======Distribution Waterfall======
A Distribution Waterfall is the financial plumbing that dictates how profits from an investment are paid out to different investors. Think of it as a cascading series of buckets: once the first bucket is full, the money spills over to fill the next, and so on, until all the profits are distributed. This method is the backbone of partnerships in fields like [[Private Equity]], [[Venture Capital]], and real estate funds. It's designed to prioritize certain investors over others, creating a specific order of repayment. The two main players in this arrangement are the [[Limited Partner]] (LP), who provides the majority of the capital (that’s you, the investor), and the [[General Partner]] (GP), who manages the fund and makes the investment decisions. Understanding the waterfall structure is non-negotiable for anyone considering an investment in these types of funds, as it directly determines when—and how much—you’ll get paid. A poorly structured waterfall can mean the fund manager gets rich even if you, the investor, barely break even.
===== Why It's Called a Waterfall =====
The name is a perfect analogy. Imagine a pool of profits collected at the top of a cliff after selling an investment. This money doesn't just splash down randomly. Instead, it flows down a series of tiered basins.
  * **The First Basin:** This must be completely filled before any water spills over. This represents the first group of people to get paid.
  * **The Second Basin:** Catches the overflow from the first.
  * **And so on...** until all the money has been channeled into someone's pocket.
This tiered, sequential process ensures that payments happen in a strict, predetermined order. The people at the top of the waterfall get their money first and with the most certainty. The people at the bottom only get paid if the investment was a big success, but their potential reward can be huge.
===== The Four Tiers of a Typical Waterfall =====
While the exact terms can vary, most distribution waterfalls in private funds follow a classic four-tier structure. This structure is often linked to the famous "//2 and 20//" fee model, where the manager takes a 2% management fee annually and 20% of the profits. The waterfall deals with that 20% profit share, also known as [[Carried Interest]].
  - **Tier 1: Return of Capital (ROC)**
    * **Who gets paid:** The Limited Partners (LPs).
    * **What they get:** 100% of the initial money they invested. Before anyone talks about profits, the LPs must be made whole. If you invested $1 million, you get the first $1 million back. This is the safest tier for the investor.
  - **Tier 2: The Preferred Return**
    * **Who gets paid:** The Limited Partners (LPs).
    * **What they get:** A pre-agreed minimum rate of return on their investment. This is often called the [[Hurdle Rate]], and it's typically around 6-9% per year. This tier rewards the LPs for the risk they took and the time their money was tied up. The GP doesn't see a dime of the profit share until this hurdle is cleared.
  - **Tier 3: The GP Catch-Up**
    * **Who gets paid:** The General Partner (GP).
    * **What they get:** A large portion (often 100%) of the profits //after// the LPs have received their capital and preferred return. The goal of this tier is to allow the GP to "catch up" to their agreed-upon profit share (e.g., 20%). So, if the total profits distributed so far add up to $10 million (all going to the LPs), the GP might get the next $2.5 million to bring the overall profit split to 80/20.
  - **Tier 4: The Final Split (Carried Interest)**
    * **Who gets paid:** Both the LPs and the GP.
    * **What they get:** All remaining profits are split according to a predetermined ratio, most commonly 80% for the LPs and 20% for the GP. This 20% is the GP's "carried interest" and is the primary incentive for the manager to generate massive returns.
===== A Simple Example =====
Let's say you and other LPs invest $100 million in a fund. The fund is later liquidated for $300 million, generating a $200 million profit. The agreement specifies an 8% preferred return for LPs and a 20% carried interest for the GP with a catch-up provision.
Here’s how the $300 million flows down the waterfall:
  * **Tier 1 (Return of Capital):** The first **$100 million** goes straight back to the LPs.
    * //Remaining cash to distribute: $200 million.//
  * **Tier 2 (Preferred Return):** LPs get their 8% return. For simplicity, let's say the investment period makes this an **$8 million** payment.
    * //Remaining cash to distribute: $192 million.//
  * **Tier 3 (GP Catch-Up):** Now the GP catches up. The LPs have received $8 million in profit. To get to an 80/20 split, the GP needs 20% of the total profit distributed. The calculation is: $8 million / 0.80 = $10 million. So, the GP needs $2 million to "catch up" ($10 million - $8 million). The GP receives the next **$2 million**.
    * //Remaining cash to distribute: $190 million.//
  * **Tier 4 (Final Split):** The remaining $190 million is split 80/20.
    * LPs receive 80% x $190 million = **$152 million**.
    * GP receives 20% x $190 million = **$38 million**.
==== Final Tally ====
  * **Limited Partners (You):** $100M (capital) + $8M (preferred return) + $152M (split) = **$260 million**. Your total profit is $160 million.
  * **General Partner (Manager):** $2M (catch-up) + $38M (split) = **$40 million**.
The total profit was $200 million ($160M for LPs + $40M for GPs), and the GP's share is exactly 20% of that total profit, so the structure worked as intended.
===== What Value Investors Should Look For =====
As an investor, the waterfall isn't just a technical detail—it's a statement of alignment. A fair structure aligns the GP's interests with your own.
  * **Hurdle Rate is Key:** A higher preferred return (hurdle rate) is better for you. It forces the GP to generate meaningful returns before they get their big payday. A fund with a low or non-existent hurdle rate should be a red flag.
  * **American vs. European Waterfall:** This is a critical distinction.
    * **American (Deal-by-Deal):** The GP can start collecting carried interest on individual successful deals, even if other investments in the fund are losing money. This is riskier for LPs.
    * **European (Whole-Fund):** The GP only gets to collect carried interest //after// all LPs have received their entire initial investment and the total preferred return across the //entire fund//. This is far more investor-friendly and is the standard in Europe.
  * **Look for a Clawback:** What happens if the GP takes performance fees on early wins, but the fund later performs poorly? A [[Clawback Provision]] is a crucial safety net that legally requires the GP to return previously paid carried interest to ensure the final profit split is fair. If a fund agreement doesn't have one, walk away.