Distribution Waterfalls

A distribution waterfall refers to the method by which profits from an investment are shared among the participants in the investment, often used in private equity and real estate investment structures. It outlines the hierarchy and priority of profit distribution among the parties involved.

The waterfall structure is often based on specific performance thresholds, usually referred to as "hurdles" or "tiers." These thresholds determine when the next tier of the waterfall is activated and who is paid out at each tier.

Here's a simplified example of a four-tiered waterfall structure:

Return of Capital: The first tier is usually the return of capital. In this tier, the initial capital contributed by the investors (often known as the "limited partners" or "LPs") is paid back.

Preferred Return: The second tier is often the "preferred return," where the LPs receive a predetermined rate of return on their investment (for instance, an 8% annual return) before the general partner (GP, i.e., the party managing the investment) receives any profits.

Catch-Up: The third tier, known as the "catch-up" tier, often gives the GP a larger portion of the profits until they have received a certain percentage of the total profits (e.g., 20%), effectively "catching up" to the LPs.

Profit Split: The fourth tier, often referred to as the "carried interest" or "promote," involves splitting the remaining profits between the LPs and the GP, often at some predetermined ratio (like 80% to the LPs and 20% to the GP).

The specifics of a waterfall structure can vary widely and are dictated by the terms of the partnership agreement or the investment contract. The concept is designed to align the interests of the GP and LPs, ensuring that the GP is incentivized to maximize the return on the investment.