What is a Waterfall Structure?

A waterfall structure is a method used to distribute profits among different classes of investors or stakeholders in an investment fund or partnership. It outlines the specific order in which profits are allocated and distributed based on predetermined criteria. The term "waterfall" is used because the profits flow down through the structure in a sequential manner, similar to how water cascades down a waterfall.

In a typical waterfall structure, profits are distributed in a series of tiers or "buckets," with each tier specifying how profits are allocated among different parties involved in the investment. The structure is often designed to ensure that certain investors receive priority in receiving profits before others, based on their investment terms and preferences.

Here is a simplified example of a common waterfall structure used in private equity investments:

Preferred Return –

The first tier typically involves providing a preferred return to certain investors, such as limited partners, before any profits are distributed to other stakeholders, such as general partners. This preferred return is usually a fixed percentage of the initial investment amount.

Return of Capital –

The second tier involves returning the initial capital invested by all investors, including the preferred return, to ensure that investors recoup their principal investment before additional profits are distributed.

Promote or Carried Interest –

The third tier may involve distributing profits between the investors and the fund manager or general partner. The fund manager may receive a share of the profits, known as a "promote" or "carried interest," once certain profit thresholds are met.

Hurdle Rate –

Some waterfall structures include a hurdle rate, which is a minimum rate of return that must be achieved before the Sponsor, GP, or fund manager is entitled to receive a share of the profits. This ensures that they are incentivized to generate returns above a specified benchmark.

Catch-Up Provision –

In certain cases, a catch-up provision may be included in the waterfall structure, allowing the fund manager to "catch up" to a certain percentage of the profits before the remaining profits are distributed between the investors and the fund manager according to a pre-determined split.

The Lookback Provision

The lookback provision provides that the sponsor and investor “look back” at the end of the deal. If the investor doesn’t achieve a predetermined rate of return, then the sponsor will be required to give up a portion of its already distributed profits to provide the investor with the predetermined return.

Conclusion-

Overall, a waterfall structure is a mechanism used to align the interests of different stakeholders in an investment fund or partnership and ensure that profits are distributed fairly and in accordance with the agreed-upon terms. It provides clarity and transparency regarding how profits will be shared among investors and fund managers based on their respective contributions and performance.

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Disclaimer

The content within these articles is not intended to provide, nor should it be construed as providing, tax, investment, or legal advice. You should consult your own professional advisors before making any decisions. These articles and emails are for informational purposes only.