Sample interview questions: Can you explain the concept of cash flow waterfalls and how they are used in private equity?
Sample answer:
Understanding Cash Flow Waterfalls and Their Importance in Private Equity
Cash flow waterfalls are financial models used in private equity (PE) to distribute cash proceeds to various stakeholders and investors in a structured manner. They provide a roadmap for how cash is allocated among limited partners (LPs), general partners (GPs), and other parties involved in a PE investment. The primary objectives of cash flow waterfalls are:
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Fair Distribution of Cash: Ensure that all stakeholders are compensated in a fair and equitable manner. This helps mitigate potential conflicts and create alignment of interests.
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Incentivizing Performance: Encourage GPs and investment managers to maximize returns for investors. By linking compensation to performance, GPs are motivated to make sound investment decisions that generate positive cash flows.
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Transparency: Provide clarity and predictability in the distribution of cash proceeds. LPs can evaluate the potential returns and risks associated with an investment by understanding the waterfall structure.
Typical Structure of Cash Flow Waterfalls:
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Preferred Return: LPs typically receive a preferred return on their invested capital before any other distributions are made. This is a fixed percentage return, usually ranging from 7% to 9%.
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Hurdle Rate: Once the preferred return is met, the GP may receive a hurdle rate, which is a minimum threshold return before they can participate in the distribution of profits. This is usually set between 6% to 8%.
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Carry: The carry is the share of profits distributed to the GP after the hurdle rate is reached. This is typically a percentage of the remaining cash flow, often ranging from 20% to 30%.
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Waterfall Distribution: Additional returns above the carry are then distributed among LPs and GP according to a predetermined waterfall structure. Common variations include:
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Equal Split: Cash flow is split equitably between LPs a… Read full answer
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