Distribution Waterfalls Explainer
A distribution waterfall is the contractual sequence that determines how a private fund divides cash among investors and the manager. Proceeds may first return contributed capital, then pay a preferred return, then fund a manager catch-up, and finally split remaining profit according to the carried-interest percentage.
In a whole-fund waterfall, the manager generally receives carry only after investors recover capital and the required return across the portfolio. A deal-by-deal waterfall can pay carry after individual successful exits while other investments remain unrealized. Escrows and clawbacks help address the risk that early distributions prove excessive.
The waterfall translates investment performance into actual cash received by each party. Its design influences manager incentives, payment timing, reinvestment, and the difference between gross and net returns. Tax distributions and recycled proceeds may follow separate rules that interact with the main sequence.
Small drafting choices can materially change outcomes. Investors should test the agreement with worked examples covering early wins, later losses, partial exits, write-offs, extensions, and final liquidation. Terms such as contributed capital, realized proceeds, preferred return, catch-up, and netting must be defined consistently.
Capital return, preferred return, catch-up, and profit split occur in sequence.
The agreement defines every tier.
One delays carry until portfolio recovery; the other can pay after each exit.
Timing affects investor protection.
Early gains and later losses can produce surprising results.
Model several paths before committing.
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