What is a Distribution Waterfall?

A distribution waterfall is an approach in the allocation of capital gains which entails that the profit made in an investments are distributed between the participants. A distribution waterfall aims allocate profits or capital gains made by a company to investors and partners of the company.

 Distribution waterfall is commonly used in private equity funds, it entails sharing the profits of the funds properly so that participants in the funds can be motivated. During the allocation of gains, investors or participants receive more money than their initial investment, the addition is as a result of the allocation of capital gains.

How Does a Distribution Waterfall Work? 

One of the key ways to incentivize investors is the distribution of profits realized in an investment. The distribution waterfall is a method that allocates capital gains between a funds investors. However, the allocation of profit is done with regards to the tiers of hierarchy that make up the fund structure, taking the form of a waterfall. 

The waterfalls (tiers) of an investment is basically the structure of the investors, in a distribution waterfall, when the highest level/tier has been satisfied with the amount of profit allocated to them, the remaining profit can be allocated to the other tiers. Typically, a distribution waterfall consists of four tiers which are;

• Return of capital- investors receive 100% of distribution until all initial capital contributions are recovered.
• Preferred return- this tier places premium of preferred return. This means that investors receive 100% of further distributions until preferred return is earned on the investment.
• Catch-up tranche- this tier is made of sponsors. The distribution waterfall in this tier holds that 100% of the distributions is allocated to the sponsor of the fund so that they can earn a percentage of profits.
• Carried interest- this is a stated percentage of distributions that is allocated to the sponsor.

Here are some important things you should know about a distribution waterfall;

• A distribution waterfall is a method of allocating capital gains between participants or investors in an investment.
• The distribution waterfall seeks to achieve distribution of profits to participants as a way of motivating and incentivizing them.
• Four tiers exist in a distribution waterfall and allocation of capital gains is done according to the tiers.
• The American waterfall structure pays more attention to fund managers while the European waterfall structure favor the investors more.

American vs European Waterfall Structures

The American and European waterfall structures are the common types of distribution waterfall. The American waterfall structure basically pays more attention to fund managers being allocate the profits of an investment before any attention is paid to the investors. Before investors receive their initial capital and preferred return, the managers of the funds must have been allocated a reasonable portion of profit as incentive. 

The European waterfall structure however advocates distribution of profits to investors in which managers are not entitled to profits until the investor receive their initial capital and preferred return. Hence, managers are expected to wait until the investors are fully satisfied before they benefit from the profit of the investment.