Every partnership agreement should address how and when its cash is distributed to its partners. In the simple deal, the partners share cash according to a fixed metric, like “percentage interest”. In more complicated cases, partners share cash according to a waterfall with several steps, each step providing for a different cash split among the partners. For example, partnership waterfall provisions may provide that “available cash” is distributed as follows:

• First, to Limited Partners (LPs) until the LPs have been returned all Invested Capital;
• Second, 10% to the General Partner (GP) and 90% to the LPs until the LPs have achieved a 10% (Internal Rate of Return) IRR;
• Third, 15% to the GP and 85% to the LPs until the LPs have achieved a 15% IRR;
• The balance, 20% to the GP and 80% to the LPs.

The partnership agreement defines the term “available cash” and usually directs the managers or general partners to calculate and distribute “available cash” at certain times or in management’s discretion. The partnership agreement also typically defines the term “Internal Rate of Return”. A typical Internal Rate of Return provision reads as follows:

“Internal Rate of Return” as to a Unitholder as of a given time means the discount rate that would equate the net present value of Unitholder’s Capital Contributions as of that time to zero dollars. The Internal Rate of Return shall be calculated using Microsoft Excel’s XIRR function.

Defining the Internal Rate of Return with reference to how it will be calculated is a good thing. However, we don’t need to define what the discount rate is. That’s a given. The waterfall designates the rates of return for each distribution step. That rate of return is the discount rate. We also know the present value and the compounding periods. The future value is the only unknown. So, in defining the Internal Rate of Return, we need to define it with the goal of determining the future value (i.e., the distribution amount).

So, now you might be thinking, “let’s use the FV (future value) Microsoft function to determine the payment amount.” But, that would not be right. The Microsoft FV function is quite limited. It only works if all of the distribution amounts are the same. That’s seldom the case.

So, maybe we use the Microsoft XIRR function after all. Unfortunately, though, Microsoft XIRR function uses annual compounding. If your internal rate of return analysis of investments requires a different compounding period, Microsoft XIRR will not be useful. You’d have to adjust for the annual compounding. That’s a lot of work.

Unfortunately, the Microsoft IRR and NPV functions are not any more useful. Those functions assume that payments are made on a regular basis, like quarterly or monthly.

So, how should Internal Rate of Return be determined? The simplest approach includes using a Microsoft function with some assumptions. For example, you can use the XIRR function if all partners agree to annual compounding. You can also use the IRR function assuming that all payments are made as of a given date, regardless of when made. So, for example, you can provide in the partnership agreement that each distribution is made as of the last day of the quarter within which it is actually made.

The simple approach of using a Microsoft comes with a cost. An investor who relies on accurate internal rate of return to compare investment options will likely be unsatisfied with using a Microsoft function.  In the alternative, the investor might require that higher internal rates of return from the partnership investment to take account of the risk that cash might not flow in the way assumed for purposes of the chosen Microsoft function.

In any case, regardless of how you mechanically determine the internal rate of return, it needs to be defined in a way that provides a path to determine future value. Bradley Borden, a law professor at Brooklyn College of Law, wrote an excellent article on this topic. The article first appeared in a 2014 edition of Tax Notes. It was republished about a year ago. In that article, Brad walks through the technical financial logic behind the internal rate of return. He then suggests language for a good internal rate of return definition.

Brad’s suggested approach is very good. It is one of many that can be used. Whether you use Brad’s approach or another accurate approach does not matter so much. Properly defining “Internal Rate of Return” to provide a path for determining distribution amounts does matter. It matters to your investor partners. It also matters to the “general partners”, too. It would be a good practice for all of us who draft partnership waterfall provisions to draft accordingly.

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