1. Summary
  2. Distribution Waterfall
  3. Importance of the Distribution waterfall
  4. Understanding Distribution Waterfalls


Imagine a waterfall cascading down into a series of vertically-aligned buckets. The water represents cash, and also the buckets represent investors, partners, or stakeholders. The water fills the primary bucket first. The second bucket can fill solely when the primary is full and spills over.

Distribution Waterfall

A distribution waterfall may be thanks to assigning investment returns or capital gains among participants of a bunch or pooled investment. Usually related to personal equity funds, the distribution waterfall defines the chain of command during which distributions are allotted to restricted and general partners.

Usually, the final partners receive a disproportionately larger share of the entire profits relative to their initial investment once the allocation method is complete. This can be done to incentivize the fund’s general partner to maximize profit for its investors.

  • A distribution waterfall spells out the order during which gains from a pooled investment are allotted between investors within the pool.
  • It is usually employed in the context of hedge funds or personal equity assets.
  • Generally, there are four tiers in a very distributed waterfall schedule: come of capital; most popular return; the catch-up tranche; and carried interest.
  • There are 2 common varieties of the waterfall structures: yank, which favours the investment manager; and European, which is a lot of investor-friendly.

Importance of the Distribution waterfall

A distribution waterfall lays down the principles and procedures for the distribution of profits in a very personal equity investment agreement. Its main purpose is to align incentives for the final partner and outline a pay structure for restricted partners.

The distribution structure may be envisioned as a collection of buckets placed one below the opposite. every bucket defines an allocation of profits. once the primary bucket is crammed to the brim, the profits flow into the second bucket, and so on.

In such a way, the capital flows from restricted partners (favored by the initial buckets) to the final partner (favored by buckets any off from the source). Such a structure of allocation protects the interests of the investors and, at a similar time, incentivizes the final partner to maximize the come of the fund.

Understanding Distribution Waterfalls

A distribution waterfall describes the tactic by that capital is distributed to a fund’s varied investors as underlying investments are sold out for gains. the entire capital gains attained are distributed in keeping with a cascading structure created of ordered tiers, therefore the relevance of a waterfall. once one tier’s allocation necessities are happy, the surplus funds are then subject to the allocation necessities of the consequent tier, and so on.

Though the waterfall schedules is also tailored, typically the four tiers in a very distributed waterfall are:

  1. Return of capital (ROC) – 100% of distributions head to the investors till they recover all of their initial capital contributions.
  2. Preferred Return – 100% of any distributions head to investors till they receive the popular come on their investment. Usually, the popular rate of coming for this tier is close to seven-membered to the 11th of September.
  3. Catch-up part – 100% of the distributions head to the sponsor of the fund till it receives a definite share of profits.
  4. Carried interest – A expressed share of distributions that the sponsor receives. The expressed share within the fourth tier should match the expressed share within the third tier.

Hurdle rates for the schedule additionally are also layer, reckoning on the entire quantity of carried interest of the final partners. Typically, a lot of carried interest, the upper the hurdle rate. in addition, a feature referred to as “clawback” is often enclosed within the fund prospectus and is supposed to shield investors from paying a lot of incentive fees than needed. just in case such a happening, the manager is beholden to pay back the surplus fees.

American vs. European waterfall Structures

The investment waterfall mechanics is elaborated within the distribution section of the personal placement note (PPM). There are 2 common varieties of the waterfall structures – yank, which favours the final partner, and European, which is a lot of investor-friendly.

  • An American-style distribution schedule is applied on a deal-by-deal basis, and not at the fund level. The yank schedule spreads the entire risk over all the deals and is a lot useful to the final partners of the fund. This structure permits managers to induce payment before investors receive all their endowed capital and most popular come, tho’ the capitalist remains entitled to those.
  • A European-style distribution (also referred to as Global-style) schedule is applied at the combination fund level. With this schedule, all distributions can head to investors, whereas the manager won’t participate in any profits till the investor’s capital and most popular come are happy. A downside is that the bulk of the manager’s profits might not be accomplished for many years when the initial investment.