Distribution Waterfall: How PE Profit Sharing Works

Once a portfolio company is sold for a profit, who gets paid first, and how much?

Enter the distribution waterfall—a critical yet often misunderstood framework that dictates how profits flow between investors and fund managers.

Let’s unravel this system and its role in aligning incentives, mitigating risk, and driving PE’s trillion-dollar engine.

What is a Distribution Waterfall?

The distribution waterfall is a predefined sequence for allocating profits from a private equity fund’s investments.

Embedded in the fund’s Limited Partnership Agreement (LPA), it ensures that Limited Partners (LPs) recoup their capital and earn a minimum return before General Partners (GPs) receive performance-based payouts.

Imagine a literal waterfall: cash cascades down tiers, each with specific rules.

This structure balances fairness with performance incentives, ensuring LPs are protected while GPs are rewarded for delivering outsized returns.

The American Waterfall: A Deal-by-Deal Approach

The most common model, the American Waterfall (or deal-by-deal), distributes profits as each investment is exited. Here’s how it breaks down:

1. Return of Capital to LPs
   • First priority: LPs get back 100% of their initial investment in the specific deal.
   • Example: If an LP invested $1M in a company later sold for $1.5M, the first $1M goes to the LP.
2. Preferred Return (Hurdle Rate)
   • LPs then receive a minimum agreed return (e.g., 8% annually) on their invested capital.
   • Example: On the $1M investment, $80,000 paid to LPs from profits.
3. GP Catch-Up
   • GPs receive 100% of subsequent profits until they “catch up” to their carried interest share (typically 20%).
   • Example: If total profits after hurdle are $20,000, GPs take this until their 20% share of cumulative profits is met.
4. Carried Interest Split (80/20)
   • Remaining profits are split: 80% to LPs, 20% to GPs.
   • Example: On a $100,000 profit post-hurdle:
     • LPs get $80,000 (80%)
     • GPs get $20,000 (20%)

Putting It All Together:
Imagine a $1M LP investment turns into $2M upon exit ($1M profit after capital return):

1. Hurdle Rate (8% of $1M): $80,000 to LPs.
2. GP Catch-Up: Next $20,000 to GPs ($100,000 total profit so far).
3. Remaining $900,000: Split 80/20 → LPs get $720,000, GPs get $180,000.
   Total Takeaway:

• LPs: $1M(capital) + $800,000 profit
• GPs: $200,000 profit

The European Waterfall: Whole-Fund Safety

In contrast, the European Waterfall (whole-fund model) delays GP payouts until all LP capital + preferred returns are repaid across the entire fund.

This is more LP-friendly:

• No carried interest is paid until the fund’s total returns exceed the hurdle rate.
• Reduces risk of GPs earning carry interest on early wins while later deals underperform.

American vs. European Waterfall: A Quick Comparison

Why the Waterfall Matters

1. Incentivizes Performance: GPs only earn carry after LPs are made whole, aligning interests.
2. Protects LPs: Capital and preferred returns are prioritized, cushioning against losses.
3. Clarity & Trust: Predefined rules in the LPA minimize disputes.
4. Drives Discipline: GPs focus on sustainable growth, not quick flips.

Key Terms

• Hurdle Rate: Minimum return LPs must earn before GPs get carry (e.g., 8%).
• Catch-Up: Mechanism to accelerate GP profits post-hurdle.
• Carried Interest: GPs’ share of profits (typically 20%), their “performance fee.”
• Management Fee: Annual fee (1-2% of assets) covering GP operational costs.

The Bottom Line

The distribution waterfall isn’t just a financial technicality—it’s the backbone of private equity’s success.

By prioritizing LPs while rewarding GPs for excellence, it balances risk and reward.

Whether you’re an investor or a budding PE professional, grasping this structure is key to decoding how private equity turns capital into value.