What Is a Distribution Waterfall?
A distribution waterfall is a way to allocate investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall defines the pecking 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 fund's general partner to maximize profitability for its investors.
- A distribution waterfall spells out the order in which gains from a pooled investment are allocated between investors in the pool.
- It is often used in the context of hedge funds or private equity investment funds.
- Generally, there are four tiers in a distribution waterfall schedule: return of capital; preferred return; the catch-up tranche; and carried interest.
- There are two common types of waterfall structures: American, which favors the investment manager; and European, which is more investor-friendly.
Understanding Distribution Waterfalls
A distribution waterfall describes the method by which capital is distributed to a fund's various investors as underlying investments are sold for gains. Essentially, the total capital gains earned are distributed according to a cascading structure made up of sequential tiers, hence the reference to a waterfall. When one tier's allocation requirements are fully satisfied, the excess funds are then subject to the allocation requirements of the next tier, and so on.
Though waterfall schedules may be customized, generally the four tiers in a distribution waterfall are:
- Return of capital (ROC) - 100% of distributions go to the investors until they recover all of their initial capital contributions.
- Preferred return - 100% 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% to 9%.
- Catch-up tranche - 100% of the distributions go to the sponsor of the fund until it receives a certain percentage of profits.
- 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 fund prospectus 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.
American vs. European Waterfall Structures
Investment waterfall mechanics are detailed in the distribution section of the private placement memorandum (PPM). 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 (also called Global-style) schedule is applied at an aggregate fund level. With this schedule, all distributions will go to investors, while 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.
Why Is It Called a Distribution Waterfall?
Imagine a waterfall cascading down into a series of vertically-aligned buckets. The water represents money, and the buckets represent investors, partners, or stakeholders. The water fills the first bucket first. The second bucket will fill only after the first is completely full and spills over. As water flows, more buckets are filled in the order in which they appear.
What's the Key Difference Between an American and European Distribution Waterfall?
In the European-style distribution waterfall, investors are given precedent over fund managers, whereas managers may be paid ahead of investors using the American-style waterfall.
How Do Private Equity and Hedge Fund Managers Get Paid?
Often, private equity and hedge funds will feature a two-and-twenty payment scheme. Under this, the fund managers retain 2% of assets under management (AUM) each year, plus 20% of any profits returned above some hurdle rate or benchmark.