Private equity funds utilize waterfall distributions to allocate profits, often distinguishing between European and American models. These models define how and when investors—general partners (GPs) and limited partners (LPs)—receive payouts, based on their limited partnership agreements (LPAs). Knowing these models is crucial for stakeholders aiming to maximize investment returns.
We have a ready-to-go Private Equity Fund Cashflows Model (Investor Cashflows) – American Waterfall Distribution Template and a European Waterfall Distribution Template for those looking for an easy-to-understand PE Fund Model Template to use for their PE Funds or to understand the flow of investment cash flows to a GP and LP.
What is a Waterfall Distribution in Private Equity?
In private equity, a “waterfall” refers to the sequence in which profits are distributed to stakeholders. The primary objective is to align incentives, reward efficient fund management, and ensure LPs recover their capital with returns. Essential components include:
- Return of Capital: Repaying the original investment.
- Preferred Return: Minimum return for LPs before GP profits.
- Catch-Up: Boosting the GP’s profit share after LPs get their preferred return.
- Profit Split: Dividing profits, often favoring GPs once thresholds are met.
The European and American waterfall models vary in profit allocation, particularly how swiftly GPs accrue carried interest.
The European Waterfall Distribution Model
Structure and Mechanics
The European Waterfall is LP-friendly. GPs only collect carried interest once LPs reclaim their invested capital and a preferred return, typically 6-8%.
Steps:
- Return of Capital: Prioritize LP capital repayment.
- Preferred Return: LPs receive a hurdle rate, compensating for time value.
- Catch-Up Clause: GPs gain a larger share until their carried interest matches agreed terms, usually 20%.
- Profit Split: Remaining profits split, often 80/20 in LP favor.
This structure minimizes early GP profits, emphasizing LP compensation.
Advantages and Disadvantages
Advantages:
- LP Protection: Prioritizes LP capital and returns before GP profits.
- Risk Mitigation: Guards against GPs earning fees before fund viability.
Disadvantages:
- Delayed GP Fees: GPs wait for distribution, potentially deterring risky, rewarding ventures.
- Lower GP Incentives: Delayed earnings might reduce GP motivation.
For more on European waterfalls, see this resource.
The American Waterfall Distribution Model
Structure and Mechanics
In contrast, the American Waterfall allows earlier GP earnings, contingent upon LPs receiving each investment’s preferred return.
Steps:
- Return of Capital: LP capital returns remain priority.
- Preferred Return: LPs receive a hurdle rate.
- Catch-Up Clause: GPs rapidly gain profits in the catch-up phase until terms (e.g., 20%) are satisfied.
- Profit Split: Profits split per deal upon LP preferred return receipt.
An advantage is speedier GP payments.
Advantages and Disadvantages
Advantages:
- Quick GP Payments: Early profit-sharing favors GPs in multiple-exit funds.
- Incentive Alignment: Encourages consistent GP performance for swift LP returns.
Disadvantages:
- LP Risk: Earlier GP earnings can precede full LP capital recovery.
- Reduced LP Protection: Profit-sharing may disadvantage LPs in underperforming funds.
For differences, explore this comprehensive guide.
Key Differences Between European and American Waterfalls
Timing of Carried Interest
- European: GPs profit post-LP capital and return recovery.
- American: GPs profit deal-by-deal after LPs get preferred return.
Incentives
- European: Protects LPs over fast GP profits.
- American: Early GP rewards, risking LP capital.
Distribution of Risk and Reward
- European: Prioritizes LP capital recovery.
- American: Quick GP profit but less LP protection.
Frequently Asked Questions
What is a distribution waterfall?
A distribution waterfall determines how investment returns are allocated among fund participants, defining profit-sharing and payout schedules.
How does the European waterfall favor LPs?
The European model delays GP carried interest until LPs fully recover their capital and preferred returns, ensuring greater LP security.
Why might GPs prefer the American waterfall?
GPs benefit from quicker carried interest payments, aligning with incentives for immediate investment success.
Final Thoughts!
Choosing between European and American waterfall models affects GP and LP returns. While the European model favors LPs with delayed GP profits, the American provides prompt GP earnings, better aligning incentives for fund success. Each has distinct benefits and drawbacks, necessitating careful consideration according to investment objectives. Understanding these models enables effective fund management, benefiting all stakeholders.
