What is a 'Distribution Waterfall'
The distribution waterfall is the order in which a private equity fund makes distributions to limited and general partners. It is a hierarchy delineating the order in which funds are distributed and may ensure different types of investors have priority of payment compared to others within the same fund. A distribution waterfall describes the method by which capital is distributed to a fund's investors as underlying investments are sold.
BREAKING DOWN 'Distribution Waterfall'A distribution waterfall specifies, for example, that an investor receives his initial investment plus a preferred return before the general partners can participate in the profits of the fund. Such an arrangement can increase the investor's confidence in the equity fund and its potential profitability.
Typical Tiers in a Distribution Waterfall Schedule
Though tiers may be customized, in general, there are four tiers involved in a typical distribution waterfall schedule. These are:
First Tier - The return of capital tier
Second Tier - The preferred return tier
Third Tier - The catch-up tier
Fourth Tier - The carried interest tier
The first tier is structured so 100% of distributions go to the investors until they recover all of their initial capital contributions. The second tier is structured so 100% of further distributions go to investors until they receive the "preferred return" on their investment. This preferred return is also commonly known as a hurdle rate. Usually, the preferred rate of return for this second tier is approximately 7 to 9%. The third tier, the catch-up tranche, is structured so 100% of the distributions go to the sponsor of the fund until it receives a certain percentage of profits. The fourth tier is structured so the sponsor receives a stated percentage of distributions as carried interest. The stated percentage in the fourth tier must match the stated percentage in the third tier.
Types of Distribution Waterfall Schedules
Distribution waterfall schedules are either European style or American style. A European style distribution schedule means the stated schedule is applied at an aggregate fund level. An American style distribution schedule is applied on a deal-by-deal basis, and not at the fund level. The American style schedule spreads the total risk over all the deals and is more beneficial to the general partners of the fund.
Hurdle rates for the schedule may also be tiered, depending on the total amount of carried interest of the general partners. Typically, the more carried interest, the higher the hurdle rate.