Private Equity: Episode 14 – The Waterfall

The ultimate goal of an investment fund is to generate capital gains and distribute them to its investors. In the fund’s operations, the manager also receives a share of this value creation. This profit-sharing between the manager and the investors is governed by an essential mechanism: the waterfall!

The waterfall mechanism is a profit distribution process. The money is distributed in a cascade, according to several steps that are outlined at the time of subscription.

To recap, the investors (the Limited Partners or LPs) of the fund provide the necessary capital for the investment. Then, the fund managers (the General Partners or GPs) use this capital to invest in target companies.

Once the investments have generated revenue, the waterfall mechanism kicks in.

1. The first step is to repay the initial capital invested by the LPs, as well as the management fees.
2. The investors receive a priority return, typically ranging from 6 to 8%, to compensate for the immobility of their money. This payout is calculated based on a target rate of return, ensuring a minimum to the investors.
3. Once the minimum return has been exceeded, any surplus profits are divided according to a predefined ratio between the investors and the manager, often 80/20. This is the catch-up, or the manager’s compensation catch-up.
4. The profits are then shared 80% for the investors and 20% for the manager. This share of the profits is called the carried interest, and it rewards the manager for the strong performance of their investments.

This cascade is the most common, but it can have countless variations (no catch-up, no priority interest, 80/20 then 70/30...). The tiers aren’t always fixed and can change based on the investment’s return level. For example, if the investment reaches a certain profitability level, the profit-sharing structure may be adjusted to allocate a larger share to the manager.

In summary, the waterfall mechanism is a process designed to reward investors while providing financial incentives for the fund managers. The waterfall ensures that the interests of both parties are aligned!

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