🛠️ Investment Fund Key Terms, Part 19

🎉 Happy Friday, funds family!

Today, we have Part 19 in our many-part series walking through each term in an investment fund term sheet in detail.

Here’s the index of each article in this series (so far):

• Part 1: Naming your entities

• Part 2: Investment objectives

• Part 3: Fund size

• Part 4: LP minimum check size

• Part 5: GP commitment

• Part 6: Fund term

• Part 7: Fundraising period

• Part 8: Investment period

• Part 9: Capital recycling

• Part 10: Investment limitations

• Part 11: Leverage Limitations

• Part 12: LP Withdrawals

• Part 13: Key Person Event

• Part 14: Successor Funds

• Part 15: Carried Interest

• Part 16: Preferred Returns

• Part 17: GP Catch-Up Provisions

• Part 18: American vs. European Waterfalls

This week focuses on Split Waterfalls (Cash Flow / Dispositions). 

Does your strategy focus on cash flow? Want to hold assets for the long term?

If so, you might want a “split waterfall” that gets you carried interest sooner.

➡️ Why have a split waterfall?

Split waterfalls are helpful if your strategy focuses on cash flow. Most standard waterfalls require a return of capital to LPs as well as a preferred return before the GP can start earning carried interest.

Clearing these hurdles is manageable if the GP plans to sell the assets in a short window.

However, if the plan is to hold the investments for the long term, the “return of capital” step can be problematic. It will take forever for the GP to get carry.

➡️ How does a split waterfall work?

A split waterfall is actually two waterfalls – one for cash flow and one for disposition proceeds. Typically, the two waterfalls look the same, except the cash flow waterfall removes the “return of capital” step.

Here’s an example:

💵 Ongoing cash flow (rents, interest income, operating profits)

1. First, 100% to LP until LP has received an 8% preferred return.

2. Thereafter, 80% to LP and 20% to GP.

💰 Capital events (sales, refinances, recapitalizations)

1. First, 100% to LP until LP has received a return of capital.

2. Second, 100% to LP until LP has received an 8% preferred return.

3. Thereafter, 80% to LP and 20% to GP.

➡️ Anything to keep in mind when using split waterfalls?

You should always have a return of capital step in the disposition waterfall. Full stop.

Refinancing proceeds could theoretically go towards either waterfall, depending on how the LPA is drafted. I take the position that refinance proceeds should run through the disposition waterfall.

This only really makes sense if the fund wants to incentivize the GP to hold onto assets long term but there’s a preferred return to clear. In general, this is suited for private credit and buy-and-hold real estate and private equity. It doesn’t make as much sense for venture capital (which doesn’t have a preferred return) and development (if the plan is to sell the project after it’s built).

⏩ Next up in Part 20 – Carried Interest Clawback

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.