Distribution Waterfall: How PE Profit Sharing Works

Once a portfolio company is sold for a profit, who gets paid first, and how much?

The distribution waterfall is a critical yet often misunderstood framework that dictates how profits flow between investors and fund managers.

Understanding this structure is fundamental to grasping how PE firms generate returns and how their incentives are aligned with their investors.

The Parties Involved

Before we dive into the distribution waterfall, let's quickly identify the key players:

• Limited Partners (LPs): These are the investors who commit capital to the PE fund. They can be institutional investors like pension funds, endowments, sovereign wealth funds, or high-net-worth individuals. They are limited in their liability, typically only to the amount of capital they've committed.
• General Partner (GP): This is the private equity firm itself, the fund manager. The GP is responsible for sourcing deals, making investment decisions, managing the portfolio companies, and ultimately exiting those investments. They typically have unlimited liability.

What is a Distribution Waterfall?

The distribution waterfall is a predefined sequence for allocating profits from a private equity fund’s investments.

Embedded in the fund’s Limited Partnership Agreement (LPA), it ensures that Limited Partners (LPs) recoup their capital and earn a minimum return before General Partners (GPs) receive performance-based payouts.

This structure balances fairness with performance incentives, ensuring LPs are protected while GPs are rewarded for delivering outsized returns.

The American Waterfall: A Deal-by-Deal Approach

The most common model, the American Waterfall (or deal-by-deal), distributes profits as each investment is exited. Here is the typical four step process:

1. Return of Capital to LPs
   • First priority: LPs get back 100% of their initial investment in the specific deal before any profit-sharing begins.
   • Example: If an LP invested $1M in a company sold for $1.5M a year later, the first $1M goes to the LP.
2. Preferred Return (Hurdle Rate)
   • LPs then receive a minimum agreed return (e.g., 8% annually) on their invested capital. This hurdle rate is a minimum annual rate of return that the LPs must earn on their invested capital before the GP can start taking a share of the profits. It compensates LPs for the opportunity cost and risk of their investment.
   • Example: On the $1M investment, $80,000 (8%) is paid to LPs from profits.
3. GP Catch-Up
   • GPs receive 100% of subsequent profits until they “catch up” to their carried interest share (typically 20%).
   • Example: GPs take the next distributions until their 20% share of cumulative profits is met (e.g., $20,000 if LPs received $80,000).
4. Carried Interest Split (80/20)
   • Once the GP has caught up, all subsequent distributions are split according to a pre-defined ratio, most commonly 80% to the LPs and 20% to the GP. This 20% is the GP's primary profit incentive and is known as carried interest.
   • Example: On a $100,000 profit post-hurdle and GP catch-up:
     • LPs get $80,000 (80%)
     • GPs get $20,000 (20%)

Putting It All Together:
Imagine a $1M LP investment turns into $2M upon exit ($1M profit after capital return):

1. Hurdle Rate (8% of $1M): $80,000 to LPs.
2. GP Catch-Up: Next $20,000 to GPs ($100,000 total profit distributed so far).
3. Remaining $900,000: Split 80/20 → LPs get $720,000, GPs get $180,000.
   Total Takeaway:

• LPs: $1M(capital) + $800,000 profit
• GPs: $200,000 profit

The European Waterfall: Whole-Fund Safety

In contrast, the European Waterfall (whole-fund model) delays GP payouts until all LP capital + preferred returns are repaid across the entire fund.

This is more LP-friendly:

• No carried interest is paid until the fund’s total returns exceed the hurdle rate.
• Reduces risk of GPs earning carry interest on early wins while later deals underperform.

American vs. European Waterfall: A Quick Comparison

Why the Waterfall Matters

1. Incentivizes Performance: GPs only earn carry after LPs are made whole, aligning interests.
2. Protects LPs: Capital and preferred returns are prioritized, cushioning against losses.
3. Clarity & Trust: Predefined rules for profit distribution in the LPA minimize disputes.
4. Drives Discipline: GPs focus on sustainable growth, not quick flips.

Key Terms

• Hurdle Rate: Minimum return LPs must earn before GPs get carry (e.g., 8%).
• Catch-Up: Mechanism to accelerate GP profits post-hurdle.
• Carried Interest: GPs’ share of profits (typically 20%), their performance fee.
• Management Fee: Annual fee (1-2% of assets) covering GP operational costs.

Clawbacks and Hurdles

• Clawback Provisions: Most fund agreements include a clawback clause. This provision requires the GP to return any excess carried interest received if, by the end of the fund's life, the LPs haven't achieved their overall preferred return or if the GP received carried interest on deals that ultimately became unprofitable. It's a vital safeguard for LPs.
• Deal-by-Deal vs. Fund-Level Hurdles: As mentioned, the American waterfall typically allows the GP to earn carry on a deal-by-deal basis once that specific deal clears its hurdle, potentially leading to earlier carry for the GP. The European waterfall requires the entire fund to return all committed capital plus the hurdle before the GP earns any carried interest, aligning GP and LP interests more closely over the fund's full life.

The Bottom Line

The distribution waterfall is the backbone of private equity’s success.

By prioritizing LPs while rewarding GPs for excellence, it balances risk and reward.