In private equity, aligning the interests of limited partners (LPs) and general partners (GPs) is key to fostering successful partnerships, and this alignment is often achieved through profit-sharing agreements. A key component of these agreements is carried interest, a performance-based fee paid to fund managers as a percentage of profits. How and when managers are rewarded for their performance is determined by the model used to distribute profits. A common approach is a hierarchical “distribution waterfall,” of which there are two main types: American and European. Let’s examine each.
Private Equity Distribution Waterfall Models
Private Equity investment proceeds are often distributed to limited partners (LPs or general partners (GPs) according to a waterfall model. Like a waterfall filling a series of pools at descending heights — filling one before overflowing into the next — cash flows to LPs and GPs in a clear order.
Waterfall models typically have four tiers:
- Return of capital: LPs receive all of a fund’s distributions until they recoup the initial investment.
- Preferred return: Also known as a hurdle rate, LPs receive a percentage of their initial investment. Preferred return often ranges from 7% to 9%.
- Carried Interest: GPs receive a percentage of the remaining profit, often 20%.
- Distribution Split: GPs and LPs share the remainder of the profit, usually at an 80/20 split.
Comparing American and European Waterfalls
The American waterfall is sometimes called a deal-by-deal waterfall because it distributes profits following each deal. Cash flows through the four tiers on a deal-by-deal basis.
On the other hand, the European waterfall works at the fund level. Profits flow through the four tiers once per fund term, meaning GPs only receive carried interest once LPs receive all of their initial investment and preferred return.
Pros and Cons of American and European Waterfalls
Each model has benefits and drawbacks.
The American waterfall is usually preferred by GPs, as it pays carried interest earlier in the life of the fund. This can be especially helpful to emerging managers that rely on the proceeds for operating costs and company growth.
On the other hand, the American waterfall can become complicated and costly for GPs with “clawback provisions” that require GPs to pay back carried interest in the event that LPs preferred returns are not realized. While these provisions protect LPs, they can also cause administrative challenges and disputes.
The European model is characterized by greater protection for LPs, because GPs are only paid once LPs recoup their initial investment and receive the preferred rate of return. This equates to delayed returns for GPs. The European model, however, does offer a simplified administrative process for distributions.
Combining American and European Approaches: Hybrid and Tiered Waterfalls
Hybrid and Tiered waterfalls are two variations on the traditional European and American models. A hybrid waterfall distributes a smaller amount of carried interest on a deal-by-deal basis. At the close of the fund, GPs are further rewarded for high performance according to a catch-up provision or, in the case of low performance, are required to pay back carried interest to LPs via a true-up mechanism.
A tiered waterfall structure introduces defined return thresholds, where the carried interest and preferred return percentages increase as the fund’s return meets each tier.
Choosing the Right Partner
The choice of a distribution waterfall model is only the first step—ensuring its successful implementation and ongoing oversight requires the right technology and professional expertise. Fund administrators play a crucial role in helping private equity firms select and manage the right distribution waterfall for their funds. By leveraging their expertise, fund administrators provide a thorough analysis to align the chosen model with a fund’s objectives and investor preferences. On an ongoing basis, experienced fund administrators calculate returns, manage clawback provisions and facilitate clear communication with LPs. This support enables GPs to focus on investment performance while ensuring distributions are handled accurately and transparently.
In Summary
Choosing the right distribution waterfall model is an important decision for private equity funds as it directly impacts how and when both LPs and GPs receive returns. The American and European waterfall models each offer unique advantages and challenges. Regardless of which waterfall your fund uses, having the right technology and professionals is key. Ready to engage an experienced fund administration partner? Contact VIRIDIS Fund Solutions.