The distribution waterfall is a fundamental concept in the realm of private equity investments. It outlines the process by which investment returns are distributed among the various stakeholders in a private equity fund, including general partners (GPs) and limited partners (LPs). Understanding the distribution waterfall is essential for investors to comprehend how profits are shared and the factors that influence the distribution process.
What is a private equity waterfall?
A private equity waterfall is a structured framework that defines the sequence and priority of profit distributions from a fund’s investments to its investors. It follows a step-by-step process, often depicted in a hierarchical manner, to ensure that each participant receives their share of returns based on specific terms and conditions.
Why are distribution waterfalls important?
The distribution waterfall is crucial in private equity as it helps align the interests of GPs and LPs. It incentivizes GPs to achieve higher returns and rewards LPs for their investments by ensuring they receive their expected returns before GPs are entitled to carry (profit share).
How Do Distribution Waterfall Models Work?
A typical distribution waterfall has four tiers:
- Preferred Return
- Return of Capital
- Carried Interest
- Hurdle Rate and Clawback Provisions (in some cases)
Why is it called a “waterfall”?
The term “waterfall” stems from the cascading effect of profit distributions through the different tiers or buckets in the distribution waterfall. Each tier is sequentially filled until it is satisfied before moving to the next tier, similar to how water flows down a series of steps in a waterfall.
What is Preferred Return?
Preferred return is the first tier in the distribution waterfall. It refers to the minimum rate of return that LPs expect to receive on their investments before GPs can earn carried interest. It ensures that LPs receive a priority return on their capital.
What is Multihurdle waterfall?
A multihurdle waterfall includes multiple hurdles or thresholds that must be surpassed before GPs can receive carried interest. These hurdles can be based on various performance benchmarks, allowing GPs to earn higher carried interest as the fund achieves greater levels of success.
What Are the Different Types of Distribution Waterfalls?
Two common types of distribution waterfalls are:
- American Waterfall: In this type, GPs start receiving carried interest once the preferred return and the return of capital are met. The carried interest is calculated throughout the fund’s life cycle.
- European Waterfall: The European waterfall prioritizes returning capital to LPs before GPs receive carried interest. GPs usually earn carry in separate distribution periods after the end of the fund’s investment period.
How does a distribution waterfall work?
The distribution waterfall works by following a predefined sequence of distributions based on the fund’s performance and the terms agreed upon in the fund’s legal agreement. As the fund generates profits, they are allocated among the various tiers of the waterfall, ensuring that LPs’ interests are prioritized, and GPs are incentivized to perform well.
Private Equity Waterfall Example
Let’s consider a simplified example to illustrate how a distribution waterfall works:
Assume a private equity fund with a preferred return of 8%, a carried interest percentage of 20%, and a hurdle rate of 10%. The fund generates a total return of 15%.
- The first 8% of the total return is allocated to LPs to satisfy their preferred return.
- Next, the return of capital bucket is filled, and LPs receive their initial investments back.
- The remaining 2% (10% hurdle rate minus the 8% preferred return) goes towards LPs to meet the hurdle rate.
- Finally, the remaining 5% (15% total return minus the 10% hurdle rate) is allocated to GPs as carried interest.
In conclusion, the distribution waterfall is a vital mechanism in private equity that ensures fair and efficient profit sharing among all stakeholders involved in a fund.