The WATERFALL reflects the commercial agreement between the partners in a private equity fund for the share of the proceeds of the partnership according to certain pre-set rules set out in the Limited Partnership Agreement (LPA). The rules determine how much each partner in the fund gets paid, and according to what priority. The waterfall will need to be recalculated on every DISTRIBUTION.

It is also the crux of the commercial agreement between the investors (the Limited Partners) and the principals of the fund (the Manager or General Partner), who typically invest via a separate partnership – the Carry Partnership. The carried interest (or, simply, “carry”) that the fund manager agrees with the other partners is often around 20% of profits but some funds provide for a higher/lower amount and others may provide for a carry percentage that rises once certain return targets are met. This kind of “ratcheted” arrangement is more common in venture capital funds than in private equity.

The waterfall of a typical private equity fund may follow the following order of cash return:

  • General Partner Share (GPS, often termed the “management fee” to the General Partner
  • Return of loan capital to Limited Partners
  • An IRR based premium “hurdle”, or preferred return) of usually between 6-8% to the Limited Partners
  • “Hurdle Catch up”, if the LPA provides for this, for the carry meaning that, when any hurdle is passed, the carry partner would receive any additional profits until it had received the appropriate carry share payable on the amount paid to Limited Partners as an IRR premium
  • Distributions shared according to the capital ratios (typically 80/20 split) – includes the profit share for the Manager or GP

For example, in a fund of £100m, the Limited Partner and carry partners invest small capital sums reflecting the agreed capital sharing between them (the 80:20 profit share) and the LPs invest the balance as loan capital. At the point of a distribution, the waterfall calculation would look to fill each bucket up to the amount due at that point. So, for example, where there was sufficient proceeds being distributed:

  • The GPS would be settled first
  • Then, the loans drawn down to that point would be repaid and the hurdle rate would be calculated on the amounts drawn to that date
  • Next, the hurdle catch up would be calculated to ‘make good’ the carry partner
  • If there were then proceeds remaining, the balance would be split along the capital sharing ratio.

If there are insufficient proceeds to fill each of these buckets, that which could be paid would be, and the record of how the proceeds were distributed would then be taken into account the next time the distribution waterfall is calculated.