In private equity investing, distribution waterfall is a method by which the capital gained by the fund is allocated between the
limited partners
A limited partnership (LP) is a form of partnership similar to a general partnership except that while a general partnership must have at least two general partners (GPs), a limited partnership must have at least one GP and at least one limited ...
(LPs) and the
general partner General partner is a person who joins with at least one other person to form a business. A general partner has responsibility for the actions of the business, can legally bind the business and is personally liable for all the partnership's debts an ...
(GP).
Overview
In a
private equity fund
A private equity fund (abbreviated as PE fund) is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity ...
, the general partner manages the committed capital of the limited partners. The GP usually commits some amount to the fund (the "GP co-investment"), usually 1 to 2% of the commitment. When distributing the capital back to the investor, hopefully with an added value, the general partner will allocate this amount based on a waterfall structure previously agreed in the Limited Partnership Agreement.
A waterfall structure can be pictured as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital flows into the next bucket. The first buckets are usually entirely allocated to the LPs, while buckets further away from the source are more advantageous to the GP. This structure is designed to encourage the general partner to maximize the return of the fund.
Typical distribution waterfalls
Waterfalls usually consists of the following phases:
* Return of Capital
* Preferred Return
* Catchup
* Carried Interest
Allocation
Before the waterfall, the distributed amount is allocated across the partners of the funds. The partners include both GP and LP. The amount distributed to the GP is kept by the GP, while the amount distributed to each LP will then go through the waterfall and be redistributed between the GP and the LP.
Various Allocations
* Global per Commitment: Allocated in proportion to each Partner's commitment to the fund
* Global per Capital Called: Allocated in proportion to each Partner's cumulative called amount
* Global per Commitment, with a GP exception: The rule could be: 2% to the GP, and the remainder reallocated per commitment between the LPs
* Deal by Deal per Capital Called: In proportion of the amount called for this specific investment
Return of Capital
The first step of the waterfall is to return to the LP at least the amount it was called. We find here a lot of variations on what exactly has to be returned. This usually includes the capital called for investments, plus some expenses and fees.
= Various Return of Capital
=
* Total Investment Contribution: Total Capital Co