What is a Distribution Waterfall

The distribution waterfall is the order in which a private equity fund makes distributions to limited and general partners.

BREAKING DOWN 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). There are two common types of waterfall structures, American and European, and they can exist in either an individual deal or fund structure.

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.

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 their preferred return and 100 percent of invested capital. In this structure, a manager could receive a disproportionate share of cash flow right away. 

Distribution waterfall schedules

Though tiers may be customized, generally, the four tiers in a distribution waterfall schedule are: return of capital; preferred return; catch-up and carried interest. With return of capital, 100 percent of distributions go to the investors until they recover all of their initial capital contributions. In 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. The catch-up tranche is structured so 100 percent 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. 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. The clawback feature is detailed in the PPM and entitles investors to be repaid any incentive fees taken by the manager during the life of the investment.