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.