An equity waterfall, also known as a distribution waterfall, maps cash flow between sponsors (general partners) and limited partners of a private equity fund. A fund's limited partnership agreement describes the terms of the distribution waterfall. Investors must agree to the limited partnership agreement, and thus the waterfall, as part of their investment.
Parts of an equity waterfall
Equity waterfalls follow a tiered cash flow structure. Think of these tiers like stacked pools of water. Upper pools will fill before spilling over to the pool beneath it.
In private equity, rates of return, or hurdle rates, define each tier. Cash flow requirements of senior tiers must be met before monies flow to subordinate tiers.
Most equity waterfalls consist of four distinct tiers:
- Return of capital: In this first tier, limited partners receive 100% of distributions until they reach their initial investment.
- Preferred return: Limited partners continue to collect 100% of distributions up to their preferred rate of return. The rate of return varies by agreement, but most limited partners choose a hurdle rate between 7% and 9%.
- Catch-up: Once the limited partners achieve their preferred return, the fund's sponsor receives 100% of the distributions. This tier allows sponsors to ‘catch up’ with the limited partners. Typically, sponsors will receive 20% of the profits in this tier.
- Carried interest: In 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
In a European equity waterfall, sponsors 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 allocations for limited partners are proportionate to their initial investment. In other words, an investor with a 20% stake in the fund will receive 20% of the distributions until they recover all of their initial capital and achieve their preferred rate of return. Sponsors do not receive any payment until all of the limited partners have been fully satisfied.
For example, assume five limited partners each own 20% of a fund with an 8% preferred return and European waterfall. Each partner will receive 20% of the distributions until they recover their investment and an 8% preferred return. Afterward, sponsors receive cash flow as part of their catch-up.
The European model is more favorable for limited partners. Sponsors may wait for years to receive a share of the profits. This increases the sponsor’s risk and incentivizes them to sell investments early.
American equity waterfalls
Some call the American equity waterfall the deal-by-deal model. The key difference between American waterfalls and European waterfalls is the treatment of carried interest. In an American waterfall, sponsors receive carried interest from individual investments in the fund before limited partners are made whole. In other words, sponsors earn carried interest from individual deals rather than the fund as a whole.
For example, assume five limited partners each own 20% of a fund with an 8% preferred return and American waterfall. Limited partners are entitled to their preferred rate of return. However, the sponsor may collect carried interest from individual investments before they receive the full return.
This model favors the sponsor since they typically wait much less time to receive carried interest from the fund. In some cases, they begin collecting carried interest on day one. Additionally, limited partners bear more risk, since they may not reach their hurdle rate before sponsors receive carried interest. Since the American waterfall is less attractive to limited partners, sponsors often include a clawback (or look-back) clause. A look-back clause entitles limited partners to a sponsor's carried interest when they don't achieve their preferred return.
U.S. sponsors prefer the American equity waterfall
Sponsors worldwide use both waterfall models. However, the American model is most prevalent in the United States. Unsurprisingly, the European model is a favorite in Europe. Some sponsors now use hybrid waterfall models that partially distribute carried interest on a deal-by-deal basis. For the time being, however, European and American equity waterfalls are the two standard waterfall models for commercial real estate.
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