Mastering Illiquidity: Risk management for portfolios of limited partnership funds

12

Distribution Waterfall

Risk models for funds can be constructed bottom-up or top-down. In a bottom-up approach the limited partnership agreement's provisions related to the distribution waterfall are often the most complex part to model. The waterfall sets out how distributions from a fund will be split and in which priority and when they will be paid out, i.e. what amount must be distributed to the LPs before the fund managers can take a share from the fund's profits. One immediate reason to model the distribution waterfall is its relationship with the returns of the fund in question. A fund's economics has a significant impact on incentives and, as a consequence, on the behavioural drivers of the fund managers' performance (Mathonet and Meyer, 2007).

The design of the waterfall's terms and conditions is one of few opportunities where LPs can anticipate and manage risk: it will always have effects – sometimes even unintended ones – as it drives motivation and attitude, sense of responsibility, accountability and priorities of fund managers.

Box 12.1 Definitions for main waterfall components based on the EVCA glossary1

• Carried interest is “a share of the profit accruing to an investment fund management company or individual members of the fund management team, as a compensation for the own capital invested and their risk taken. Carried interest (typically up to 20% of the profits of the fund) becomes payable once the limited partners have achieved repayment of their original ...