In the last video we ended with a slide that showed the tremendous leverage that is available on the General Partner’s capital.
Before we dig into the economic mechanics of an investment partnership, we need to understand a few concepts:
- Carried Interest
- Preferred Return
Carried Interest is defined as a share of any profits as long as i) all capital is returned to the investors; and ii) the investors receive their Preferred Return.
Preferred Return is the return on invested capital before the General Partner receives its carried interest.
The Waterfall defines the priority of the distribution of invested capital of an investment fund in general, and from the exit of each discrete investment in particular. The Waterfall is not just for an investment fund, or blind pool; its also applicable if you are raising money for a single asset transaction – such as a single real estate investment.
So, what does a waterfall look like, in other words, what does the priority of distribution look like?
Below is the “Executive Summary” version of a waterfall from one of our offering memorandum templates:
i. return of 100% of invested capital;
ii. the Preferred Return;
iii. 100% to the G.P. as a catch-up until the G.P. has received 20% of distributed profits; and
iv. thereafter, 80% to the partners and 20% to the G.P.
Traditionally, the carried interest on investment funds is 20%
Also, note that the Partners do not receive their Preferred Return AND an 80% allocation of the profits; they receive 80% of the profits. The Preferred Return is the hurdle rate for the G.P.
For example, if the G.P. has been receiving its Carried Interest in the early years of the partnership, but the the partnership sustains some losses so that the Partners’ return is less than the Preferred Return, then the Partners can “Claw Back” some of the Carried Interest received by the G.P. until the Preferred Return is met.
Towards the end of the video in this post I walk through an example of a fund and show how the dollars flow. I also present the IRR for the fund, the Limited Partners, and the General Partners.