## Common Issues with Waterfall Calculations

Waterfall calculations are some of the most complex and time-consuming in all of the investment world. In talking with GPs in private equity and commercial real estate firms, we often hear of their frustration in not finding systems that can calculate waterfalls – and having to resort to using Excel. This leads to all the usual problems – “fat finger” entry mistakes, lack of integration with other systems, lack of version control, and other problems. There are 2 challenges managers often encounter even when they do find systems with built-in waterfall management: model frequency and calculating the accrued preferred return on initial capital contributions.

Model Frequency

LPAs will often specify when capital contributions are deemed to be made. Most commonly, this will be stated as the actual day of activity. This becomes important when determining the amount of preferred return attributable to a capital contribution when the preferred return is expressed using an annual rate. A problem here is when the XIRR function is used instead of a more accurate rate of return formula using (1 + Rate) ^ (number of days / 365). This can lead to overpayment of the preferred return. It is therefore important to choose a system that offers a variety of rate-of-return methodologies to help you meet the needs of any situation.

Calculating the accrued preferred return on initial capital contributions

The preferred return is calculated based on the initial capital contributions using the preferred rate of return outlined in the LPA. The preferred return may either be calculated on a cumulative or noncumulative basis. A preferred return calculated on a cumulative basis is added to the initial capital contributed. Distributions are deducted from the cumulative preferred return earned. Under these circumstances, the preferred return earned in the current period cannot be reduced if the previous period’s distributions exceed the preferred return. For example, if a preferred return is calculated assuming that cash flow distributions in excess of the preferred return are a reduction to the initial capital contribution instead of a distribution, it is subjected to a waterfall calculation. This may cause an overstatement of distributions to the initial capital contribution. Understanding the economic terms of a transaction is critically important in ensuring that returns to investors are consistent and correctly calculated in accordance with the LPA and the marketing materials that may been shared with the investors.

In summary, a system touting its waterfall calculation capabilities should offer flexible capabilities to capture or calculate:

• Side letters
• Preferred Return – Commitment/IRR
• GP/LP – Catch-up
• GP/LP – Excess Cash

The waterfall setup below, from First Rate Vantage, illustrates components to look for: