July 13, 2023
Marketing Director
Waterfall calculations are used to determine the returns and fees of investments between partners and are based on pre-agreed terms. The proceeds earned are distributed via sequential steps in a cascading structure, hence the term ‘waterfall distribution’ which is commonly found in private equity.
Since building a platform that automates waterfall calculations, we frequently encounter mistakes in calculation models that have usually been created manually using spreadsheets. Since auditing spreadsheets is challenging, we often discuss these mistakes with our clients and how to address them using qashqade.
Here’s a list of some of the most common errors we see in waterfall calculation models:
In calculations of funds with many LPs, LPs with different side letter arrangements get mixed up and accounted for in the waterfall partially on non-applicable terms.
Despite the LPA stating that distributions are apportioned among the LPs pre-waterfall, in the calculations after every waterfall step (e.g., return of capital, preferred return) the still distributable amounts per LP are summed up and re-allocated again among the LPs based on various allocation keys.
Payments in the waterfall that the GP receives as investor (LP or internal LP) and amounts that it receives in its capacity as fund / investment manager got commingled giving rise to rolled-forward calculation mistakes.
Preferred return calculations that work well under the assumption of one single distribution (liquidation proceeds, NAV) may experience disturbances if many smaller distributions take place instead of one bullet payment only.
Waterfall calculations often mix up the preferred return calculation of annually compounded return and the internal rate of return (IRR) approaches and consider or fail to consider amounts paid to the LPs in steps following the preferred return as contributors to the attainment of the preferred return.
In management fee waiver programs, the special contributions of LPs were double-counted and accounted for in the waterfall both as LP cost contributions and deemed GP contributions.
In a subsequent close, the equalization interest that incumbent LPs receive is considered as an amount that increases their unfunded commitment, even though this item should not have any impact either on commitments or on contributions.
A consideration is omitted that while the preferred return calculation has to consider contributions and distributions on the very date of their occurrence, the gross and net IRR metrics have to be based on the month-end cash flow balances.
Clearly the days of using spreadsheets for waterfall calculations is coming to an end. Whilst spreadsheets can still play their part in the process, they should not be used as the waterfall calculation engine at the heart of your process.
qashqade provides private market organizations an enterprise product suite for streamlining their calculation, allocation, tracking and reporting processes. Waterfall and carried interest calculations can be automated, replacing manual, error-prone spreadsheets and improving communications between GPs and LPs through enhanced reporting. Built by private markets experts, for private markets experts, the qashqade platform offers a flexible, modular based solution for fund managers, fund administrators and investors alike, and is asset-class agnostic. Contact us today for demo.
