Distribution Waterfall

The way in which capital gains of a fund are allocated between the participants in an investment

Written by CFI Team

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What is a Distribution Waterfall?

A distribution waterfall is a popular term in equity investing that refers to the way in which capital gains of a fund are allocated between the participants in an investment, typically the limited partners (LPs) and the general partner (GP).

Distribution Waterfall - Sample — Fig.1: Sample Distribution Waterfall (Source)

The capital of limited partners is managed by the general partner in a private equity fund. The general partner himself contributes a relatively small proportion of the total investment. Distribution waterfall structures are put in place primarily to ensure that profits are allocated to the manager only after the limited partners have received the agreed return on their investment. The structures are detailed in the distribution section of the private placement memorandum (PPM).

Summary

A distribution waterfall is a popular term in equity investing that refers to the way in which capital gains of a fund are allocated between the participants in an investment, typically the limited partners (LPs) and the general partner (GP).
Its main purpose is to align incentives for the general partner and define a pay structure for limited partners.
It generally comprises four cascading tiers: the return of capital, preferred return, catch-up, and carried interest.
The European and American distribution waterfalls are the most common types of waterfall structures; the former favors the investors while the latter leans towards the manager.

Importance of the Distribution Waterfall

A distribution waterfall lays down the rules and procedures for the distribution of profits in a private equity investment agreement. Its main purpose is to align incentives for the general partner and define a pay structure for limited partners.

The distribution structure can be visualized as a set of buckets placed one below the other. Each bucket defines an allocation of profits. When the first bucket is filled to the brim, the profits flow into the second bucket, and so on.

In such a manner, the capital flows from limited partners (favored by the initial buckets) to the general partner (favored by buckets further away from the source). Such a structure of allocation protects the interests of the investors and, at the same time, incentivizes the general partner to maximize the return of the fund.

Tiers in a Distribution Waterfall Structure

The allocation in question derives its name from the cascading nature of its four constituent tiers, which are shown below.

In addition, the hurdle rate, which is the minimum rate of return on an investment required by an investor, can be another tier. In case an excessive incentive fee is given to the manager or general partner, a “clawback” clause in the PPM mandates the return of such excess fees.

The four tiers are:

Return of Capital: The initial capital investments of investors, plus some expenses and fees, are returned to them.

Preferred Return: 100% of the distribution goes to the LPs until the preferred internal rate of return based on every distribution to them and every contribution called is reached.

Catch-up: The catch-up bucket is highly favorable to the general partner. They are given all or a major portion of the gain until they receive a certain percentage of profits.

Carried Interest: It constitutes the allocation of the remaining amount between the limited and general partners.

European Waterfall vs. American Waterfall

The European or global waterfall distribution is applied at an aggregate fund level. It gives precedence to the distribution of initial capital investment and a preferred return to the investors over the distribution of profits to the general partner/manager. The biggest drawback to the European structure is the payment structure of the manager, who may be demotivated to maximize investment returns in the long term.

On the other hand, the American waterfall distribution is applied on a deal-by-deal basis. It favors the general partners over limited partners of the fund and gives precedence to the distribution of profits to the GP. However, it may include a “clawback” clause in the agreement to make the equity fund attractive to investors.