Investing is about returns, and, in private equity, how those returns are distributed to investors is dictated by the waterfall provisions of the Limited Partnership Agreement.
Until recently, many investors paid less attention to this important calculation than they should, mainly because of the complexity of the calculation and the difficulty in getting enough detailed information to review it for reasonableness.
The Importance of Distribution Waterfalls
Part of the problem lies in the lack of consistency around the data General Partners (GPs) provide to their investors, but the complexity of the waterfall calculations has also created a considerable barrier. While most Limited Partners (LPs) have developed a level of comfort and familiarity with the more straightforward calculations used to determine management fees, the distribution waterfall is more complicated and nonstandard, which can make even the most seasoned LP feel out of their comfort zone.
Despite the challenges, many LPs are taking the plunge and wading deeper into waterfalls in order to understand and project their impact on investment returns. The sense of urgency has been spurred on by recent cases in which high-profile institutional investors failed to recognize and understand performance fees charged by the GP. Across the board, LPs are becoming more rigorous about monitoring their investments and more proactive about raising potential issues with their GPs.
The work of industry bodies such as the Institutional Limited Partners Association (ILPA) and standards such as the Global Investment Performance Standards (GIPS) is supporting this shift toward more active oversight. By encouraging greater transparency around investment data, these organizations are helping to break open the “black box” and giving LPs the information they need to understand and monitor the waterfall.