Distribution Waterfall Structure
Distribution Waterfall Explanation
A distribution waterfall is a hierarchical structure that determines the order and proportion in which investment returns are allocated between limited partners (LPs/investors) and general partners (GPs/sponsors). The structure typically consists of multiple tiers or “hurdles,” with each tier having specific distribution rules. As cash flows reach each tier, they’re distributed according to that tier’s allocation percentages before “cascading” down to the next tier. This mechanism aligns interests by ensuring investors receive their preferred returns before sponsors participate significantly in profits, while also incentivizing sponsors through increased participation at higher return levels.
Example Distribution Waterfall Table
Here’s a typical four-tier distribution waterfall structure:
| Tier | Hurdle/Threshold | Distribution Split | Description |
|---|---|---|---|
| Tier 1: Return of Capital | 100% of invested capital | 100% to LPs / 0% to GP | All distributions go to investors until they recover their initial investment |
| Tier 2: Preferred Return | 8% IRR (cumulative) | 100% to LPs / 0% to GP | Investors receive all distributions until they achieve an 8% annual preferred return on their investment |
| Tier 3: GP Catch-Up | Until GP receives 20% of Tier 2 profits | 0% to LPs / 100% to GP | Sponsor receives all distributions until they “catch up” to 20% of the preferred return profits |
| Tier 4: Carried Interest | All remaining distributions | 80% to LPs / 20% to GP | After catch-up is complete, all additional profits are split 80/20 between investors and sponsor |
Numerical Example
- Initial Investment: $10 million
- Total Proceeds: $18 million
- Total Profit: $8 million
Distribution Flow:
- Tier 1: First $10M → 100% to LPs (capital returned)
- Tier 2: Next $800K → 100% to LPs (8% preferred return)
- Tier 3: Next $200K → 100% to GP (catch-up to 20% of $1M in preferred profits)
- Tier 4: Remaining $7M → $5.6M to LPs (80%), $1.4M to GP (20%)
Final Distribution:
- LPs receive: $16.4M (initial capital + preferred return + share of excess)
- GP receives: $1.6M (catch-up + carried interest)
This structure ensures investors are prioritized for capital return and minimum returns, while providing strong upside incentive for the sponsor to maximize overall returns.