Waterfall structure is the order in which private equity funds pay out distributions after the liquidation of every investment( Buchner& Wagner, 2015 ). For instance, the traditional waterfall structure encompasses a limited partnership which gets their invested funds for investments and management done initially. This is followed consistently by their preferred return. Additionally, based on traditional waterfall structure, the GP gets a carry immediately after the invested funds and preferred returns have been paid. In this case, there is an assurance of GP's reception of its carry early in the life of the fund. It is also noted that some structures which are non-traditional like the European style waterfall structure, GP's tend to pay back the invested funds on respective investments of both those which have been liquidated and those which have not yet been sold.
The structures tend to be one of the most complex concepts in equity real estate. In these structures, cash flows from development or even an investment project are split into countless ways making them more confusing. They, therefore, divided profits among partners in any transaction allowing uneven distribution of profits among investors. Additionally, these structures can be thought of in the form of a series of pools which fill up with cash flows and immediately they are full, they spill over all cash flows into further additional pools. As stated by Cheffins&Armour, (2008 ), such structures are of great importance since they allow equity investors to reward the operating partner with an extra and disproportionate share on return to investments. The extra share on return is known as promote and is usually used as a bonus to motivate operating partners to exceed their return expectations.
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With these waterfall structures, also, cash flows can be distributed with regard to the owner's agreement. This is so because many variables exist in investment waterfall structures. Therefore, the rate at which profits are split among partners is spelled in the initial waterfall agreement. However, even though there are some commonly used terms, waterfall structures can be of different varieties. In this sense, therefore, it implies that no one size fits all solutions. Additionally, the only way that one can understand a specific waterfall is by getting familiarized through the agreement.
How Effectively Alignment of Interests between Investors, Principals and Managers can be addressed through Private Fund Documentation.
A lot of issues emerge regarding the complexity of aligning interests between the GP and the LP. This makes it difficult to be able to solve the interests through reform of an existing structure or even by a single structure. The first step that could work effectively in resolving these interests is adoption of the limited partnership model which allows LPs to take part in the GP’s or even the fund manager’s financial skills while at the same time giving a substantial investment discretion to the GP (Page, Jones&Fetterman, 2008) . This also implies discretion freedom to parties within the structure while at the same time providing for adequate oversight.
Literally, relationships between the LPs and the GPs are strengthened by only a long-term trend of reducing marginal returns. A long-term trend enables LPs to be able to actively voice their implicit and explicit expectations in the agreement hence presenting their interests. Additionally, it also supports the assessment of the alignment of interests between the two parties. ( Kay, 2012 ) Explains that in order to comprehend on how limited partners (LP) s can create a good relationship which builds both parties interests and expectations, it is good to understand first what happens when partners have conflicting interests when investing in the private equity funds. Additionally, they are supposed to identify the performance each party plays, for instance, what performance the GP and subsequently the LP plays in order to earn good returns (Meyer&Mathonet, 2005) effectively.
Extra costs and additional financial criteria might occur in the agreements. When this happens, three steps might be applied basing on the actual situation. For instance, if the gross returns are in favor of the returns with additional financial criteria, the GPs will cut costs and save resources at the same time. Additionally, in the event that the gross returns are at par between pure returns generated and returns with additional financial criteria initiatives, which implies that the net return favors the first category (Talmor&Vasvari, 2011) . In this case, the leverage for proponents will be to compensate the GP by supporting extra costs or modifying their cost structures.
Therefore, financial incentive structure between the LPs and GPs may break down when there are poor performances. Conflict of interests similarly which emerge from operational activities can be a source of misalignment in the structures, and they can be solved by closely monitoring them or even avoid them at all cost. Furthermore, in order to preserve and improve the interest alignment between the parties, the PE market should come up with a clearing mechanism where the top performing GPs are rewarded highly with increased carried interests. This helps to evade undue incentive for the GPs which may accumulate more substantial funds to benefit them.
References
Buchner, A., & Wagner, N. (2015). Rewarding risk-taking or managerial skill? The case of private equity fund managers.
Cheffins, B., & Armour, J. (2008).The eclipse of private equity. Del. J. Corp. L. , 33 , 1.
Kay, J. (2012). The Kay review of UK equity markets and long-term decision making. Final Report , 112 .
Meyer, T., &Mathonet, P. Y. (2005). Beyond the J curve: Managing a portfolio of venture capital and private equity funds (Vol. 313).John Wiley & Sons.
Page, S. N., Ankner, D. W., Jones, C., &Fetterman, R. (2008).The risks and rewards of private equity in infrastructure. Public Works Management & Policy , 13 (2), 100-113.
Talmor, E., &Vasvari, F. (2011). International private equity .John Wiley & Sons.
