Black-box Waterfall Calculation Considerations

30th October 2018

There are many in our industry who would like to see a “black-box” waterfall calculation, referring to the idea that a waterfall can be completely automated and instantly calculated, with the push of a button. The idea is an obvious one, however we believe at this time that there are some major issues to consider before it is possible to exclusively rely on such a system.

In a private equity fund structure, waterfall calculations (the “waterfall”) are utilized to properly allocate investment gains between the investors and the Fund Manager (“Manager”), according to the terms outlined in a Fund’s legal documents (i.e., Limited Partnership Agreement or Limited Liability Company Agreement).  The gains allocated to the Manager (i.e., their incentive fee) are known as Carried Interest (“Carry”).  

As a Fund Administration firm, we are often asked our opinion regarding this approach.  

I should first note, that waterfall calculations are quite complex and, often, misunderstood.  As such, all waterfalls (including those automated), should still have each level of the waterfall properly reviewed by someone with the appropriate expertise.  

With that in mind, the following should be taken into consideration when building or utilizing a black-box waterfall:

  • The entire calculation must be extractable to a file that clearly shows how each step of the waterfall was calculated (i.e., excel format).  If it’s hard coded, it can’t be reviewed, unfortunately.  
  • Each level of the waterfall should be simple and easy to review.  Too many lines of calculations within one part/cell of a file is likely too difficult to follow, and susceptible to error. 
  • The interface of the black-box must be dynamic enough to allow for numerous changes in the calculation, to accommodate the intricate, specifically customized, aspects of each individual waterfall.   
  • The final workpaper should include additional “control checks”, applied to the final numbers, to gain comfort that an error was not made within the calculation.  Proper controls are essential to a waterfall calculation.  

The main issue is that the numbers produced from these calculations result in the movement of a significant amount of cash to either investors and/or Managers.  As such, proper controls and proper review, by a qualified person, are critical to ensure cash is moved appropriately.  

Therefore, although a black-box system could be somewhat helpful, we have not yet found a system that meets all the requirements outlined above. Our sense, when speaking to industry practitioners, is that the calculation is always re-performed in excel, and once a proper workpaper is developed to meet these requirements, an automated system becomes less relevant.  If a waterfall computation is developed properly, updating it, within the workpaper, should also be as easy as pushing a button.