Flevy Management Insights Q&A
What is a waterfall structure in private equity?
     Mark Bridges    |    Private Equity


This article provides a detailed response to: What is a waterfall structure in private equity? For a comprehensive understanding of Private Equity, we also include relevant case studies for further reading and links to Private Equity best practice resources.

TLDR A waterfall structure in private equity is a framework for sequentially distributing investment returns among partners, ensuring alignment between General Partners and Limited Partners.

Reading time: 5 minutes

Before we begin, let's review some important management concepts, as they related to this question.

What does Waterfall Structure in Private Equity mean?
What does Preferred Return mean?
What does Catch-Up Mechanism mean?
What does Limited Partnership Agreement (LPA) mean?


Understanding the concept of "what is waterfall in private equity" is crucial for C-level executives navigating the complex landscape of investment returns. At its core, the waterfall structure in private equity is a framework used to allocate capital gains among partners within a private equity fund. This allocation takes into account the return of capital provisions, preferred returns, and carried interest. The term "waterfall" itself is indicative of the sequential manner in which distributions are made, flowing down from the top priority (usually the return of capital to limited partners) to the lower priorities (such as the carried interest to the general partners).

The rationale behind employing a waterfall structure is to align the interests of the general partners (GPs) and limited partners (LPs) by establishing clear, predefined rules for profit distribution. This framework ensures that LPs receive their initial investment back, plus a preferred return, before the GPs can participate in the profits through carried interest. The preferred return is a hurdle rate that acts as a minimum threshold rate of return that must be achieved before the profits can be distributed according to the carried interest agreement. This mechanism incentivizes GPs to generate higher returns, as their compensation is directly tied to the fund's performance beyond the preferred return.

Waterfall structures can be complex, often involving multiple tiers or "tranches" that dictate the order and percentages of distributions. Each tier represents a different level of return and is associated with specific distribution percentages. For example, the first tier may involve returning the initial capital to investors. The second tier might provide a preferred return to the LPs, and subsequent tiers could allocate remaining profits between LPs and GPs in varying proportions. The specific terms of a waterfall structure are typically outlined in the fund's limited partnership agreement (LPA), making it essential for investors to thoroughly understand these provisions before committing capital.

Key Components of a Waterfall Structure

The waterfall structure in private equity is built around several key components that define how returns are distributed. The first component is the return of capital, ensuring that investors receive their initial investment back before any profits are shared. Following this, the preferred return or hurdle rate comes into play, setting a minimum annual return percentage that benefits the LPs. After meeting these conditions, any additional profits are then split between the LPs and GPs according to the carried interest agreement, which typically sees GPs receiving a proportion of the profits as a reward for their management and performance.

Another critical aspect of the waterfall structure is the catch-up mechanism. This provision allows GPs to receive a larger share of the profits after the preferred return has been paid but before the standard profit split applies. The catch-up is designed to ensure that once LPs have received their preferred return, the GPs can "catch up" to a predetermined level of profit participation. This mechanism is crucial for maintaining the incentive for GPs to maximize fund performance.

The final distribution tier involves the split of residual profits, often adhering to an agreed-upon ratio such as 80/20 or 70/30, with the larger percentage going to the LPs. This tier reflects the long-term profit-sharing agreement between the LPs and GPs, rewarding the GPs for surpassing the preferred return threshold. The intricacies of these components necessitate a deep understanding of the LPA and a strategic approach to fund management, underscoring the importance of comprehensive due diligence and expert negotiation skills.

Are you familiar with Flevy? We are you shortcut to immediate value.
Flevy provides business best practices—the same as those produced by top-tier consulting firms and used by Fortune 100 companies. Our best practice business frameworks, financial models, and templates are of the same caliber as those produced by top-tier management consulting firms, like McKinsey, BCG, Bain, Deloitte, and Accenture. Most were developed by seasoned executives and consultants with 20+ years of experience.

Trusted by over 10,000+ Client Organizations
Since 2012, we have provided best practices to over 10,000 businesses and organizations of all sizes, from startups and small businesses to the Fortune 100, in over 130 countries.
AT&T GE Cisco Intel IBM Coke Dell Toyota HP Nike Samsung Microsoft Astrazeneca JP Morgan KPMG Walgreens Walmart 3M Kaiser Oracle SAP Google E&Y Volvo Bosch Merck Fedex Shell Amgen Eli Lilly Roche AIG Abbott Amazon PwC T-Mobile Broadcom Bayer Pearson Titleist ConEd Pfizer NTT Data Schwab

Real-World Application and Considerations

In practice, the application of waterfall structures varies widely across private equity funds, influenced by market conditions, fund size, sector focus, and the negotiation power of LPs and GPs. For instance, a fund specializing in high-risk ventures may offer a higher preferred return to compensate for the increased risk exposure, whereas a fund with a strong track record may negotiate lower hurdles and higher carried interest percentages. The flexibility of the waterfall structure allows it to be tailored to the specific goals and risk tolerance of the fund's stakeholders.

From a strategic standpoint, the design of a waterfall structure can significantly impact the attractiveness of a private equity fund to potential investors. A well-balanced structure that offers fair compensation to GPs while protecting the interests of LPs can enhance fund marketability. Conversely, a structure perceived as overly favorable to GPs may deter sophisticated investors. Thus, the negotiation and implementation of the waterfall structure require a nuanced understanding of investor expectations and market dynamics.

Moreover, the evolving regulatory landscape and market trends necessitate ongoing monitoring and potential adjustments to waterfall structures. For example, shifts in interest rates, economic cycles, and investor sentiment can all influence the optimal configuration of these structures. Staying abreast of these changes and understanding their implications is essential for maintaining alignment between GPs and LPs and ensuring the long-term success of the fund.

In conclusion, the waterfall structure in private equity is a critical framework for aligning the interests of GPs and LPs through the strategic distribution of fund returns. Its complexity and variability underscore the need for meticulous planning, negotiation, and adaptation to market conditions. For C-level executives and investors alike, mastering the nuances of waterfall structures is indispensable for optimizing investment outcomes and fostering enduring partnerships in the private equity space.

Best Practices in Private Equity

Here are best practices relevant to Private Equity from the Flevy Marketplace. View all our Private Equity materials here.

Did you know?
The average daily rate of a McKinsey consultant is $6,625 (not including expenses). The average price of a Flevy document is $65.

Explore all of our best practices in: Private Equity

Private Equity Case Studies

For a practical understanding of Private Equity, take a look at these case studies.

No case studies related to Private Equity found.

Explore all Flevy Management Case Studies

Related Questions

Here are our additional questions you may be interested in.

What emerging technologies are PE firms focusing on to drive operational efficiencies and value creation in their investments?
PE firms are leveraging AI and ML, blockchain, and cloud computing and big data analytics to transform investment strategies, operational processes, and achieve superior returns. [Read full explanation]
What strategies can PE firms employ to ensure sustainable growth and value creation in their portfolio companies post-exit?
PE firms can ensure sustainable growth and value creation post-exit by implementing Robust Governance, Leadership Development, fostering Innovation and Digital Transformation, and ensuring Financial Stability and Operational Excellence. [Read full explanation]
How to calculate carried interest using Excel?
Calculating carried interest in Excel involves setting up a dynamic template to account for initial investment, hurdle rate, total returns, and profit splits for strategic planning. [Read full explanation]
In what ways can PE-backed companies leverage technology and digital transformation to outperform competitors in their industry?
Discover how PE-backed companies can achieve superior industry performance through Strategic Planning, Operational Excellence, and enhanced Customer Experience with technology and Digital Transformation. [Read full explanation]
How do PE firms assess and integrate ESG (Environmental, Social, and Governance) factors into their investment strategies?
PE firms integrate ESG factors into investment strategies through comprehensive Due Diligence, adjusting Valuation models, active Portfolio Management, and detailed ESG Reporting, aiming to mitigate risks and capitalize on opportunities for sustainable value creation. [Read full explanation]
What is a waterfall calculation in private equity?
A waterfall calculation in private equity is a tiered payout system that dictates the distribution of cash flows between general and limited partners to align their interests. [Read full explanation]

 
Mark Bridges, Chicago

Strategy & Operations, Management Consulting

This Q&A article was reviewed by Mark Bridges.

To cite this article, please use:

Source: "What is a waterfall structure in private equity?," Flevy Management Insights, Mark Bridges, 2024




Flevy is the world's largest knowledge base of best practices.


Leverage the Experience of Experts.

Find documents of the same caliber as those used by top-tier consulting firms, like McKinsey, BCG, Bain, Deloitte, Accenture.

Download Immediately and Use.

Our PowerPoint presentations, Excel workbooks, and Word documents are completely customizable, including rebrandable.

Save Time, Effort, and Money.

Save yourself and your employees countless hours. Use that time to work on more value-added and fulfilling activities.




Read Customer Testimonials



Download our FREE Strategy & Transformation Framework Templates

Download our free compilation of 50+ Strategy & Transformation slides and templates. Frameworks include McKinsey 7-S Strategy Model, Balanced Scorecard, Disruptive Innovation, BCG Experience Curve, and many more.