How do distribution waterfalls work?

Distribution waterfalls illustrate how returns or capital gains are distributed to investors. The word “waterfall” is an accurate depiction of the investor hierarchy, which is often utilized by hedge funds and in the private equity space to define the order in which payments will be made to limited and general partners. 

Typically, general partners – or the fund manager – have more skin in the game, and thus tend to receive a larger share of the profits, a mechanism that can be used as a way to incentivize them to maximize returns for investors within that tranche. The payment method has earned its name because, as you can see in the examples below, the returns generated from an opportunity make their way down to all participants in a deal. 

Return of Capital / Preferred Return To Limited Partners

Before any profits on an investment can be realized, all limited partners (LPs) are repaid for their initial investment. This is the first stage of the process, and before general partners (GPs) receive any benefit, the investors in this position will be fully compensated. 

In the most basic distribution waterfalls, capital will be returned to investors until they reach their preferred rate of return (varying depending on the terms of the deal). Afterwards excess proceeds are split (typically 80/20) between limited partners and the fund’s general partners. However, in the private equity space, there are often additional details added to further incentivize the manager of the fund.

Catch-Up Tranche

A more common structure for payouts and for distribution waterfalls includes a catch-up tranche for general partners after limited partners have received their predetermined rate of return. For example, after LPs receive their capital and preferred return, GPs would receive all distributions until they receive 20% of all profits (the catch up) matching the principal and initial return made to LPs. This wrinkle makes the GP stakes inherently more valuable. Instead of just splitting 20% of profits after a deal has paid out for LPs, general partners with a catch-up instead receive 20% of distributions made to this point before reverting back to the 80/20 payout split between LPs and GPs. 

In some deals, however, there can be additional details that further incentivize the GP stakes of a deal. 

Raising The (GP) Stakes w/ IRR Hurdles

Some deals are structured to further reward the management and general partners for their contribution.

This comes in the form of a hurdle rate, or minimum preferred return at which point the profit split between GP and LP changes and is specified by the general partner in advance.For example, suppose that below a 15% IRR the profit split between a GP and LP investor is 10% and 90%. However, after returns over a 15% IRR, the distribution rate to General Partners and Limited Partners changes to 30% and 70%. Thus, the GP receives a larger share of income when they generate higher returns. In turn,LP investors also receive a larger return on their capital. 

Diversify Your Portfolio Today

How can they be beneficial to an investor?

For investors who may be participating as a limited partner, or in LP stakes, investors can take solace knowing that they’ll be able to benefit from the upside of an investment opportunity and that as profits and certain goals are achieved, they will benefit from a preferred position for realizing the profits. There are many private equity opportunities available on Yieldstreet, as well as opportunities offering ownership stakes for private alternative managers. Depending on the structure of the given opportunity and the potential upside earned, investors in these opportunities may be able to benefit from a preferential position in the given distribution waterfall. 

How helpful is this content?

Share this article:

Join a community of 350,000+ members

  • Gain access to unique offerings previously reserved for the ultra-wealthy

  • Customize your portfolio for income, growth, or a balance of both

  • Get started today and earn an average IRR of over 8%

What investors are saying about Yieldstreet

Apr 2022

The due diligence, risk management, and product education materials are thorough, excellent, and easy to use and understand.

Manoj J
Member since 2019
Apr 2022

Excellent and unique selections that I can't find elsewhere.

Jonathan S
Member since 2019
Apr 2022

The platform delivers in a very concise manner. Easy to get a clear understanding at a glance from the web or mobile app.

Tim S
Member since 2021
The testimonials presented on this page have been provided by actual investors in Yieldstreet funds without compensation. Yieldstreet has selected the testimonials, and certain testimonials have been edited to remove personally identifiable information and for brevity. Testimonials were not selected based on objective or random criteria, but rather were selected based on Yieldstreet's understanding of its relationship with the providers of the testimonials. The uncompensated testimonials presented here may not be representative of other investors' experiences, and there can be no guarantee that investors will experience future performance or success consistent with the testimonials presented.

The Yield

Our weekly podcast providing ideas about how to make money work for you and bring you closer to your dreams.

Since inception, over $2.8B has been invested on Yieldstreet

Join today for free to access alternative investment opportunities.