Definition

Waterfall structure is basically the process or sequence in which a money is distributed in a fund. The waterfall implies that until and unless the first tier is full with the water i.e money will not fall into the next tier.

The fund has basically two types of partners:

  • General Partners: Also known as the sponsor of the fund and is responsible for managing the fund
  • Limited Partners: They are the persons who invest money in the fund

Types of Structure

  • European Structure

This structure works on a whole fund level basis i.e money is distributed when all the deals in a fund are realized. In this structure the liquidation is less as it takes a long time to realize all the deals after the initial investment is made and General partners only gets the money after initial capital and preferred return is paid to the limited Partners.

  • American Structure

This structure works on deal by deal basis i.e money is distributed as and when a deal is realized. This structure overcomes the liquidity issues associated with the European structure and the general partners are paid even though the Limited partners are not compensated fully with the return of capital and preferred return.

Tiers of the Waterfall Distribution

  • Return of Capital: It is the return of initial capital invested by the Limited Partners and General Partners as Limited Partners
  • Preferred Return: Also known as hurdle rate that Limited Partners and General Partners as Limited Partners get on the amount of investment made by them. It is a agreed percentage and usually ranges between 8% to 10%. It gets accumulated year over year
  • Carried Interest: Also known as carry paid after the Return of capital and preferred return is paid and is basically paid to limited partners. It is a kind of performance fees and is usually around 20% of the profits
  • Balance: After all the above tiers are paid the balance money if any is paid to limited partners and general partners in an agreed ratio usually in the ratio of 80:20. 80 for limited partners and 20 for general partners

Waterfall Structure of a fund

Clauses under Waterfall Distribution agreement

  • Clawback Clause

This clause favors the Limited Partners and is usually used in case of American Structure. In American Structure incentive fee can be paid to general partners even when the limited partners are not fully compensated with capital and preferred return (deal by deal basis). To protect investors this clause says that if the limited partners are not fully compensated then the money paid to general partners as carry can be called back and only excess of initial capital and preferred return can be paid to general partners

  • Catch-Up Clause

This clause favors the general partners. General partners receive carry as a percentage of total return reduces by return of capital and preferred return. But if this clause is present the general partners would get carry as a percentage of total return without reducing return of capital and preferred return

Illustration

Initial investment

 3,00,000 by limited partners

60,000 by general partners as limited partners

Cumulative Preferred Return for four years

96,000 to limited partners

19200 to general partners as limited partners

Amount realized on sale of all deals – 7,00,000

Solution

Tier 1 – Return of initial Capital

3,00,000 to limited partners

60,000 to general partners as limited partners

Tier 2 – Preferred return

96,000 to limited partners

19200 to general partners as limited partners

Tier 3 – Carried Interest (Assuming catch-up clause is not present)

20% of (7,00,000- 3,00,000- 60,000- 96,000- 19,200)

= 44,960

Tier 4- Balance assuming ratio is 80:20

Limited Partners (80%) – 1,43,872

General Partners (20%) – 35968

Total amount received by Limited partners = 5,39,872

Total amount received by general partners = 1,60,128

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