By Mariya Stefanova, PEAI
Over the past few years, in addition to our Carry/Fee Validation services for Limited Partners (LPs), our Waterfall Model Certification Services for General Partners (GPs) have gotten quite a boost. We have noticed a clear trend of increased interest by GPs in having their waterfall models either just informally reviewed or fully scored and certified by an independent third-party expert, and on certain occasions when the models were falling flat, some GPs had them completely rebuilt from scratch up to a higher standard.
ome of the GPs we performed
waterfall reviews for just wanted to
get an idea of how accurate,
robust and compliant (with the Limited Partnership Agreement (LPA)) their
models were, others sought an
endorsement through our carry
certification services to serve as a proof
to third parties (e.g. LPs, auditors,
Advisory Boards, etc.) interested in the
This trend is no surprise since there has been a lot of pressure from LPs, legislators and regulators towards more fee transparency and fee validation is becoming very popular amongst LPs, so what is happening now is that clever GPs are trying to preempt future enquiries into their waterfall calculation from LPs which need an assurance that carry has been calculated by the GP accurately and in compliance (LPA). By doing this, the GP is in the clear. In addition to that, since it is done for investor protection, similarly to the standard audit, the GPs have grounds to charge the carry verification/certification fee to the fund instead of the Manager, subject to the provisions of the LPA. From an LP perspective, waterfall selfcertification is another way for the LPs to get the GPs to have their carry calculation certified instead of the LPs having to perform their own carry validation which is usually a hassle as it would typically involve a Request for Proposal (RFP) for a pension plan and the fully-outsourced carry/fee validation services cost a good amount of money to the LP which needs to be justified and budgeted for. The bill for the waterfall model certification/review may be ultimately picked by the LPs, but at least it will save the LP the hassle of going through painful lengthy procedures and requiring a formal approval.
As a result of these reviews, in order to quantify our observations from a GP carry review/certification, we have developed a scoring system which helps us measure the results of our findings and allows any interested (in the waterfall model) party, including the GP itself, to identify any issues with the model. It also represents an opportunity for the GP to have a fresh expert pair of eyes to look at their calculation and critically assess any potential flows, thus allowing them to fix these flows in their model.
In this article, we’ll discuss our scoring system in the context of what is best practice and what is to be expected from a good waterfall model. Our scoring criteria are based on best-practice principles of financial modelling.
In Exhibit 1 below, we have provided a sample score for a GP waterfall model
The waterfall model scoring explained
In our waterfall model scoring system we use 13 criteria to assess a waterfall model – three of them are essential and ten are ancillary. Provided below are the thirteen criteria with a brief explanation of the nature of each criterion. We have assigned different weights to each criterion with the three essential criteria accounting for 80% of the total weigh and the remaining 20% are distributed (unevenly) between the other ten criteria.
The following three main/primary criteria are essential to the quality of the model:
Compliance This criterion assesses the compliance with the provisions of the LPA, reasonability of the interpretations and conservatism of the assumptions made where the LPA provisions are vague.