Distribution Waterfall

A distribution waterfall is the mechanism that decides how money coming out of a private investment fund is divided between the investors, known as limited partners, and the manager, known as the general partner. It is written into the fund's limited partnership agreement as a sequence of tiers. Cash fills the first tier completely before any flows to the second, and so on, like water running down a series of pools. The waterfall determines when and how much the manager earns as its share of profits.

Waterfalls are used in private equity, venture capital, real estate, infrastructure and private credit funds. The same word is used in structured finance for the order of payments to noteholders, described under securitisation waterfall, and more generally under cash flow waterfall. In a fund, its purpose is to align the manager's reward with investors' results.

1. Return of capital. All distributions go to investors until they have received back the capital they contributed, usually including the fees and expenses they funded.
2. Preferred return. Investors then receive all distributions until they have earned a minimum annual return on their contributions, the preferred return or hurdle rate. A rate of 8% a year is a common market convention in buyout funds.
3. Catch-up. The general partner next receives most or all distributions until it has caught up to its agreed share of total profits.
4. Carried interest split. Remaining cash is divided in a fixed ratio, typically 80% to investors and 20% to the general partner. The general partner's share is its carried interest.

Not every fund uses all four. Many venture capital funds have no preferred return, and some agreements use a partial catch-up or tiered splits that rise once returns pass higher hurdles.

Suppose investors contributed 100 million, the fund's investments return 200 million in total, and the accumulated preferred return is 30 million. The first 100 million returns capital. The next 30 million pays the preferred return. In the catch-up tier, with a full catch-up and a 20% carry, the general partner receives 7.5 million, because 7.5 is 20% of the 37.5 million of profit distributed up to that point. The remaining 62.5 million is split 50 million to investors and 12.5 million to the general partner. In total the general partner receives 20 million, exactly 20% of the 100 million profit, and investors receive 180 million.

The tiers can be applied to the fund as a whole or to each investment separately.

• Whole-fund, or European, waterfall. The general partner receives no carry until investors have received back all contributed capital across the whole fund plus the preferred return. Carry arrives late in the fund's life, which protects investors.
• Deal-by-deal, or American, waterfall. The tiers are applied to each realised investment, usually after covering that deal's cost, any realised losses and write-downs on other deals, and a share of expenses. The general partner can receive carry early from successful exits, even if later deals fail.

Because the deal-by-deal model can overpay the manager, such funds include a clawback provision requiring the general partner to return excess carry at the end of the fund, often backed by an escrow of part of each carry payment or by personal guarantees from the carry recipients.

Several details change the economics. The preferred return may be simple or compounded, and may run from the date of each capital call or from when capital is invested. Management fees and fund expenses may or may not count as capital to be returned first. Recallable distributions allow the fund to reinvest early proceeds. Tax distributions permit advance payments to the general partner to cover tax on allocated income. The general partner's own investment, the general partner commitment, normally shares in distributions alongside each limited partner commitment and bears no carry.

Calculating the waterfall is one of the more complex tasks in private equity fund administration. The administrator tracks every contribution and distribution by date and investor, applies the agreement's definitions, and records carry on both a paid and an accrued basis. Each payment is explained to investors in a distribution notice. Auditors and investors review the calculation, and regulators, including the United States Securities and Exchange Commission, have taken action against managers that calculated carry or allocated expenses in ways not permitted by their fund documents.

Investors generally favour whole-fund waterfalls, strong clawbacks with escrow, and hurdles that apply after all fees. Managers value earlier access to carry, which helps them retain staff over a fund life of ten years or more. Guidance from the Institutional Limited Partners Association recommends whole-fund waterfalls, or deal-by-deal models with robust safeguards, and standard reporting templates so that investors can check calculations themselves. Open-ended and credit funds often replace the waterfall with a periodic performance fee measured against a high-water mark.

• Institutional Limited Partners Association