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Automate your private equity waterfall

By Ras Sipko, Chief Operating Officer of Koger, Inc – Common feedback from private equity funds when questioned about running profit/performance allocations is that they have a process that works, mainly driven by the use of spreadsheets. While it is certainly easy to build out the required accounting methodologies on an Excel spreadsheet is it the best way to handle this work?

When pressed further on the topic the overwhelming refrain is complex calculations like private equity waterfalls cannot be easily automated and it must be an expensive proposition to not only build these but provide ongoing support.

Breaking down the complexities of these calculations allows for a high level view into how these can be formulated to be effectively used through automation and allows for a process required to provide unique calculations on a fund-by-fund basis.

First, let’s take a look at the primary elements or tranches of these distributions and examine a common distribution model.

The typical order these tranches are applied to a calculation is as follows:

1. Repayment of investors up to the point where they have received all of their capital contributions.

2. Repayment of investor’s percentage share (typically pro rata) of fund expenses inclusive of management fees.

3. Payments to investors which represent their agreed preferred return.

4. Payment to the fund sponsor or General Partner which represents the first portion of performance allocation by the fund, commonly referred to as the “catch up”

5. Payments of the Carried Interest split (typically 80:20), this would be 20% of any remaining profits payable to the sponsor or General Partner with the remaining 80% of profits being paid to the investors.

While this may seem straightforward, the complexity underlying this is based on additional elements within the LP agreement. For example, looking at the first tranche, while the intent is to return in full the original capital contributions to investors this could be impacted by items such as the methodology chosen e.g. whole fund or deal by deal basis; additional tiers of carried interest; any clawback provisions or whether or not opt-out clauses are available for investments.

While the list above is not exhaustive, any one of these can impact each of the five tranches, with all tranches having the potential to be impacted based upon the terms of the fund agreement and the resulting uniqueness of each fund’s final performance.

In order to automate these fee calculations you need to have a base methodology in place, but you also need a flexible system in which to make specific changes to the base calculations, along with the expertise to implement the formula changes specific to each fund’s documents. This requires a dedicated staff whose role is to exclusively support these business needs.

All of this automation exists today in Koger’s PENTAS Private Equity system, allowing Koger’s clients to eliminate spreadsheets and run a fully automated process.

Additionally, the ability to fully report on these, at both the fund and LP level, through automated distribution methods creates a risk averse process with successful audit and due diligence reviews allowing funds a better opportunity to raise capital.

Koger’s PENTAS system allows for complete control over these critical administrative tasks for large global administrators or standalone managers. You will benefit from the support that both the Koger team and their software solutions offer.  

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