Although there is a long history of outside investors buying stakes in private companies, private equity as an industry – specialist firms organised to find, make and sell investments in a portfolio of private companies – was born in post-war America.
The first American PE firms were not dissimilar to venture capital firms, insofar as they focused predominantly on small businesses and would often accept minority stakes. PE managers initially raised most of their capital from wealthy families, but the industry’s excellent track record eventually attracted the interest of institutional investors. Fund managers’ investing strategies also became more ambitious over time, with the first leveraged buyouts taking place in the 1970s. Europe got in on the act a few years later: the first purely European private equity firms emerged in the 1980s.
Although PE funds on both sides of the Atlantic have comparable investment objectives and strategies, and tend to structure themselves as limited partnerships, the European industry did develop largely independently of its more venerable American cousin. As such it’s not surprising that there are some important differences between them, particularly at the fund partnership level, in the economic terms offered to LPs.
U.S. private equity funds have historically favoured a more GP-friendly waterfall, whereby carry accrues on a deal-by-deal basis. By contrast, European funds almost always use a more LP-friendly waterfall, whereby carry is calculated on a whole-fund basis. The distinction is longstanding and ingrained enough in market practice that the deal-by-deal model is sometimes referred to as an ‘American style’ waterfall, while the whole-fund model is ‘European style’.
Although U.S. and European fund managers now compete directly for investors’ capital, their traditional waterfall models have so far mostly defied the pressure of convergence. For example, MJ Hudson’s broad-based survey of PE fund terms in 2017 found that 64% of North American funds featured deal-by-deal carry, whereas 88% of European funds in the same survey offered whole-fund carry.
That said, GPs on both sides of the Atlantic are increasingly experimenting with the development of alternative models of carried interest, such as the hybrid waterfall, whereby a portion of returns is distributed on a deal-by-deal basis and the remainder on a whole-fund basis.
Both U.S. and European funds typically contain a GP clawback mechanism as protection against the overpayment of carried interest.
However, by virtue of the way in which it calculates carry, a European style waterfall is less likely than an American style one to result in overpayment of carry during the life of a fund. Therefore, in Europe, it is common for the clawback to kick in at liquidation only, often backed up by escrow protection.
Conversely, in funds with American style waterfalls, clawback protection takes on an altogether greater significance, and LPs are more likely to negotiate for interim clawbacks, with multiple test dates, from the end of the investment period through to liquidation of the fund. Escrow accounts are less common in U.S. funds than in European funds. Only 14% of funds in the MJ Hudson 2017 research survey that utilised a deal-by-deal waterfall built in some form of escrow protection.
The other type of investor protection that is commonly seen alongside American-style waterfalls is the personal guarantee – in MJ Hudson’s 2017 fund terms survey, 71% of funds with a deal-by-deal waterfall required either the recipients of carried interest or the fund’s sponsor to guarantee the GP’s obligation to return overpaid carry.
In MJ Hudson’s 2017 survey of funds, we found that some 80% of such guarantees came from management team members who were ultimately entitled to receive carry distributions, whereas only 20% were given by the private equity firm itself. For funds adopting a European style waterfall, the inclusion of guarantees is somewhat less ubiquitous, perhaps because of the much greater use of escrow protection and, indeed, the lower overpayment risk that is inherent in whole fund waterfalls.
Management fee waivers
Another major difference in the economic terms of European and U.S. funds is the option to finance GP commitment via management fee waiver. This is seldom seen in European fundraising, but it has a history of being widely used in the U.S. The waiver mechanism involves reducing capital calls to investors for management fees and instead drawing down the saved amounts from investors to meet the GP’s obligation to contribute capital alongside investors toward the fund’s investments and expenses.
By recycling cash within the fund structure, rather than drawing it out in the form of fees and then ploughing it back in as capital, the GP can make its contributions on a gross basis for tax purposes. It also has the advantage of allowing first time fund managers and more junior members of the management team, who may not have enough cash on hand to meet regular drawdowns on account of GP commitment, to make a more meaningful contribution to the fund. But some LPs question whether fee waivers mean that the GP has less ‘skin in the game’ – the latter being seen as an important way of aligning the interests of manager with those of its investors.