The profit distribution model of private investment funds varies according to the different fund models. Traditional buy-out funds, hedge funds, debt funds and other funds obtain profits in different ways, which leads to different ways and orders of profit distribution. Traditional M&A funds have two basic profit distribution modes: full capital priority mode and transaction-by-transaction mode. This paper focuses on the principal priority return model (also known as European distribution waterfall), which is a fund profit distribution model to ensure GP and LP to distribute profits after LP recovers the investment principal. Because this distribution model is beneficial to LP, LP likes this distribution model very much.
Under the principal priority return mode, the fund does not distribute the profits of a single project, but calculates the profits of all projects in a unified way. The specific distribution order of fund profits is as follows:
1. The return of the fund is first returned to LP to pay off all its principal contributions (including investment in the project, management fees and other expenses);
2. If the internal rate of return of the fund does not exceed the preferred rate of return, GP will not get any arbitrage, and the remaining fund profits will be distributed to all partners in proportion to the capital contribution after the full principal of LP is returned. Priority rate of return is the investment rate of return promised by fund GP to investors when the fund was established. The practice of American fund industry is that the priority income is usually 8% compound annualized rate. It is worth mentioning that, unlike China, the United States is a country with a very low basic interest rate. If the IRR of the fund is higher than the preferred rate of return, investors will get the preferred return based on the total principal.
3. After investors get priority returns, GP will get 20% commission income of LP priority returns through catch-up clauses.
4. The remaining fund profits are all distributed between GP and LP according to the proportion of 20% and 80%.
Another basic profit distribution model of private equity investment funds is the transaction-by-transaction model, that is, every time the fund withdraws from an investment project, the investment income of the project will be distributed between GP and LP.
This distribution model is more beneficial to fund managers than the all-capital priority model. Most investment funds in the United States adopt the project allocation model, so this model is also commonly known as the American waterfall (European waterfall relative to the principal priority return model). However, with the deterioration of the market environment in recent years, this income distribution model has been greatly challenged. According to the principle of private equity investment issued by ILPA, the best profit distribution mode of the fund is the principal priority return mode. This principle provides a strong foundation for institutional investors to negotiate with GP. In addition, due to the market environment, it is increasingly difficult to raise funds. When fund managers face institutional investors, their bargaining power is not as good as before, and many economic terms should listen to LP's opinions, including the fund income distribution model.
There are different ways to assign items. Strict project allocation mode is that GP accounts for the profit and loss of each project separately. Once LP recovers the investment and priority return of a project, GP can collect royalty income. Assuming that the fund invests in five projects at the same time, GP can collect commission income when one project is profitable, regardless of whether other projects are losing money. In this mode, GP will lose the motivation to dispose of loss-making projects.
Another common distribution model by project is to calculate all realized gains and losses of the fund. In this model, the fund's income is first used to repay LP's contribution and priority return in all realized investments. If a project has a loss, the next profitable project needs to fill this loss first, and then calculate the possible priority return and GP royalty income.
Compared with the principal priority return model, the project allocation model has obvious advantages for GP, and GP will get the carried interest earlier. However, according to the profit and loss of each investment project of the fund, this method may make GP get more commission income than the agreed commission income ratio. Therefore, it is necessary to calculate the overall profits of all projects of the fund when the fund is dissolved, so as to judge whether the commission income actually collected by GP exceeds its due commission income. For investors, the risk of the project allocation model is that GP may be unwilling or unable to return this extra royalty income to the fund for various reasons. Investors can use the GP callback mechanism in the fund's legal documents to let GP return this extra royalty income to the fund. The callback mechanism is complex, usually combined with the escrow account and the fund manager's personal back-to-back guarantee.