Carried Interest Dynamics

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I’ve heard of a lot of venture firms who do European distribution waterfalls instead of American-distribution waterfalls. I’m not sure where the naming convention came from, but for a quick primer on the difference between the two:

– In a European distribution waterfall, the General Partnership (GP) has to pay back all of the principal drawn down from the Limited Partners (LPs) first, and then they earn carried interest on the subsequent profits, usually of around 20%.

– In an American-style distribution waterfall, the GP may earn carried interest on capital on a deal-by-deal basis, so as soon as a business exits and returns funds, the GP earns carried interest in the profits.

The latter is obviously highly advantageous to the GP: they start earning their profits much earlier – in a 7 year fund, it may be as much as 5 or 6 years earlier – which has a huge impact on an individual’s IRR. While the material difference isn’t usually that different for the LP, it can be wildly different for the GP. Conventional wisdom suggests that in tough times, LPs ask for European-distribution, but in good times, GPs ask for American-distribution. So, what’s the point?

There is a big concern, with the American-style waterfall, that if a GP starts earning serious money too soon, they may have less ‘skin in the game’, and their motivations may change in a way that negatively impacts their ability to invest. “You make money when I make money” is a pretty core tenet to fund management, and a great way to ensure alignment between managers and their investors.**

But on the other hand, with the European distribution, if the GP knows that they won’t see a dime until they’ve returned the whole fund, perhaps there’s a motivation to encourage founders to exit more quickly than they perhaps should… I haven’t seen this play out, myself, but I’ve heard a number of people say that they think that’s a secret motivating factor behind some GP decisions they’ve seen out there – particularly in small funds. And, to make matters worse, the IRS doesn’t recognize European distributions! So you could be paying taxes on carried interest on exited deals that you haven’t seen a dime from! Ouch.

Tough either way. But maybe the downside of the European distribution on how a portfolio performs is underconsidered, at least from what I’ve read and heard from mentors in the business.

Anyway, a little inside baseball, for those interested in the game.

** Andy reminded me to mention the clawback, which is an important feature of some Limited Partnership Agreements, too. There are cases (most, heh) where the fund isn’t actually going to be profitable, but a few early investments have been, and the GP has earned carried interest. In these cases, in the LPs have a provision whereby they can demand the GPs pay back whatever profits they earned, if it doesn’t make the LPs whole. Related to that, there are two ways of thinking of being “made whole” – one is committed capital, one is called capital. Committed capital is “how much we said we’ll give you” while called capital is “how much we have given you”. Many scenarios where these numbers could be different, and most of these scenarios are painful ones…

*** Thanks Eric for getting my head spinning on this.

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