What Is a Distribution Waterfall?

What Is a Distribution Waterfall?

Let me explain to you what a distribution waterfall is in private equity. It's a structured approach to allocating returns among investors, mainly benefiting general and limited partners. This tiered system ensures maximized returns through strategic profit sharing, and there are notable differences between American and European structures that influence how capital gets distributed. You need to understand these mechanisms if you're navigating the complexities of private equity funds effectively.

Key Takeaways

Distribution waterfalls prioritize how investment returns are allocated in private equity funds, often favoring general partners. The waterfall system involves sequential tiers, including return of capital, preferred return, catch-up tranche, and carried interest. American distribution waterfalls benefit general partners with earlier profit access, while European waterfalls prioritize investors' returns first. The 'two-and-twenty' model used by funds includes a 2% management fee and 20% of profits over a benchmark for managers. Hurdle rates and clawback provisions are essential components of distribution waterfalls, protecting investors from excessive fees.

Understanding the Mechanics of Distribution Waterfalls

A distribution waterfall describes the method by which capital is distributed to a fund's various investors as underlying investments are sold for gains. Capital gains are distributed through a cascading structure of sequential tiers, like a waterfall. Once funds fill one tier, the excess moves to the next tier, continuing the process.

While waterfall schedules can vary, they generally have four tiers. First, there's return of capital (ROC), where 100% of distributions go to the investors until they recover all of their initial capital contributions. Next is preferred return, where 100% of further distributions go to investors until they receive the preferred return on their investment—usually around 7% to 9%. Then comes the catch-up tranche, where 100% of the distributions go to the sponsor of the fund until it receives a certain percentage of profits. Finally, carried interest is a stated percentage of distributions that the sponsor receives, and this percentage must match the one in the third tier.

Hurdle rates for the schedule also may be tiered, depending on the total amount of carried interest of the general partners. Generally, more carried interest means a higher hurdle rate. A feature called 'clawback' is often included to protect investors from overpaying incentive fees—if this happens, the manager must repay the excess fees.

American vs. European Waterfall Structures: Key Differences

Details about investment waterfall mechanics are in the distribution section of the private placement memorandum (PPM). There are two common types of waterfall structures—American, which favors the general partner, and European, which is more investor-friendly.

An American-style distribution schedule is applied on a deal-by-deal basis, and not at the fund level. The American schedule spreads the total risk over all the deals and is more beneficial to the general partners of the fund. This structure allows for managers to get paid prior to investors receiving all their invested capital and preferred return, though the investor is still entitled to these.

A European-style distribution (also called Global-style) schedule is applied at an aggregate fund level. With this schedule, all distributions will go to investors, while the manager will not participate in any profits until the investor’s capital and preferred return have been fully satisfied. A drawback is that the majority of the manager’s profits may not be realized for several years after the initial investment.

Why Is It Called a Distribution Waterfall?

Picture a waterfall pouring into vertically-aligned buckets. The water symbolizes money, and the buckets represent investors or partners. The water fills the first bucket first. The second bucket will fill only after the first is completely full and spills over. As water flows, it fills each bucket in sequence.

What's the Key Difference Between an American and European Distribution Waterfall?

In the European-style distribution waterfall, investors are given precedent over fund managers, whereas managers may be paid ahead of investors using the American-style waterfall.

How Do Private Equity and Hedge Fund Managers Get Paid?

Private equity and hedge funds often use a two-and-twenty payment scheme. Under this, the fund managers retain 2% of assets under management (AUM) each year, plus 20% of any profits returned above some hurdle rate or benchmark.

The Bottom Line

Distribution waterfalls play a crucial role in private equity investments by systematically allocating returns among investors. This structured method consists of distinct tiers—return of capital, preferred return, catch-up tranche, and carried interest—that dictate the flow of capital gains. Understanding the differences between American and European waterfalls is essential, as they offer varied benefits for limited and general partners. Familiarity with terms like 'hurdle rates' and 'clawback' further equips you to make informed decisions. This knowledge can empower both beginners and seasoned investors in navigating the complexities of private equity fund distributions.