By Beth Manzi, CPA, Chief Operating Officer, PEF Services, LLC
There are two basic methods into which private equity distribution waterfall schedules are classified: European or American. Typically, the European waterfall is preferred by Limited Partners (LPs), while the American waterfall is preferred by General Partners (GPs.).
The two methods are typically differentiated by the ways in which they deal with the timing and allocation of distribution proceeds to GPs and LPs. In the end, the result should be the same; it’s only the timing that differs.
European vs. American Waterfalls
Because the American waterfall supports a deal-by-deal return schedule, it allows managers to get paid before investors receive all of their invested capital and preferred return.
In the European waterfall, the allocation of the distribution proceeds is determined at a “whole fund” level, and each distribution reflects the aggregate performance rather than being tied to an individual investment.
The carried interest is determined on a net cumulative basis and distributable to the manager only after a full return to the investors of their contributed capital and preferred return. With a European waterfall, the first distributions typically return all of the contributed capital.
With an American waterfall, the distribution proceeds are generally allocated on a deal-by-deal basis. As a result, performance is tied to each individual investment. This method is more beneficial to the GP in the earlier years as it distributes carried interest faster by making the carry payable with respect to each investment that gets the fund to a net-cumulative-profits-to-date position.
In this type of deal-by-deal waterfall, the first deal may return some carried interest if the deal’s internal rate of return (IRR) is above the preferred return.
PROs, CONs, and Variations
For LPs, the drawback with an American waterfall is that while this waterfall still entitles the LP to a preferred return and their return of capital, it’s structured so that a manager could receive a disproportionate share of cash flow early in the fund’s life cycle if there are significant early exits.
In a European waterfall, 100% of the contributed capital and preferred return is paid out to investors on a pro rata basis before the GP receives any distribution of carried interest. Because it’s pro rata, all capital is treated equally and distributions are paid out in proportion to the amount of capital invested.
One potential drawback for the LP is that with a European waterfall, managers may realize positions quickly in order to receive distributions rather than maximizing long-term investment returns. Also, due to the delayed compensation, the European waterfall may also make it challenging to attract senior investment professionals to private equity firms and delay spin-out teams, especially if they are not bringing a mature portfolio with them.
How the Waterfall Methods Differ
To see how the European and American waterfalls differ, let’s look at Year 3 and Year 4 distributions in this example:
As you can see, while both waterfall methods result in the same total distributions, the European method supports higher distributions for the LP and no distributions for the GP in Year 3.
Waterfall Trends and Variations
While there are generally two methods of the distribution waterfall, in reality, LPs are likely to see many different variations and modifications.
GPs may offer:
- A choice of American vs. European waterfall, with a discounted management fee and/or carried interest offered to LPs that choose the American waterfall.
- A discounted management fee in exchange for a higher carried interest rate above higher hurdles.
- A hybrid waterfall in which a European calculation is applied until distributions reach a certain percentage, after which they are distributed according to the American waterfall.
- A modified American waterfall in which:
- Write-downs as well as write-offs are included in the calculations.
- All expenses and preferred return are distributed before carried interest is calculated.
- Carried interest or interim clawback is modified to be based on the unrealized waterfall position.
While the waterfall has often been seen as an impenetrable “black box,” understanding its impact doesn’t have to involve complicated analysis or a complete recalculation.
LPs should be able to understand the two main waterfall methods, recognize the key elements, and conduct reasonableness checks to help ensure that they protect investment returns and identify potential issues.
To learn more, read Distribution Waterfalls: The Definitive Guide for Limited Partners.