Private Equity funds had a remarkable year in 2021. If you are looking to launch a fund, invest in a fund or are new to the PE industry, or both and need to brush up on PE waterfall models, this primer is for you.

This article aims to look at how the private equity waterfall model works and how it might benefit LPs investing in private equity funds. We’ll examine:

• the fundamentals of PE waterfalls
• the importance of waterfall distributions
• types of waterfall structures
• various tiers of waterfall structures

Waterfall Overview

Investing in private equity funds can be financially beneficial, especially when limited partners (LPs) benefit from dividing capital gains or investment returns between all participants, including the General Partners (GPs), also known as the private equity waterfall model.

Private equity waterfall models define all the rules for distributing profits within the private equity agreement. Furthermore, a waterfall model is a structure designed to ensure that the interests of GPs and LPs align in a way that adequately compensates everyone involved in an investment. Ideally, waterfall models ensure that everyone receives the correct incentives.

In addition, waterfalls can be difficult to model or explain in partnership agreements; therefore, they should be done carefully and approved by third-party professionals with years of private equity industry experience.

Fundamentals: What Is the Waterfall Model in Private Equity?

Private equity waterfall models are a method of dividing the capital gain or investment returns across all investors.

Waterfall structures allow LPs to provide the GP or fund manager with financial incentives intended to motivate them to achieve even bigger returns. However, if returns come in lower than expected, the GP receives a lower share of profits.

Distributions from a capital event, such as a refinance or sale of the investment, are allocated to the GPs and LPs based on their roles. The terms of a waterfall model are generally outlined in the fund’s legal documents or partnership agreement, accessible to everyone who is part of an investment. All terms included in the documentation should be clear to all parties and establish agreed-upon boundaries for the deal.

Importance of the Private Equity Distribution Waterfall

In a private equity limited partnership agreement, a distribution waterfall lays out the rules and methods for profit distribution. Its primary goal is to match general partner incentives and design a pay structure for limited partners. The distribution system can also be represented as a series of buckets stacked on top of each other. Each bucket represents a profit distribution. When the first bucket is full, the profits are transferred to the second, and so on. This type of allocation structure protects investors’ interests while also incentivizing the general partner to maximize the returns.

Types of Waterfall Structures

The two most common forms of distribution waterfalls are the American Waterfall Model and the European Waterfall Model. LPs typically favor the European waterfall, whereas GPs prefer the American waterfall model.

In the American waterfall model, the GPs benefit more. The model gets applied to every deal instead of at the fund level. The risk gets spread over each investment and ensures that the GPs receive a higher share of profits before LPs receive back their initial investment and preferred returns. Likewise, in the European waterfall, LPs receive preference. The distribution proceeds are allocated at the aggregate fund level, and each payout reflects the overall performance rather than being tied to an individual investment. Managers never receive any profits until LPs recoup their initial investment and the amount owed in the preferred return, if applicable. It can take GPs a long time, up to several years, before they make good on their initial investment and start seeing profits.

The two methods are usually differentiated by how they handle the timing and allocation of distribution revenues to GPs and LPs. Ultimately, the end outcome should be the same, and only the timing differs.

How Does a Private Equity Waterfall Work?

A private equity investment structure aims to align the interests of all parties involved in a single deal or a private equity fund. As such, a private equity waterfall works by allocating the profits with regard to the tiers of the hierarchy that constitute the fund structure, taking the form of a waterfall.

The waterfalls (tiers) of investment are essentially the structure of the investors. In a distribution waterfall, when the highest tier has been satisfied with the amount of profit allocated, the remaining profit can be allocated to the tiers below.

Tiers in a Private Equity Distribution Waterfall Structure

Private equity waterfalls follow a tiered cash flow structure. The allocation in question derives its name from the cascading nature of its constituent tiers. As such, a typical distribution waterfall consists of the following four tiers:

1. Return of Capital (ROC) – Investors receive 100% of any distributions until they have received all their initial investments. Investors at this tier can’t receive gains or recoup losses resulting from any money spent. Essentially, they’re entitled to get back only what they put in at this tier and nothing more.
2. Preferred Return (Hurdle Rate) – This tier is one of the primary features of a distribution waterfall model. When LPs make their initial investment, they expect they’ll receive a certain level of returns, typically set between 8% and 10% percent. However, some entities can provide returns at a higher rate of 20% or more or not have a hurdle at all.
3. Catch-up provision – The catch-up bucket is highly beneficial for the general partner, which pushes any distributions back to the GP, making sure the GP is made whole. They get all or a significant share of the profit until they reach a certain profit percentage.
4. Carried Interest – Carried interest represents the portion of any profits provided to the GP regardless of their initial investment (typically 20%). LPs also receive disbursements from any leftover profits (typically 80%). This tier represents the primary source of funding for a sponsor. In return, it’s the GP’s job to ensure that LPs receive their initial investment back, along with the agreed-upon preferred returns.

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ULP 14774846  04/04/2022