What Is a Distribution Waterfall of a Private Investment Fund?

A distribution waterfall consists of stages that determine the order in which returns are allocated to fund investors and managers.  

The waterfall structure, which is outlined in a fund’s legal documents, is commonly used by limited partnerships and limited liability companies (LLCs). 

In a limited partnership’s waterfall, capital is typically distributed initially to the limited partners until they have gotten back all of their capital contributions before any is distributed to the general partner. This order protects the interests of limited partners while also offering incentives to the general partner to maximize returns.  

In LLCs with different investor classes, a distribution waterfall prioritizes returns by class, with preferred classes receiving returns first. 

Below, we walk through the basic components of a limited partnership’s distribution waterfall and include an example of how the waterfall works. Then we answer some frequently asked questions about the waterfall.

Key Components of a Distribution Waterfall

The term “waterfall” in a distribution structure refers to how profits are distributed step by step, like water cascading down a series of levels. The water represents the money, and each level represents a specific priority or return threshold that must be fully met before moving to the next. This sequence ensures that the fund’s participants (the limited partners and the general partner) receive their allocated share before the remaining profits flow to the next tier, just as water must fill each tier of a waterfall before spilling over to the next. 

A distribution waterfall for a limited partnership typically has several tiers, which may vary depending on the agreement but often include the following:

First, return of capital: The top level of the waterfall represents the return of capital to the investors. All of the profits are distributed solely to the limited partners until they have fully recouped their initial contributions. Funds can be structured so “return of capital” means all contributed capital including expenses and management fees paid, but some fund structures capture only invested contributions in this tier.

Second, preferred return (or hurdle rate): In this stage, the investors continue to receive all the profits until they reach a specified minimum return known as the “preferred return” or “hurdle rate,” which is typically 8% of their original investment.  

The preferred return is in addition to the return of the initial capital. For instance, if a limited partner invests $1 million and the preferred return is 8%, the limited partner must first get their $1 million back (return of capital), plus an additional $80,000 (preferred return). 

Third, catch-up: At this stage, the fund sponsor starts "catching up" with investors to receive a predetermined profit share (the carried interest rate of 20%) of the preferred return. Carried interest is designed to qualify as long-term capital gains, meaning it is taxed at a lower rate than ordinary income. 

Fourth, remaining split: Any remaining profits after the catch-up phase are divided between the investors and fund sponsor, often with investors receiving 80% and the fund sponsor receiving 20% in carried interest. 

Example of a Distribution Waterfall

Let’s consider a simplified example in which the limited partners contribute $1 million to be invested and the fund achieves a total return of $1.5 million when the investment is sold. The preferred return is set at 8%, and the carried interest is 20%. The general partner receives a 100% catch-up to achieve 20% of all distributions, excluding the capital return.  

Here is a table that lays out how much the limited partner and general partner receive at each stage. The “remaining profit” column represents how much profit remains at the end of each stage:

Stage	Description	Amount distributed		GP Share	LP Share	Remaining profits
Return of capital	LPs get back original capital contributions of $1,000,000	$1,000,000		$0	$1,000,000	$1,500,000-$1,000,000=$500,000
Preferred return	LPs receive preferred return (e.g., 8% of $1,000,000).	$80,000		$0	$80,000	$420,000
Catch-up provision	GP receives a 100% catch-up to achieve up to 20% of total distributed profits to date.	$16,000		$16,000	$0	$404,000
Remaining profit split	Remaining profits of $404,000 split with 20% to GP and 80% to LPs.	$404,000		$80,800	$323,200	$0

For simplification, this table includes any small investment the general partner might have made as a limited partner as part of the LP share.

Exact calculations vary according to agreed-upon terms. Catch-up provisions, for instance, can include or exclude certain distributions, adding a layer of complexity. Determining which distributions are included requires careful reading of the legal agreement and nuanced understanding of how the catch-up is structured.

Is carried interest always part of the catch-up provision?

Not always. Some distribution waterfalls don’t include a catch-up provision at all. In these cases, after the limited partners receive their preferred return, distributions move directly to a split phase (e.g., 80% to general partners and 20% to limited partners).

What happens if the preferred return is not reached?

If a preferred return is not met, distributions usually remain with the limited partners, and the general partner’s share of distributions are delayed until the preferred return is fully paid.

Some funds use an accumulated preferred return, in which any shortfall in the preferred return carries over to the next year. For example, if limited partners should receive a preferred return of $80,000 in year one but the fund generates only $50,000 in profits, there is a $30,000 shortfall in year one that rolls into year two. In year two, the preferred return target becomes $110,000 ($80,000 plus $30,000 shortfall).;

What is a European vs. American waterfall?

European and American waterfalls are not designated as such based on the locations of the fund manager. The primary difference between European and American waterfalls lies in how carried interest is calculated.

In the European waterfall, carried interest is calculated at the fund level, meaning the general partner earns carried interest only after limited partners get back both their full capital contributions and the preferred return on all deals across the entire fund. (Our earlier examples were European waterfalls.)

In the American waterfall, carried interest is calculated deal by deal, allowing the general partner to start earning carried interest from individual deals. This means the general partner is able to start collecting carried interest earlier in the life of a fund.

What is a clawback provision?

Most fund governing agreements include a clawback provision, which is a clause that requires the general partner to return previously received carried interest to the limited partners if later fund performance doesn’t meet expectations. This provision ensures that the general partner doesn’t receive excess profits if the fund's overall performance falls short of the agreed returns to the limited partners. 

The clawback is usually calculated at the end of the fund’s term, but some agreements may include interim clawback assessments. 

Limited partners may also be subject to clawback assessments of distributions for transaction-based obligations and to cover fund expenses when the fund has no remaining uncalled commitments, but most agreements limit this liability by time (typically two to three years from the date of distribution) and by amount (typically 25% to 50% of aggregated distributions). 

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.