An equity waterfall, also known as a distribution waterfall, maps cash flow between sponsors (general partners) and limited partners of a private equity fund. A fund's limited partnership agreement describes the terms of the distribution waterfall. Investors must agree to the limited partnership agreement, and thus the waterfall, as part of their investment.
Equity waterfalls follow a tiered cash flow structure. Think of these tiers like stacked pools of water. Upper pools will fill before spilling over to the pool beneath it.
In private equity, rates of return, or hurdle rates, define each tier. Cash flow requirements of senior tiers must be met before monies flow to subordinate tiers.
Most equity waterfalls consist of four distinct tiers:
Equity waterfalls generally fall into one of two categories: European or American.
In a European equity waterfall, sponsors do not receive carried interest until all of the limited partners’ capital contributions – including unrealized investments – have been recovered and their preferred rate of return has been reached. The distributions are allocated on a pro-rata basis, meaning allocations for limited partners are proportionate to their initial investment. In other words, an investor with a 20% stake in the fund will receive 20% of the distributions until they recover all of their initial capital and achieve their preferred rate of return. Sponsors do not receive any payment until all of the limited partners have been fully satisfied.
For example, assume five limited partners each own 20% of a fund with an 8% preferred return and European waterfall. Each partner will receive 20% of the distributions until they recover their investment and an 8% preferred return. Afterward, sponsors receive cash flow as part of their catch-up.
The European model is more favorable for limited partners. Sponsors may wait for years to receive a share of the profits. This increases the sponsor’s risk and incentivizes them to sell investments early.
Some call the American equity waterfall the deal-by-deal model. The key difference between American waterfalls and European waterfalls is the treatment of carried interest. In an American waterfall, sponsors receive carried interest from individual investments in the fund before limited partners are made whole. In other words, sponsors earn carried interest from individual deals rather than the fund as a whole.
For example, assume five limited partners each own 20% of a fund with an 8% preferred return and American waterfall. Limited partners are entitled to their preferred rate of return. However, the sponsor may collect carried interest from individual investments before they receive the full return.
This model favors the sponsor since they typically wait much less time to receive carried interest from the fund. In some cases, they begin collecting carried interest on day one. Additionally, limited partners bear more risk, since they may not reach their hurdle rate before sponsors receive carried interest. Since the American waterfall is less attractive to limited partners, sponsors often include a clawback (or look-back) clause. A look-back clause entitles limited partners to a sponsor's carried interest when they don't achieve their preferred return.
Sponsors worldwide use both waterfall models. However, the American model is most prevalent in the United States. Unsurprisingly, the European model is a favorite in Europe. Some sponsors now use hybrid waterfall models that partially distribute carried interest on a deal-by-deal basis. For the time being, however, European and American equity waterfalls are the two standard waterfall models for commercial real estate.
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