limited partnership level through automated distribution methods creates a risk averse process with successful audit and due diligence reviews allowing funds a better opportunity to raise capital. Koger’s PENTAS system allows for complete control over these critical administrative tasks for large global administrators or standalone managers. You will benefit from the support that both the Koger team and their software solutions offer.
Breaking down the complexities of these calculations allows for a high level view into how these can be formulated to be effectively used through automation and allow for a process required to provide unique calculations on a fund by fund basis. However, just looking at the typical layering of private equity waterfall tiers is not enough as there are endless options with regards to not only which are applied but when in the calculation. But first let’s take a look at the primary elements or tranches of these distributions and examine a common distribution model.
The typical order these tranches are applied to a calculation is as follows:
Repayment of investors up to the point where they have received all of their captal contributions.
Repayment of investor’s percentage share (typically pro rata) of fund expenses inclusive of management fees.
Payments to investors that represent their agreed preferred return.
Payment to the fund sponsor or general partner, which represents the first portion of performance allocation by the fund, commonly referred to as the ‘catch up’.
Payments of the carried interest split (typically 80:20). This would be 20 percent of any remaining profits payable to the sponsor or general partner with the remaining 80 percent of profits being paid to the investors.
While this may seem straightforward the complexity underlying this is based on additional elements within the limited partnership agreement. For example, looking at the first tranche, while the intent is to return in full the original capital contributions to investors this could be affected by items such as: the methodology chosen, eg, whole fund or deal by deal basis; additional tiers of carried interest; any clawback provisions; or whether or not opt out clauses are available for investments. While the list above is not exhaustive, any one of these can affect each of the five tranches identified with all tranches having the potential to be affected based on the terms of the fund agreement leading to uniqueness of each fund’s final performance.
In order to automate these fee calculations, you need to not only have a base methodology in place but also a flexible system in which to make specific changes to the base calculations, along with the expertise to implement these formula changes specific to each fund’s documents. This requires a dedicated staff whose role is to support these business needs exclusively. All of this automation exists today in Koger’s PENTAS Private Equity system, which allows Koger’s clients to eliminate spreadsheets and run a fully automated process.
Additionally, the ability to fully report on these at both the fund and limited partnership level through automated distribution methods creates a risk averse process with successful audit and due diligence reviews allowing funds a better opportunity to raise capital. Koger’s PENTAS system allows for complete control over these critical administrative tasks for large global administrators or standalone managers. You will benefit from the support that both the Koger team and their software solutions offer.
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