A distribution waterfall provides a structured method to allocate investment returns or capital gains among participants in a group or pooled investment. This mechanism is commonly utilized within private equity funds to define the sequence in which distributions are allocated to limited and general partners.
Typically, general partners receive a disproportionately larger share of the total profits once the entire allocation process concludes. This aims to incentivize the fund’s general partner to maximize profitability for its investors.
Key Takeaways
- A distribution waterfall outlines the order in which gains from a pooled investment are allocated among investors.
- Frequently applied in hedge funds or private equity investment funds.
- Generally, there are four tiers in a distribution waterfall schedule: return of capital; preferred return; the catch-up tranche; and carried interest.
- Two common types of waterfall structures: American, which tends to favor the investment manager; and European, perceived to be more investor-friendly.
Understanding Distribution Waterfalls
A distribution waterfall details the method by which capital is distributed to a fund’s various investors as underlying investments are sold for gains. Essentially, the total capital gains are distributed according to a cascading tier structure, thus the reference to a waterfall. Once one tier’s criteria are met, any excess funds flow to the next tier in sequence.
Typically, the four main tiers in a distribution waterfall include:
- Return of capital (ROC) - Allocates 100% of distributions to the investors until they recoup all of their initial capital contributions.
- Preferred return - Further distributions go to investors until they achieve the preferred return on their investment, often set between 7% to 9%.
- Catch-up tranche - Subsidizes the fund’s sponsor until they receive a specific percentage of profits.
- Carried interest - A delineated percentage of distributions apportioned to the sponsor, matching the stated percentage in the catch-up tranche.
Additionally, hurdle rates for the schedule can vary based on the total carried interest of the general partners. More carried interest often corresponds with higher hurdle rates. A “clawback” provision might also be included to safeguard investors from paying excess incentive fees, requiring managers to return unjustified fees if such a situation arises.
American vs. European Waterfall Structures
Investment waterfall details are typically outlined in the distribution section of the private placement memorandum (PPM). Common waterfall structures include:
- An American-style schedule, which applies on a deal-by-deal basis rather than at the fund level. This structure disperses risk across all deals and is more advantageous for the general partners. Managers may receive payments before investors recover their initial capital and preferred return, though the investor’s entitlements remain intact.
- A European-style schedule, applied at an aggregate fund level. Under this scheme, all distributions go exclusively to investors until they recover their capital and preferred return. Managers’ profits might not be realized for several years post the initial investment.
Why Is It Called a Distribution Waterfall?
Imagine a waterfall cascading down into a series of vertically-aligned buckets. The water symbolizes money, and the buckets signify investors, partners, or stakeholders. As water fills the first bucket, it overflows to the next only when it’s completely full, continuing down the line in sequence.
Key Differences Between American and European Distribution Waterfalls
In a European-style distribution waterfall, investors receive distributions before fund managers, whereas, in the American-style waterfall, managers can be paid ahead of investors.
Compensation for Private Equity and Hedge Fund Managers
Often, private equity and hedge funds subscribe to a two-and-twenty payment scheme. This allows fund managers to retain 2% of assets under management (AUM) annually, in addition to 20% of profits exceeding a specific hurdle rate or benchmark.
Related Terms: capital gains, private equity, distribution, general partner, return of capital, carried interest, hurdle rates, clawback, preferred return.
