Distribution waterfalls are the industry standard when investing in alternatives.

When most people think of waterfalls, they think of water flowing off a surface, tapering off upon hitting the ground.

What most people don’t think about when thinking of waterfalls is how they can be used to describe the distribution of capital in private equity funds.

Waterfalls are the mechanism for how capital is distributed back to investors in private equity funds. But there are two main types of waterfalls. One type is referred to as European and the other is called American.

Investopedia defines a Distribution Waterfall as “a way to allocate investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall defines the pecking order in which distributions are allocated to limited and general partners.”

Investopedia also lists the following steps, which describe European Waterfalls quite well:

1. Return of capital (ROC) - 100 percent of distributions go to the investors until they recover all of their initial capital contributions.

2. Preferred return - 100 percent of further distributions go to investors until they receive the preferred return on their investment. Usually, the preferred rate of return for this tier is approximately 7 percent to 9 percent. This is also known as the hurdle rate.

• Hurdle rates are most prominent amongst Buyout and Credit Funds.

• Venture Funds do not typically have a hurdle rate.

• Growth Equity Funds are mixed with some featuring a hurdle rate and others not.

3. Catch-up tranche - This applies to Funds that DO have hurdle rates. After the LP has received all of their capital contributions and expenses back, the majority of distributions will then go to the sponsor of the fund until it receives a certain percentage of profits. *optional step.

• Hurdle rates are most prominent amongst Buyout and Credit Funds.

4. Carried interest - Once the catchup tranche has been completed, the GP will receive the agreed-upon performance fee as a percentage of all distributions.

• For example, if the performance fee is 20%, they will receive 20% of all remaining distributions.

While the first, second, and final steps are standard in the alternative investment industry, the Catch-up tranche is not always included. Due to the nature of “catching up”, this step would always come before the final step (“Carried Interest”).

The first and second steps exist to protect investors’ initial investment, while the “Catch-up tranche” and “Carried Interest” steps exist to incentivize managers to generate returns in excess of the capital invested.

However, the American type of distribution waterfall is also important to understand. The European type waits to reward investors based on the performance of the fund. American distribution waterfalls reward investors on a deal-by-deal basis. So, after a private equity manager has sold an investment in their portfolio, generally investors are returned the portion of their capital invested in that deal first before the fund manager, akin to the investors sitting at the top of the waterfall, receiving the strongest flow of water. Similar to how strong waterfalls will lead to more water reaching the surface, more capital being distributed back (or profits from the exit) will result in managers receiving a higher reward.

Because the American style distribution waterfall begins rewarding managers before an investor’s entire investment has been recouped, there are clawback provisions in case the preferred return is not met.

This is mutually beneficial since higher quality managers do not need to wait to be compensated, while investors still protect themselves from overpaying managers who do not maintain their performance through the entire life of the fund.

Distribution Waterfalls are standard operating procedure in the private capital industry.

The key reason this payment mechanism exists is to protect investors’ initial capital while ensuring a preferred return on that capital.

A secondary benefit to this incentive structure is the rewards good managers can reap.

However, this comes second to the investors and is why the hurdle rate can also be referred to as a “Preferred Return.”

There are different types of distribution waterfalls. The European type waits to reward investors based on the performance of the fund. American distribution waterfalls reward investors on a deal-by-deal basis.

With American-style distribution waterfalls, investment managers can earn bonuses before an entire fund is fully recovered. For this reason, extra protection, known as a clawback provision, is used to ensure the investment manager is not rewarded if an investor does not earn sufficient returns.