Introduction

In the world of private equity investing, the distribution waterfall refers to the priority and sequence in which profits are distributed to the parties involved, such as the limited partners (LPs) and general partners (GPs), based on the terms outlined in the private equity fund's operating agreement. The distribution waterfall plays a crucial role in determining how profits are allocated once investments are realized.

Components of the Distribution Waterfall

The distribution waterfall typically consists of several important components:

Preferred Return

The preferred return or "pref" represents the minimum rate of return that the limited partners expect before any profits are distributed to the general partners. It provides LPs with some level of protection by ensuring they receive a predetermined return on their investment before GPs can participate in profits.

Return of Capital

Once the preferred return is met, the distribution waterfall proceeds to return the original capital contributions made by the limited partners.

Carried Interest

The carried interest, often referred to as "carry," is the GP's share of profits after meeting the preferred return and returning the contributed capital to LPs. It is the GP's performance-based incentive and is typically expressed as a percentage, such as 20%.

Hurdle Rate

The hurdle rate is an optional feature typically used to increase the GP's carried interest beyond the initial percentage if certain performance or return targets are achieved. For example, if the fund's overall return exceeds a predetermined threshold, the GP may be entitled to a higher share of profits.

Catch-Up Provision

The catch-up provision ensures that the GP catches up to their contractual share of profits before the distribution ratio reverts back to the original profit-sharing allocation between the LPs and GPs set by the carried interest.

Considerations in Setting up a Distribution Waterfall

When structuring the distribution waterfall, GPs and LPs need to consider various factors:

Investment Strategy and Risk-Return Profile

The distribution waterfall should align with the fund's investment strategy and risk-return profile. Strategies that involve higher risks or longer holding periods might necessitate different distribution structures.

Alignment of Interests

It's important to ensure alignment of interests between LPs and GPs, ensuring that both parties benefit from a successful investment outcome.

Ability to Attract Investors

The structure and terms of the distribution waterfall can affect a fund's ability to attract potential investors. Transparency and well-defined distribution mechanics often enhance investor confidence.