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Distribution Waterfalls in Private Investment Funds

Distribution Waterfall

The number of private equity (PE) funds in Israel has increased in recent years. The Israeli market, which in the past focused more on venture capital funds (VCs), when it was a young market of startups, has matured. Companies in the Israeli economy have grown and there are now also high-budget PE funds, such as the veteran FIMI Fund (1996), the Fortissimo Fund (2004), the Sky Fund (2005), and the Apex Fund (2006).


Both PE funds and VC funds execute capital investments in private companies. The difference between them, however, is that VC funds usually specialize in investing in early-stage companies (startups), while PE funds usually specialize in investing in medium-sized and larger private companies.


PE funds are considered to be more solid investments than VC funds. This is due not only to the difference in the type of companies in which these funds invest, but also from the differences in the contractual relationship between the general partner (GP) managing the fund and the limited partners (LPs), the investors in the fund. Partnership agreements (LPAs) regulate the relationship between the GP and the LPs. An LPA’s key component is the distribution waterfall that determines the order in which the fund’s profits are distributed between the GP and the LPs.


PE Stages of the Distribution Waterfall


A PE fund’s classic distribution waterfall includes four stages. To illustrate, let’s suppose that an investor invested ILS 100 in the fund and the fund earned ILS 130 within one year. The distribution waterfall determines how to distribute the ILS 130 amount. During the first stage, the investor will recoup 100% of the value of his investment, i.e., ILS 100. During the second stage (ILS 30 remains to be distributed), the investor will receive what is called a “preferred return,” a fixed annual percentage, let’s say 8%, of the total capital invested in the fund, so that, in our example, the investor will receive ILS 8. The third stage (ILS 22 remain) is called the “catch-up,” during which the GP receives a particular percentage (say 20%) of the total profit distributed in the second and third stages together, i.e., ILS 2 (20% of the ILS 10 distributed so far, including in this third stage). During the fourth and final stage (ILS 20 remain), the GP will receive a particular percentage (say 20%), which is ILS 4, while the LP receives 80%, ILS 16.


VC Stages of the Distribution Waterfall


In contrast, a VC fund’s classic distribution waterfall includes only two stages. During the first stage, the LPs receive a 100% return on investment, and during the second stage, distribution of a particular percentage, say 20%, goes to the GP and 80% to the LPs.


The difference between the two waterfalls derives from the fact that, commercially, while VC funds are perceived as being more “high risk, high reward,” PE funds are, to some extent, perceived as being a more conservative investment channel. Consequently, it is important for the distribution waterfall to reflect the fact that GPs are assuming the risk of failing to achieve the fund’s profit targets.


The purpose of the distribution waterfall is to determine the cash distribution priorities in order to cope with situations when there is not enough money to advance to the next stage of the distribution. For example, if, in the above example, the profit was only ILS 105, the investor would receive the entire ILS 105, while the GP would receive no success fee at all.


The Issue of Leverage


Another major difference that may be reflected in LPAs of both types of funds is the fund’s use of leverage. VC funds usually use only the LPs’ funds (“capital commitments”), as well as short-term bridge loans designed to bridge time gaps until investors inject capital into the fund, for the purpose of purchasing shares in the target companies. On the other hand, PE funds do tend to use leverage to complete acquisitions of companies. This difference also derives from the different degrees of risk in VC funds and PE funds, since banks (and other lending institutions) feel more comfortable extending credit to PE funds, due to their lower risk, than to VC funds. Furthermore, adding leverage risk on top of the risks inherent in VC funds may deter investors.


Ultimately, the decision about which type of fund (PE or VC) to invest in depends on a large number of factors, with the degree of risk being one of the most significant factors.




Barnea Jaffa Lande’s investment funds team is at your service if you have any questions in this regard.


Adv. Roy Engel heads the firm’s investment funds practice.


Adv. Yakov Vilenski is an associate in the department.


Tags: PE | VCs