How do distribution waterfalls work?

August 5, 20223 min read
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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. 

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.