Distribution waterfall

In private equity investing, distribution waterfall is a method by which the capital gained by the fund is allocated between the limited partners (LPs) and the general partner (GP).

In a private equity fund, the general partner manages the committed capital of the limited partners. The GP usually commits some amount to the fund, usually 1 to 2% of the commitment. When distributing the capital back to the investor, hopefully with an added value, the general partner will allocate this amount based on a waterfall structure previously agreed in the Limited Partnership Agreement.

A waterfall structure can be pictured as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital flows into the next bucket. The first buckets are usually entirely allocated to the LPs, while buckets further away from the source are more advantageous to the GP. This structure is designed to encourage the general partner to maximize the return of the fund.

Waterfalls usually consists of the following phases:

Before the waterfall, the distributed amount is allocated across the partners of the funds. The partners include both GP and LP. The amount distributed to the GP is kept by the GP, while the amount distributed to each LP will then go through the waterfall and be redistributed between the GP and the LP.

The first step of the waterfall is to return to the LP at least the amount it was called. We find here a lot of variations on what exactly has to be return. This usually includes the capital called for investments, plus some expenses and fees.

Once the capital is returned, 100% will still be distributed to the LP until a specific IRR is reached. Regardless of whether the waterfall is global or deal-by-deal, this preferred return is always calculated on every cashflow.

The main variations here are in what is included in the payment cashflows. As contribution, the GP may choose to consider only the capital called for investment, or may include the capital called for fees and expenses. For the distribution, the amount previously distributed as carried interest may be excluded.

Catchup is a bucket which is strongly favorable to the GP. The rationale of a catchup is to give to the GP all or a majority of the gain, until the share of the profit received by the GP equals the carried interest (a percentage of the preferred return e.g. 20%)

The catchup is defined by two elements: an allocation (usually 80% for the GP, 20% for the LP), and a target (in relation to the carried interest).

Example:

Carried interest is a simple allocation of the remaining amount between LP and GP

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