• 073 01/12/2018

    The calculation behind the catch-up provision that determines the general partner's (GP) carried interest at a private equity fund can cause some confusion. In this post we will explain the math in the Excel template available on ASM.

    For reference, the calculation refers to the second example cited in this DISTRIBUTION WATERFALL (follow link for Excel template). The language for the second example cited in the Excel file is as follows:

    First, 100% of all cash inflows to the LP until the cumulative distributions equal the original capital invested plus some preferred return.  

    Second, a "20% catch up" to the GP equivalent to 20% of the of the distributions realized in step 1 plus the distributions realized in this step. 

    Third, thereafter, cash flows in excess of distributions made in step 1 and step 2 (if any) are distributed 80% to the LP and 20% to the GP. 

    Based on the emails I receive, most of the confusion comes from the calculation used in the second step. So let's reframe the objective:  In step 2 you want the GP to receive 20% of all distributions up to and including step 2. For this exercise, think about (All Distributions up to and including Step Two) as all cash flows received by both the GP and LP up to and including Step Two.

    If the GP is supposed to get 20% of (All Distributions up to and including Step Two), it follows that the LP has received 80% of (All Distributions up to Step Two):

    (All Distributions up to and including  Step Two) * 0.8 = (LP First Distribution)

    (All Distributions up to and including Step Two) = (LP First Distribution) /0.8 

    And since the GP only receives what is not allocated to the LP (what the GP receives = the catch up):

    (Catch Up) = (LP First Distribution) /0.8 - (LP First Distribution)

    If subtracting the "(LP First Distribution)" is confusing, think about it this way (different formula, same result):

    (Catch Up) = ((LP First Distribution) /0.8)*0.2


    To help this sink in I thought I would provide an additional way to think through this exercise: The Catch Up is equal to 20% of all cash flows received in both steps 1 and 2. It follows that:

    C = Catch Up

    P = LP return in First Distribution


    C = 0.2*P + 0.2*C

    0.8*C = 0.2*P

    C = P*0.2/0.8


    C = P * 0.25

    For the exercise I thought the first approach would make it easier to follow the formulas (I find the 0.25 in the second formula has the potential to be confusing), but generally multiple examples help.

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  • 072 09/20/2017

    EBITDA is often criticized as an imperfect measure of earnings to use broadly in comparing the profitability of companies across industries. But the concept wasn't developed for this purpose. It was invented by billionaire investor John Malone.

    If you are unfamiliar with John Malone, the two most important things to know about him for the purpose of this post are as follows. First, he is incredibly good at buying cable systems:

    “Few people have made more money for investors over the past three decades than John Malone. The billionaire cable-TV investor and operator parlayed a small group of cable systems, originally assembled in the 1970s, into Tele-Communications Inc., before selling it to AT&T in 1999 for $48 billion.” [1]

    And second, he is excellent at avoiding taxes:

    “No other executive in the U.S. has mastered the intricacies of the tax code to the same extent that Malone has,” says New York tax expert Robert Willens. “We are consistently in awe of the structures he and his advisors come up with to rearrange his extensive holdings, always without tax consequences, in the most advantageous way.” [2]

    Early in his career, as he began to consolidate cable systems in the 70s, Malone realized that scale provided a tremendous advantage in cable television. The larger the company, the more leverage that company had to negotiate lower programming costs per subscriber. Since programming costs were the largest single operating expense, the largest cable operator would always have a significant advantage over the rest of the market.

    Author William Thorndike elaborates on this approach and brilliantly reveals why Malone focused Wall Street’s attention on EBITDA in his book
    The Outsiders:

    “Related to this central idea was Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.”


    “In lieu of EPS, Malone emphasized cash flow to lenders and investors, and in the process invented a new vocabulary, one that today’s managers and investors take for granted. Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges." [3]

    Throughout the text Thorndike emphasizes how unconventional this approach was, but it is by no means the first time new metrics or language have been introduced to support valuation. The oldest example is perhaps that of putting the word "trading" before "sardine" as Seth Klarman describes in Margin of Safety:

    “There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.” [4]

    And you don't have to go that far back in time for equally inappropriate examples. In 2000 "eyeballs" could be monetized (right up until they couldn't). EBITDA, in this context, may just be the most appropriate invented metric to withstand the test of time. Before his competitors adopted it's use, Malone developed an advantage over the rest of the market by getting investors and lenders to focus on this figure over net income. Today it is an industry standard, but hopefully this origin story will motivate readers to evaluate EBITDA with the suspicion it deserves when offered as a proxy for cash flow.


    [1] Liberty Media: Better than Berkshire
    [2] Liberty Media: Better than Berkshire
    [3] Thorndike, Wiliam The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, p. 91
    [4] Klarman, Seth Margin of Safety, p. 5


  • 071 08/21/2017

    I have been working with a friend of mine who prefers to remain anonymous and happens to be a real estate professional to develop a simple real estate distribution waterfall (I will refer to him as Dimitri for the purpose of this post). Our working relationship consists of me interrupting his day with short emails containing Excel templates and bulleted questions, which he graciously responds to with quick answers pulling from years of experience. It’s a highly iterative process that hopefully consumes little of his time.

    Last week we developed a bare bones real estate distribution waterfall that, per his feedback, was as simple as it could be without risking oversimplification: a fine line this website attempts to navigate each time new content is posted.

    I thought I would include the commentary he provided that did not make it into the template as I believe it provides insights that would otherwise be lost. The template referenced in the comments that follow can be downloaded HERE.

    Funds Invested: The distribution waterfall generally does not take into consideration whether or not the sponsor (GP) invested capital. If the sponsor elects to invest capital it is generally invested on the same terms as the LP capital. For this reason the split between LP capital invested and sponsor capital invested is of little significance to the distribution waterfall.

    We decided to keep this feature in the waterfall with the input for percentage of sponsor capital invested set to 0% because the template currently calculates how much the LPs and the sponsor will have to put up in the event of a cash shortfall.

    IRR and MOIC Hurdles: This template focuses on multiple IRR hurdles that define how cash flows are split between the LP and GP. In addition to IRR hurdles, a more advanced distribution waterfall would allow for the measurement of a specific IRR or multiple of invested capital (MOIC) at each hurdle.

    The purpose of including MOIC is to control for time horizon. IRR calculations are sensitive to time horizon and MOIC calculations are not. By including MOIC the LP is protected in two ways:

    • MOIC Provides Short Term Protection: If the sponsor receives an incredible offer months after making the initial acquisition of a property it will result in a high IRR. But it is unlikely that someone would offer a sufficient multiple of invested capital (MOIC) to trigger hurdles more favorable to the GP.
    • IRR Provides Long Term Protection: If the sponsor waits a decade to sell the property, they might achieve a multiple of invested capital what would have been appropriate for a 5-year hold period. On a longer time horizon IRR protects against this discrepancy.


    Concluding Remarks: After several iterations Dimitri finally came around; “I actually really like this. Nice and simple. But I would want more context surrounding the cash flows.” He elaborated in the email that a novice should spend more time understanding the transaction before taking the time to focus on how the proceeds are split between investors and the sponsor behind the deal.

    Fortunately ASM has a template for a multifamily property: LINK.

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Models are:
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above



*Answers a, b, c, d, e, f and g are all correct.