What is a Distribution Waterfall?

A distribution waterfall delineates the method by which capital gains are allocated between the participants in an investment. Commonly associated with private equity funds, the distribution waterfall defines the order in which distributions are allocated to limited and general partners. Usually, the general partners receive a disproportionately larger share of the total profits relative to their initial investment once the allocation process is complete. This is done to incentivize the general partner to maximize profitability.

Understanding Distribution Waterfall

A distribution waterfall describes the method by which capital is distributed to a fund's investors as underlying investments are sold. Investment waterfalls are detailed in the distribution section of the private placement memorandum (PPM).

Essentially, the total capital gained is distributed according to a cascading structure made up of tiers, hence the reference to a waterfall. When one tier's allocation requirements are satisfied then the excess funds are subject to the allocation requirements of the next tier and so on.

Though tiers may be customized, generally, the four tiers in a distribution waterfall schedule are:

  1. Return of capital - 100 percent of distributions go to the investors until they recover all of their initial capital contributions.
  2. Preferred return - 100 percent of further distributions go to investors until they receive the preferred return on their investment. Usually, the preferred rate of return for this tier is approximately 7 percent to 9 percent.
  3. Catch-up tranche - 100 percent of the distributions go to the sponsor of the fund until it receives a certain percentage of profits.
  4. Carried interest - a stated percentage of distributions that the sponsor receives. The stated percentage in the fourth tier must match the stated percentage in the third tier.

Hurdle rates for the schedule also may be tiered, depending on the total amount of carried interest of the general partners. Typically, the more carried interest, the higher the hurdle rate. Additionally, a feature called "clawback" is frequently included in the PPM and is meant to protect investors from paying more incentive fees than required. In case of such an occurrence, the manager is obligated to pay back the excess fees.

Key Takeaways

  • A distribution waterfall delineates the method by which capital gains are allocated between the participants in an investment.
  • Generally, the four tiers in a distribution waterfall schedule are - return of capital, preferred return, catch-up tranche, and carried interest.
  • There are two common types of waterfall structures - American, which favors the manager, and European, which is more investor friendly.

American vs European Waterfall Structures

There are two common types of waterfall structures - American, which favors the general partner, and European, which is more investor friendly.

An American-style distribution schedule is applied on a deal-by-deal basis, and not at the fund level. The American schedule spreads the total risk over all the deals and is more beneficial to the general partners of the fund. This structure allows for managers to get paid prior to investors receiving all their invested capital and preferred return, though the investor is still entitled to these.

A European-style distribution schedule is applied at an aggregate fund level. With this schedule, all distributions will go to investors and the manager will not participate in any profits until the investor’s capital and preferred return have been fully satisfied. A drawback is that the majority of the manager’s profits may not be realized for several years after the initial investment.