A distribution waterfall defines the way the profit of a fund is distributed between the Limited Partners (LPs) and the General Partner (GP.) It also defines the distribution of carried interest to the GP once the threshold return is exceeded.
Essentially, the total profit is distributed according to a cascading, tiered structure that gives the waterfall its name. When one tier’s allocation requirements are satisfied, the excess funds are allocated according to the requirements of the next tier, and so on.
Typically, distributions flow to the LPs first in order to return contributions plus a preferred return, after which they are split between the GP and the LPs according to the carried interest calculation.
How it Works
Distributions can vary significantly, depending on the method of waterfall used. While there are technically two different waterfalls (European and American), waterfalls can also be hybrids or include variations and modifications that impact the way the returns are distributed.
Given the impact that waterfalls have on returns, it’s important for LPs to understand and be able to review and verify basic waterfall calculations. According to a survey by Probitas, 53% of fund managers say that the distribution of carried interest between senior investment professionals is an important area of focus, and 36% say the same about carry distribution waterfalls. 1
Key Components of the Waterfall
Every waterfall calculation includes several key components: return of contributions, the preferred return to LPs, and the carried interest to the GP.
1) Return of Contributions
The return of contributions is generally the first step in the waterfall, with 100% of distributions going to LPs until their capital contributions are recovered.
2) Preferred Return
The preferred return is typically distributed after contributions are returned.
3) Carried Interest
Once contributions and the preferred return have been distributed to the LPs, the carried interest can be distributed to the GP.
Realized and Unrealized Waterfall
The waterfall should be calculated on both a “realized” and an “unrealized” basis. The realized waterfall is calculated at the time of an actual distribution and allocates the actual cash proceeds from investments. It may include written-down and written-off investments. The carried interest includes the actual carried interest paid. The waterfall is calculated on an unrealized basis for financial reporting. The unrealized waterfall assumes a hypothetical liquidation of the fund as of the reporting date. By understanding these components, you can better understand how it will impact your distributions and capital account at every step.
To learn more, read Distribution Waterfalls: The Definitive Guide for Limited Partners. To see a comparison of the American and European waterfall, including the pro rata portion of expenses, preferred return, and catch-up, download the Sample American and European Waterfall Calculations spreadsheet included in the paper.
 Probitas Partners, Private Equity Institutional Investor Trends for 2017 Survey