Waterfall/Promote Nuance
Hey WSO - I'm spending some time learning how to model waterfalls and I have come across two different approaches for calculating LP interest per tier/hurdle based on various promote %'s.
Can someone help explain the difference between the below examples?
Example A:
Assume 90%/10% LP/GP Split
Tier 1: Pro-rata up to some preferred return
Tier 2: 10% Promote up to X% IRR
LP Interest in Tier 2 = (90% - 10%) = 80%, such that 80% is used in the MIN/MAX function for the LP's distribution at the respective tier
Example B:
Assume 90%/10% LP/GP Split
Tier 1: Pro-rata up to some preferred return
Tier 2: 10% Promote up to X% IRR
LP Interest in Tier 2 = 1-([GP's Initial 10%]+[LP's Initial 90%]*10%) = 72%, such that 72% is used in the MIN/MAX function for the LP's distribution at the respective tier
Thank you!
The correct methodology for promoted interest is shown below. Alternatively, what we do is utilize a simple cash flow split so there is no confusion about profit CF distributions.
Promote: Tier 1: 90%/10% LP/GP pari passu Capital Return and Preferred Return CF distribution Tier 2 (1): (90%-(90%*10%)) = 81%/19% LP/GP CF split up to X% IRR
(1) LP is promoted 10% of all cash flows after pari passu Capital Return and Preferred Return up to X% IRR meaning the LP gives 10% of 90% (9%) of their base capital split to GP
CF Split Tier 1: 90%/10% LP/GP pari passu Capital Return and Preferred Return CF distribution Tier 2: 80%/20% LP/GP CF split up to X% IRR
Isn't the GP promoted such that LP gives 10% of their 90% interest (9%) to the GP?
So that the GP is contributing essentially 1% of the equity? Doubtful. InVinoVeritas has it right. Technically you can structure a promote waterfall however you want, but that is the most common way by far, in my experience.
No, the LP is the one "promoted" despite that this sounds counter-intuitive. This has been confirmed repeatedly by seasoned MD's in the industry. If you read my reply you can see that LP gives 9% of their base pari passu cash flow split to GP in Tier 2.
Yeah I always find it helpful to think of it as the more formal "promoted interest" rather than a simple promote. As in, the interest is being promoted off of the LP. Makes it slightly less confusing.
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