A distribution waterfall is the order in which an investment vehicle makes payment distributions. It ensures the proper allocation of returns to investors in a pooled investment. Distribution waterfalls follow a cascading structure, meaning that once one tier’s allocation requirements are satisfied, the excess funds fall to the next tier to be distributed until all capital is issued.
The purpose of the waterfall model is to properly compensate all investors, both limited and general partners, based on their contributions. Waterfalls also provide financial incentives for sponsors to maximize profitability for investors, benefitting all involved parties.
Typically used for private equity funds and real estate investments, waterfalls benefit the general partner over the limited partner, as the distribution schedule is applied separately deal-to-deal rather than at the aggregate fund level. EquityMultiple uses this concept of waterfalls as a way to properly incentivize our general partners on equity deals.
Distribution Waterfall Tiers
An example of a four tier waterfall is outlined below:
Return of Capital: At this first tier, investors are returned their initial investment amount. This is not taxable income, as it is solely the recuperation of capital contributions.
Preferred Return: Once all limited partner investors receive 100% return of capital, further profits are distributed at the preferred return rate dictated prior to investment.
Catch-Up Tranche: The third tier benefits the general partner, who then earns distributions up to a predetermined percentage of profits.
Carried Interest: Finally, carried interest is the stated percentage of distributions that the sponsor receives.
The rates of return involved in waterfall distributions are calculated and agreed upon by both parties prior to investment. It is important to note that the hurdles in a waterfall as well as the split of profit is negotiated on a deal by deal basis between the general partner and the limited partner. This article goes into more depth on preferred returns within waterfalls, and examples of this process in action.
The Bottom Line
EquityMultiple returns capital following a distribution waterfall structure. It is critical for investors to understand the waterfall structure of each offering, including the preferred return rate, before investing. Waterfalls should align interests for limited and general partners by protecting the interests of investors while encouraging sponsors to maximize returns.Back to Glossary