Waterfall
Private Equity glossary · Private Equity Fundamentals
Definition
The contractual sequence allocating fund distributions between LPs and GP. Standard European (whole-fund) waterfall has four tiers: (1) return of contributed capital to LPs; (2) preferred return (8% compounded) to LPs; (3) GP catch-up (100% or 50/50 to GP until GP receives 20% of cumulative profits); (4) 80/20 split of remainder. European waterfalls are LP-favorable (GP bears full fund-level risk, no carry until fund clears 1.0x + preferred); American (deal-by-deal) waterfalls pay carry on each profitable realization in isolation and require larger clawback reserves. U.S. middle-market historically used American; institutional U.S. and European funds now predominantly European.
Waterfall in plain English
A waterfall is the agreed order in which a fund's profits get poured out between the outside investors (LPs, who supply the cash) and the managers (GP, who run it) — money fills each level before spilling to the next, like a tiered fountain. In the standard "European" version, LPs first get all their original money back, then a guaranteed minimum return (an 8% "preferred return"), then the GP "catches up" to their share, and finally everything left over is split 80% to LPs and 20% to the GP (that 20% is the manager's profit share, called "carry"). The European style is investor-friendly because the GP earns nothing until the WHOLE fund has paid everyone back plus that 8% — whereas the "American" deal-by-deal style lets managers collect their cut on each winning investment separately, which can overpay them if later deals flop, so it needs a "clawback" to take excess pay back. It's the difference between a coach only getting a bonus after the full season is a proven success, versus after each single win.
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