Distribution of Equity Funds
By: Michael Megarit
A private equity fund distribution determines how capital gains are allocated between the participants in an investment. The distribution defines the method in which the gains are allocated to limited and general partner. Most often, general partners receive a disproportionately larger share of the total profits relative to their initial investments once the allocation process is complete. This is particularly done in order to incentivize general partners and maximize profitability.
The general partner manages the committed capital of the limited partners and usually committed some amount of the fund, typically 1 to 2% of the total commitment. When the distributions of the capital are made back to the investor, usually with an added value, the general partner allocates the amount based on a structure previously agreed upon in the Limited Partnership Agreement. The total capital gained is usually distributed according to a cascading structure made of tiers. In this case, when one tier’s allocation requirements are satisfied, the excess funds are subject to the allocation requirements of the next tier.
The tires within a distribution include:
Return of capital: 100% of the distributions go to the investors until they have recovered their initial capital contribution/investments. This usually includes the capital called for investments, plus some expenses and fees. The various return to capital includes the total investment contribution, which is the total capital contributed for investments. The realized investment contribution is the capital contributed to investments that are either fully realized or liquidated. Investment and Expenses is the total capital contributed for investments while specific investment contribution is the capital contributed to the specific investment.
Preferred return: 100 % of further distributions will go to investors until they receive the preferred return on their investments. Typically, the preferred rate of return for this tier is 7 to 9%. The various forms include the capital contributed, which is the IRR calculated based on every distribution to the limited partnership and every contribution called for investments. The global IRR is usually calculated based on every distribution of the limited partnership and every contribution called.
Catch-up tranche: 100% of the distribution will usually go to the sponsor of the fund until it receives a certain percentage of profits. The catch up is usually defined by the allocation at 80% of GP and 20% of LP as well as a target. The various forms include the proportion of the LP profit as well as the proportion of the total profit.
Carried interest: This is the stated percentage of distributions that the sponsor normally receives. Notably, the stated percentage must match the stated percentage in the third tier. This is a simple allocation of the remaining amount between LP and GP
Claw Back Clause
During the liquidation of the fund, if the LPs were distributed less than the agreed preferred return, they claw back the missing amount from the carried interest distributed to the GP. A Claw Back provision allows the LPs to “claw back” any carry paid during the life of the fund on previous portfolio investments in order to normalize the final carry to the originally agreed percentage.