Distribution Waterfall

What Is a Distribution Waterfall?

A distribution waterfall a method for designating investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall characterizes the hierarchy wherein distributions are allocated to limited and general partners.

Normally, the general partners receive an excessively bigger share of the total profits relative to their initial investment once the allocation process is complete. This is finished to boost the fund's general partner to amplify profitability for its investors.

Figuring out Distribution Waterfalls

A distribution waterfall depicts the method by which capital is distributed to a fund's different investors as underlying investments are sold for gains. Basically, the total capital gains earned are distributed by a flowing structure comprised of sequential tiers, subsequently the reference to a waterfall. At the point when one tier's allocation requirements are completely fulfilled, the excess funds are then subject to the allocation requirements of the next tier, etc.

However waterfall schedules might be modified, generally the four tiers in a distribution waterfall are:

1. Return of capital (ROC) - 100 percent of distributions go to the investors until they recuperate their initial capital contributions in general.
2. Preferred return - 100 percent of additional distributions go to investors until they receive the preferred return on their investment. Generally, the preferred rate of return for this tier is roughly 7 percent to 9 percent.
3. Catch-up tranche - 100 percent of the distributions go to the sponsor of the fund until it receives a certain percentage of profits.
4. Carried interest - a stated percentage of distributions that the sponsor receives. The stated percentage in the fourth tier must match the stated percentage in the third tier.

Hurdle rates for the schedule likewise might be tiered, contingent upon the total amount of carried interest of the general partners. Commonly, the more carried interest, the higher the hurdle rate. Furthermore, a feature called "clawback" is oftentimes remembered for the fund prospectus and is intended to shield investors from paying more incentive fees than required. In case of such an occurrence, the manager is committed to pay back the excess fees.

American versus European Waterfall Structures

Investment waterfall mechanics are nitty gritty in the distribution section of the private placement memorandum (PPM). There are two common types of waterfall structures - American, which inclines toward the general partner, and European, which is more investor friendly.

• An American-style distribution schedule is applied on an arrangement by-bargain basis, and not at the fund level. The American schedule spreads the total risk over every one of the arrangements and is more beneficial to the general partners of the fund. This structure takes into consideration managers to get compensated prior to investors getting all their invested capital and preferred return, however the investor is as yet qualified for these.
• An European-style distribution schedule is applied at an aggregate fund level. With this schedule, all distributions will go to investors and the manager will avoid any profits until the investor's capital and preferred return have been completely fulfilled. A drawback is that the majority of the manager's profits may not be realized for quite some time after the initial investment.

Features

• There are two common types of waterfall structures: American, which leans toward the investment manager; and European, which is more investor friendly.
• A distribution waterfall illuminates the order wherein gains from a pooled investment are allocated between investors in the pool.
• Generally, there are four tiers in a distribution waterfall schedule: return of capital; preferred return; the catch-up tranche; and carried interest.