How distribution waterfalls work

The four tiers

1. Return of capital. LPs receive distributions until they have recovered what they contributed. 2. Preferred return. LPs receive a hurdle return on that capital. 3. Catch-up. The GP receives most or all distributions until it has its full carry share of profits to date. 4. Split. Remaining proceeds are shared, usually 80/20.

A worked example (European, whole-fund)

LPs contributed $100.0m. The fund returns $200.0m after five years. Pref is 8% compounding annually; catch-up is 100%; carry is 20%. Figures are illustrative and ignore fees and GP commitment.

• Return of capital: $100.00m to LPs; $100.00m remains.
• Preferred return: $100m × (1.08⁵ − 1) = $46.93m to LPs; $53.07m remains.
• Catch-up: the GP needs 20% of profits paid so far, so it receives C where C = 0.2 × (46.93 + C), giving $11.73m; $41.33m remains.
• 80/20 split: $33.07m to LPs, $8.27m to the GP.

Totals: LPs $180.00m, GP $20.00m — exactly 20% of the $100.0m profit, which is what a full catch-up is designed to produce.

European vs American

A European (whole-fund) waterfall pays carry only after all contributed capital and pref across the fund are returned. An American (deal-by-deal) waterfall pays carry as each deal is realised, which gets the GP paid earlier but exposes LPs to overpayment if later deals lose money — hence clawback provisions and carry escrow. Many modern LPAs are hybrids.

Where waterfalls go wrong

Most errors come from definitions: whether pref compounds, whether it runs on contributed or invested capital, whether fees are in the base, how recallable distributions and side-letter fee breaks interact with the tiers. A waterfall engine has to express those definitions, not approximate them.