Distribution Waterfall
Candlefocus EditorDistribution waterfalls are often used in the context of hedge funds or private equity investment funds, which tend to be high-risk investments, with the potential for high returns. Distribution Waterfalls are commonly used to ensure that everyone involved understands how their investments will be allocated and in what order the capital will be returned. Generally, this is done through a four-tier structure:
• Return of Capital - When all investors’ capital has been returned, the next tier of the waterfall can be activated.
• Preferred Return - After the return of capital, the investor may be entitled to a ‘preferred return’, which will be outlined at the formation of the investment. This is typically a fixed rate of return that is above the risk-free rate.
• The Catch-up Tranche - After any losses through the preferred return have been recovered, the next tier is the ‘catch-up tranche’, during which all investors receive returns that are proportionate to their invested capital until all investors or investors groups are returned their preferred return.
• Carried Interest - The final tier of the waterfall is the ‘carried interest’, i.e. the profits that are retained by the investment manager.
Under this distribution structure, rules can be tailored to the agreement of both parties. For example, there may be a clause that penalises the manager if the return of capital is not made first.
There are two common types of waterfall structures: American and European. The American structure favours the investment manager, giving them control over when to pass out the remainder totals in catch-up and carried interest. In contrast, the European structure is commonly referred to as being ‘investor-friendly’, with specific guidelines that must be met before the investment manager can receive any carried interest.
Ultimately, the choice of waterfall structure depends on the particular agreement between the two parties. For instance, in the US, the provisions for authorising a distribution waterfall are outlined in the Small Business Investment Act, whereas different clauses relating to distribution waterfalls may be mandated by the European Union or specific nations.
Distribution waterfalls continue to be of vital importance in today’s financial regulations, helping to maintain a level of transparency and reliability for investors. Without them, it would be far easier for investment managers to take advantage of investors, severely reducing their ability to generate profits. As such, it's essential to ensure that any distribution waterfall is clearly outlined and fully-understood by both parties.