If the fund allocates fees at the fund level, it will come at a cost to the IRR. For instance, a $100MM fund invests in their first deal for $10MM and charges 1.5%. Right off the bat, the investors will be charged $1.5MM in fees on their first deal. This essentially wipes out any potential distributions that the LPs were hoping to pocket and demolishes their initial IRR.
But, if you allocate fees on a per deal basis you will continue paying fees over a longer period of time, but your individual investment IRRs will be more consistent compared to the other investments. The fee is allocated based on called capital, so Funds will generally allocate fees across deals based on the proportion of capital used in the deal. For example, if you used 20% of your total capital for a deal, you would charge 20% of your total fee to that deal. However, allocating fees on a deal-by-deal basis also has its downsides. One main downside is the accrual of fees and expenses for later deals and its effect on the distributions. For instance, imagine you have 10 deals over 4 years. Deals 1-9 deals were invested in year 1, and deal number 10 was invested in year 4. In this case, deal 10 will have to perform at a higher level for its distributions to make it through the waterfall tiers. This is because deal 10 has to bear its share of years 1-3 expenses, even though it was not yet invested. Although a clear impediment to deal 10’s performance, this method is used to minimize the effects of the j-curve. It is better to have later deals bear their portion of early expenses, at a slight negative to IRRs, than have early deals bear the entire portion with massive penalties to their IRR.
Clawback Clause
A Clawback is a feature detailed in the LPA that refers to the LPs right to recoup cashflow previously distributed to the GP. A clawback is common in American-style waterfalls and is calculated upon liquidation of the fund. Clawback provisions play a key role in protecting the LPs from overpaying incentive fees to the GP. For example, in the American-style waterfall the GP could begin receiving distributions before the LPs had reached their required investment return hurdles. Let us say the GP takes a promote distribution and over the life of the Fund, it turns out the later deals in the Fund aren’t as successful as the initial deal, and the LPs never receive their entire capital back. Thanks to the clawback feature, the LPs are entitled to reclaim the promote they overpaid to the GP. However, one thing to note is that the clawback feature is only as good as the fund manager’s ability to repay. Many LPAs will require a portion of promote be deposited into escrow accounts to ensure that at least a portion of promote is easily recoverable in the clawback clause is exercised.
Deferred Distributions
If you are in an American-style waterfall model, deferred distributions will most likely be a constant theme when dealing with promote distributions. A deferred distribution is, as the name suggests, when a distribution to the GP is delayed. Since American-style waterfall models are on a per-deal basis, the GP can receive a promote distribution on the first deal after the LPs hit their hurdles for the specific deal. Usually the LPs do not want the GP cashing out on all their deals up front without guaranteeing the performance of later deals, so the fund will defer 40%-60% of the earned promote distributions until the fund as a whole reaches capital back plus preferred return. Additionally, distributions can be deferred 100% if it does not appear that the fund will return the capital plus preferred return to the LPs based on a hypothetical liquidation using the current fair value of the assets.
Investors in European-style funds will not encounter deferred distributions due to the fund-level structure of the European waterfall. In the European-style waterfall, the GP only receive a promote distribution after the LPs receive all of their capital back plus a preferred return.
