Distribution Waterfall in Private Equity
What is a distribution waterfall?
A distribution waterfall is the structured, tiered method private equity funds use to allocate realized returns among investors—typically limited partners (LPs) and the general partner (GP). Capital from asset sales flows through sequential tiers; each tier must be satisfied before distributions move to the next. Waterfalls determine who gets paid, when, and how much.
How it works — the common tiers
While implementations vary, most waterfalls follow four sequential steps:
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Return of capital (ROC)
All distributions go to LPs until they recover their contributed capital. -
Preferred return (hurdle)
Further distributions go to LPs until they receive a specified annual return (commonly ~7–9%). -
Catch-up tranche
Distributions shift to the GP—often at a high percentage—until the GP has reached its agreed share of profits relative to the LPs. -
Carried interest (carry)
Once prior tiers are satisfied, the GP receives a stated percentage of remaining profits (often 20%).
Hurdle rates and clawbacks
Hurdle rates (preferred returns) set the minimum return LPs must receive before the GP earns incentive fees. Clawback provisions protect LPs by requiring the GP to return excess carried interest if later results show the GP was overpaid across the fund’s life.
American vs. European waterfall structures
Two common allocation approaches affect timing and risk:
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American (deal-by-deal)
Carried interest can be paid on individual profitable deals before the fund-level return-of-capital or preferred return is fully satisfied. This favors GPs by accelerating incentive compensation but can expose LPs to greater timing risk. -
European (global/fund-level)
Distributions are assessed at the aggregate fund level. GPs receive carry only after LPs have recovered all contributed capital and the preferred return. This is more protective for LPs but can delay GP compensation.
Analogy
Think of the distribution as water filling vertically stacked buckets. The first bucket (return of capital) must be filled before any overflow reaches the next (preferred return), and so on until all buckets are satisfied.
How managers typically get paid
A common fee model is “two-and-twenty”: a 2% annual management fee on assets under management plus 20% of profits above the hurdle as carried interest. Exact terms vary by fund.
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Key takeaways
- A distribution waterfall prescribes the order and conditions for splitting proceeds between LPs and the GP.
- Typical tiers: return of capital → preferred return → catch-up → carried interest.
- American waterfalls allow earlier GP payouts on a deal-by-deal basis; European waterfalls require fund-level satisfaction of LP claims first.
- Hurdle rates and clawback provisions are important protections for investors.
- Familiarity with a fund’s waterfall is essential before investing—it determines timing, risk allocation, and the GP’s incentives.
Frequently asked questions
Q: Why is it called a waterfall?
A: Because cash distributions cascade through ordered tiers—each tier must be filled before the next receives funds, like water spilling from one bucket to the next.
Q: What’s the main practical difference between American and European waterfalls?
A: The timing of GP compensation: American structures can pay GPs earlier on profitable deals; European structures prioritize returning capital and preferred returns to LPs before paying carry.