An equity waterfall, also known as a distribution waterfall, is a system that determines how money is allocated to the sponsors (AKA general partners) and limited partners of a private equity fund. The specific terms of a waterfall must be agreed to by all parties involved and documented in the fund’s limited partnership agreement.
Parts of an equity waterfall
Equity waterfalls follow a tiered cash flow structure. Each distribution tier is defined by a specific rate of return, or hurdle rate, that must be reached before the next tier begins. In this sense, each tier is like a pool of water that accumulates until it is full, and then spills over into the next pool.
Most equity waterfalls consist of four distinct tiers:
- Return of capital: During this first tier, 100% of distributions are allocated to the limited partners until each one has recovered all of their initial investment capital.
- Preferred return: After their initial capital contributions have been fully recovered, limited partners continue to collect 100% of distributions until their preferred rate of return has been reached. The rate of return varies by agreement, but most limited partners elect for a hurdle rate of 7% to 9%.
- Catch-up: Once the limited partners have recovered their initial capital and reached their preferred rate of return, 100% of distributions are then allocated to the sponsor(s) of the fund. This tier allows sponsors to essentially ‘catch up’ with the limited partners until they have collected a pre-agreed percentage of the profits (20% is a typical figure).
- Carried interest: During this final tier, the sponsor receives a certain percentage of the remaining distributions as carried interest. Limited partners collect the rest.
Equity waterfalls generally fall into one of two categories: European or American.
European equity waterfalls
Under the European equity waterfall model, sponsors of a fund do not receive carried interest until all of the limited partners’ capital contributions – including unrealized investments – have been recovered and their preferred rate of return has been reached. The distributions are allocated on a pro rata basis, meaning that allocations for limited partners are proportionate to their initial investment. In other words, someone who invests 20% of investment capital will receive 20% of the distributions until they have recovered all of their initial capital and reached their preferred rate of return. Sponsors do not receive any payment until all of the limited partners have been fully satisfied.
For example, let’s say a five limited partners puts up 20% of investment capital with an 8% preferred rate of return. Under the European model, this means each partner will collect 20% of the distributions until all five have fully recovered their investment at an 8% rate of return. Once these benchmarks are reached, the catch-up tier begins and the sponsors begin to collect distributions.
The European model is considered more favorable for limited partners. Sponsors may wait years to receive a share of the profits. This increases the sponsor’s risk, and lack of payment may force them to sell off investments before they are fully realized. Limited partners, on the other hand, will be fully compensated for their investment at their preferred rate of return before anyone else gets paid.
American equity waterfalls
The American equity waterfall is also known as the deal-by-deal model. The key differences between this model and European waterfalls relate to how the fund is characterized and how quickly sponsors receive payment. Under the American model, sponsors may collect carried interest from individual investments in the fund before the limited partners have been fully compensated for their contributions. In this sense, the sponsors earn carried interest from individual deals, rather than collecting it from the fund as a whole.
Using the same example from the European model: let’s say a sponsor manages a fund where five limited partners have put forth 20% of the investment capital, all at a matching 8% rate of return. The limited partners are entitled to their distributions at the preferred rate of return, but the sponsor may collect carried interest from individual investments before limited partner distributions have been fully allocated.
This model favors the sponsor, since they typically wait much less time to receive payment from the fund – and in some cases, they begin collecting carried interest on day one. It is also favorable to sponsors because limited partners bear more risk, since they may not reach their hurdle rate before sponsors start earning profits. Since the American waterfall may be less attractive to limited partners, sponsors often include a clawback (or look-back) clause to incentivize them. In the event that limited partners have not reached their preferred rate of return after the fund has been fully distributed, this clause ensures that they will be compensated with carried interest the sponsor has collected from earlier investments.
U.S. sponsors prefer the American equity waterfall
Although both waterfall models are used worldwide, the American model is most prevalent in the U.S. while the European model is still favored across the pond. In recent years, some sponsors have introduced hybrid waterfall models that distribute some returns on a deal-by-deal basis and the remaining returns on a pro rata basis. For the time being, however, European and American equity waterfalls are considered the two standard models for commercial real estate.
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