Distribution Waterfall

Distribution waterfall is a financial term used primarily in the context of private equity and investment funds. It refers to the hierarchical structure for distributing profits or returns from an investment among various stakeholders, typically in a predetermined sequence.

The private equity distribution waterfall in investment funds ensures fair returns for investors and fund managers. There are often multiple classes of investors with different priority levels in terms of receiving distributions. It sets out the order in which these investors are entitled to receive their share of profits and the percentage of profits they are eligible to receive.

• Distribution waterfall is a financial term used primarily in the context of private equity and investment funds.
• It refers to the hierarchical structure for distributing profits or returns from an investment among various stakeholders, typically in a predetermined sequence.
• It can be highly flexible and customizable, allowing fund managers and investors to tailor the preferred return, carried interest, and splits to suit specific investment strategies.
• It sets out the order in which these investors are entitled to receive their share of profits and the percentage of profits they are eligible to receive.

The distribution waterfall model sets a systematic profit-sharing process in private equity and investment funds. It works as a structured method for allocating profits or returns from an investment among different stakeholders, such as limited partners (investors) and the general partner (fund manager). The process follows a predetermined sequence outlined in the fund's operating agreement.

Let's go through the steps of how it works:

#1 - Return of Capital (ROC)

The first step is to return the initial capital invested by the limited partners. Any initial distributions will pay back the amount each investor initially contributed to the fund.

#2 - Preferred Return

After the ROC is satisfied, some investors, typically limited partners, are entitled to receive a preferred return of investment. The preferred return is a predetermined percentage (e.g., 8%) that ensures the limited partners receive a specific rate of return on their investment before any further profits are distributed to other stakeholders.

#3 - Carried Interest

After satisfying the preferred return and any catch-up provision, the general partner is entitled to receive carried interest. Carried interest is the share of the general partner's profits as compensation for managing the fund and generating returns for the limited partners. It is typically a percentage of the remaining profits after the preferred return.

#4 - Waterfall Splits

Once the general partner has received their carried interest, the remaining profits are divided among the various classes of investors based on predefined splits or percentages. These splits can vary based on factors such as the performance of the investment or the terms agreed upon in the fund's operating agreement.

Let us look at some hypothetical and real-world examples to understand the concept better-

Example #1

Consider a hypothetical private equity fund, ABC Capital Partners Fund, with limited partners (LPs) and a general partner (GP).

The distribution waterfall for the fund is structured as follows:

First, the fund aims to return the initial capital contributed by the LPs. Once the Return of Capital (ROC) is achieved, the LPs are entitled to a preferred return of 8% on their investments.

After satisfying the preferred return, the GP can participate in the profits with a 20% catch-up provision, allowing them to receive a portion of the earnings until they reach a total share of 20%.

Subsequently, any remaining profits are distributed based on a 70-30 waterfall split, where 70% goes to the LPs, and 30% goes to the GP as carried interest.

This structure ensures that the LPs receive their preferred return, the GP is incentivized through carried interest, and the profits are shared between the stakeholders based on the agreed-upon percentages.

Example #2

In 2007, The Carlyle Group launched "Carlyle Partners V," a private equity fund targeting healthcare, energy, and telecommunications investments. The fund attracted substantial capital from institutional investors, pension funds, and qualified limited partners (LPs).

Distribution Waterfall Structure:

1. Return of Capital (ROC): The priority was returning LPs' initial investments, using profits from divestments or portfolio income.
2. Preferred Return: Following ROC, LPs received a preferred return, typically 8-10% per annum, before the general partner (the Carlyle Group) could participate in profits.
3. Carried Interest: The Carlyle Group was entitled to 20% carried interest, sharing in the fund's profits once the preferred return was met.
4. Waterfall Splits: After receiving carried interest, remaining profits were split between LPs and the Carlyle Group, following a predetermined distribution waterfall, typically 80-20 or 70-30 in favor of LPs.

The distribution waterfall is of significant importance in the realm of private equity and investment funds for several reasons:

1. Fairness and Transparency: It provides a clear and transparent framework for distributing profits among stakeholders, such as limited and general partners. This clarity helps ensure fairness and prevents potential disputes or conflicts over the allocation of returns.
2. Alignment of Interests: It is designed to align the interests of the fund managers (general partners) with those of the investors (limited partners). For instance, the preferred return ensures that limited partners receive a certain return before the general partner participates in the profits. It motivates the GP to generate strong investment returns to achieve the preferred return hurdle.
3. Long-Term Planning: It requires careful consideration of future scenarios, such as the fund's performance, market conditions, and investors' expectations. This long-term planning helps create a stable and sustainable investment strategy.

The distribution waterfall in private equity and investment funds can vary between American and European structures. Here are the key differences:

1. Preferred return (hurdle rate) in the American distribution waterfall is typically applied at the overall fund level. In European Distribution Waterfall, preferred return is often used at the investment level, meaning each investment must meet the preferred return threshold before any carried interest is distributed to the general partner.
2. American distribution waterfall generally does not include a clawback provision, which means there is no specific mechanism for returning carried interest to limited partners if certain investments underperform. On the other hand, European Distribution Waterfall typically consists of a clawback provision, allowing limited partners to reclaim carried interest previously paid to the general partner if the fund's overall performance falls short over the fund's life.

This article has been a guide to Distribution Waterfall & its meaning. We explain its examples, importance, & comparison between its American and European versions. You may also find some useful articles here -

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• Carried Interest in Private Equity