Distribution waterfall

In private equity investing, distribution waterfall is a method by which the capital gained by the fund is allocated between the limited partners (LPs) and the general partner (GP).^[1][1]

In a private equity fund, the general partner manages the committed capital of the limited partners. The GP usually commits some amount to the fund, usually 1 to 2% of the commitment. When distributing the capital back to the investor, hopefully with an added value, the general partner will allocate this amount based on a previously agreed waterfall structure.

A waterfall structure can be pictured as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital flows into the next bucket. The first buckets are usually entirely allocated to the LPs, while buckets further away from the source are more advantageous to the GP. This structure is design to incentivize the general partner in maximizing the return of the fund.

Typical distribution waterfall

A standard distribution waterfall is defined by a hurdle rate, a catchup rate and a carried interest rate.

• Recovery Phase: As long as the called capital hasn't been fully returned to the limited partner, the whole distributed amount is allocated to the limited partners.
• Hurdle Phase: The LPA may specify a hurdle rate (typically 8%). The Hurdle Rate is an IRR that needs to be reached by the LPs before the GP gets some return on its invested capital.
• Catchup Phase: Above the Hurdle Rate, the LPA defines a catchup rate (typically 50%). In this case 50% of the next distributions will be allocated to the GP, until the general partner distributed capital reaches an IRR equal to the hurdle rate.
• Carried Interest Phase: Above the catchup phase, every proceeds will be distributed based on the carried interest (typically 20%). This means that the GP will receive 20% of the distributed amount, while the LPs will share the remaining 80%.

Multihurdle waterfall

A GP may decide to defines many hurdle rate, each linked to a specific allocation. In this case, the higher hurdles are linked to allocations more favorable to the general partner. An example of hurdle would look like:

European vs American waterfall

The European waterfall, or global waterfall, means that the hurdle threshold is calculated at fund level.^[2][3] The American waterfall, or deal-by-deal waterfall, calculates the hurdle thresholds for each deal. The American waterfall is more favorable to the GP than the European watefall:

• The deal-by-deal waterfall distributes carried interest faster. With the European waterfall, the first distributed amounts are used to return the capital called by other deals. In the deal-by-deal waterfall, the first deal may return some carried interest if the deal IRR is above one of the hurdle rate.
• If the GP buys into a low-performing company, the bad performance will need to be compensated by very positive deals before the GP may reach the hurdles. In the deal-by-deal waterfall, the bad performances of a single company do not leak over the performances of the other companies.

To mitigate the effect of a deal-by-deal waterfall and to make it more attractive to LPs, private equity funds using an American waterfall may include a clawback clause in their LPAs.^[4]

Clawback clause

When liquidating the fund, if the LPs were distributed less than the agreed preferred return, they claw back the missing amount from the carried interest distributed to the GP.^[4][5] The clawback clause is triggered at the very end of the fund, at a time where the General Partner may have already put the clawback amount to other use.

In August 2010, Blackstone Group returned $3 million in carried interest to the limited partner of a fund as part of a clawback provision.^[6]

References

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