Distribution waterfall
Also called Waterfall, Distribution structure, Promote structure.
A distribution waterfall is the ordered set of tiers that determines how cash is split between limited and general partners. Each tier is filled completely before any money reaches the next one, and the general partner's share rises as it goes.
How it works
The structure exists to align incentives across an asymmetric partnership. Limited partners supply most of the capital and want their money back with a base return before anyone is rewarded for performance. The general partner supplies the work and wants a disproportionate share of the upside it creates. A waterfall encodes that bargain as an algorithm.
A conventional structure runs four tiers: return of capital, then the preferred return, then a general partner catch-up, then a residual split such as 80 to the limited partners and 20 to the general partner. Structures with multiple IRR hurdles add tiers, so the general partner's share might step from 20 percent above a 12 percent IRR to 30 percent above an 18 percent IRR and 40 percent above 22 percent.
Two structural choices dominate the outcome and both should be established before any modelling. European or whole-fund waterfalls test the hurdle across all capital before promote is paid; American or deal-by-deal waterfalls test each investment separately and pay promote earlier, usually with a clawback to protect limited partners if later deals disappoint. And IRR-based hurdles make the split depend on timing, while multiple-based hurdles do not, which is why many agreements require both to be met.
Worked example
Illustrative. $10,000,000 of limited partner capital, 8 percent cumulative compounded preferred return, five-year hold, full general partner catch-up to 20 percent, then an 80/20 residual split. Total distributions of $18,000,000.
| Tier 1, return of capital to the LP | $10,000,000 |
|---|---|
| Tier 2, accrued preferred return to the LP | $4,693,281 |
| Tier 3, GP catch-up at 100% | $1,173,320 |
| Tier 4, residual 80/20LP $1,706,719, GP $426,680 | $2,133,399 |
| Limited partner total | $16,400,000 |
| General partner total, and its share of profit | $1,600,000, exactly 20% of the $8,000,000 profit |
Every tier ties out and the catch-up does its job precisely: the general partner ends with 20 percent of all profit above return of capital, which is what a full catch-up is designed to produce.
Conventions worth knowing
- Establish whether the hurdle is measured on IRR, on equity multiple, or on both. IRR-only hurdles can be cleared by an early partial sale in a way a multiple hurdle cannot.
- Deal-by-deal promote without a clawback is a structural risk to limited partners, not a detail.
The common mistake
Assuming a residual split applies to all the profit
An 80/20 waterfall does not mean the general partner receives 20 percent of profit at every level. Below the preferred return it receives nothing beyond its pro rata share, and in the catch-up tier it may receive 100 percent. The general partner's realised share of profit is therefore a function of how much total profit there was, and on a deal that barely clears the pref it can be close to zero. The only way to know any partner's outcome is to run the actual tiers on the actual cash flows, in order.
Related terms
- Preferred returnA preferred return is a threshold rate of return that limited partners receive on their capital before the general partner participates in profits beyond its own pro rata share. It is a priority in the distribution queue, not a promise that the money will be there.
- PromoteThe promote is the general partner's share of profits in excess of its pro rata capital contribution, earned once the limited partners have received their capital back plus the preferred return. It is the performance compensation in a real estate partnership.
- GP catch-upA general partner catch-up is a waterfall tier in which the general partner receives most or all of the distributions after the preferred return has been paid, until it has received its full promote percentage of all profit distributed so far. It restores the economic bargain the preferred return interrupted.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
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