A Closer Look at the Distribution Waterfall Method

A distribution waterfall method in private equity refers to the process of distributing returns from a private equity fund's investment among its stakeholders—namely, the Limited Partners (LPs) such as investors and the General Partner (GP) such as the fund manager. The waterfall method establishes the priority and order in which the profits are shared. It is designed to ensure that investors (LPs) are compensated for their contributions before the GP receives its share of the profits, commonly referred to as carried interest.??

The Components of a Private Equity Waterfall Method?

If an individual wants to become a private equity analyst, then the knowledge of waterfall method is highly helpful. To understand how a distribution waterfalls function, knowing about its core components is essential:?

·???????? Limited Partners (LPs)?

Limited Partners (LPs) are the investors who commit capital to the fund. They offer the majority of the financing but are passive in the management of the fund.?

·???????? Return of Capital (ROC)?

ROC is the first step where investors get their initial investment or invested capital back. It’s paramount that they recoup their stake.?

• ·???????? General Partner (GP):?

The private equity firm or fund manager is responsible for managing the investments. The GP mainly commits some capital as well but is primarily responsible for sourcing, executing, and managing the investments.?

• ·???????? Preferred Return?

After the ROC, limited partners (LPs) get a considerable return. This is the return hurdle or hurdle rate, stated as a percentage of their capital.?

• ·???????? Carried Interest (Carry)?

Carried Interest is the share of profits that the GP earns, typically around 20 percent of the profits after the LPs have received their agreed-upon returns.?

• ·???????? Catch-up Provision?

The catch-up provision is where the GP catches up to the LPs in terms of profit distribution. Once the preferred return is met, the GP takes a higher cut of the investment returns until a specific threshold is reached.?

• ·???????? Hurdle Rate?

A minimum rate of return will be mainly around 7-10 percent. It can be achieved by the fund before the GP is eligible to get carried interest.?

• ·???????? Clawback?

Clawback is a kind of clause that ensures LPs get their agreed-upon return before the GP retains profits. If earlier distributions to the GP exceed the agreed share of profits, they must return the excess.?

Variations of the Distribution Waterfall Method?

There are many variations in how private equity firms' structure with their waterfalls. Knowledge of these will be helpful to grow in one’s private equity career path.?

• ·???????? American Waterfall?

In an American-style waterfall, carried interest is calculated on a deal-by-deal. The GP can start getting carried once a specific deal has generated enough returns to pay back the LPs for that deal and meet the considerable return. The deal-by-deal approach can give the GP to get carried earlier, even if some deals in the portfolio underperform.?

• ·???????? European Waterfall?

In a European-style waterfall, the GP does not get carried interest until the LPs have received all their invested capital across all investments in the entire fund. This is often preferred to be more investor friendly. The GP has to wait longer to get their carry, as it’s calculated on the whole fund performance rather than individual deals.?

• ·???????? Tiered Carried Interest?

Some funds apply tiered carry structures, where the percentage of carried interest increases if the fund gets certain performance thresholds. For instance, the GP might get 20 percent carry for returns up to 20 percent IRR but can receive 25 percent carry for returns above that threshold.?

Example of a Distribution Waterfall?

A distribution waterfall method gives clear and concise inputs related to how much both parties will get as a fund closes investment sales and commences distributions.?

• Initial Investment?

LP invests USD 10 million into the private equity fund. GP also commits some capital (e.g., USD 1 million).?

• Return of Capital?

The fund realizes a profitable exit from its investment, generating USD 20 million in total. The first USD 10 million goes back to the LP, covering their initial investment.?

• Preferred Return?

Assuming a preferred return (hurdle rate) of 8 percent, the LP is entitled to get USD 800,000 in return before the GP earns carried interest. The LP also gets an additional USD 800,000 from the next part of the distribution.?

• Catch-Up?

After returning capital and offering the preferred return to the LP, the next step is the GPs catch-up. Here the GP gets 100 percent of the profits until it has caught up to its 20 percent carried interest. Suppose the fund has USD 9.2 million left to distribute after returning the LP’s capital and considerable returns. The GP will take the next USD 2.2 million to fulfill the carry arrangement.?

• 80/20 Split?

Once the catch-up is complete, the remaining profits are split between the LP and the GP. If there are still profits remaining after the catch-up (say USD 7 million), the GP will take 20 percent (USD 1.4 million), and the LP will take 80 percent (USD 5.6 million).?

Wrapping Up?

The distribution waterfall method in private equity is an essential mechanism that offers how profits are shared between investors and fund managers. It ensures that the LPs are compensated for their capital investment and achieve a minimum return before the GP is rewarded with carried interest. The waterfall structure gets aligned with the interests of GPs and LPs, incentivizing fund managers to enhance the returns for investors while giving them substantial rewards for their success.?

??Read More: How to Become Private Equity Associate