Don’t Go Chasing Simple Waterfalls: Understanding Investment Return Structures

Waterfalls in private equity and venture capital dictate how investment returns are distributed among stakeholders. These structures determine who gets paid, in what order, and under what conditions. While all waterfalls aim to allocate cash flows, their design varies based on the complexity of the investment structure, investor preferences, the type of cash flow, and the presence of preferred returns, liquidation preferences, promotes, and carried interest.

Types of Waterfalls

Waterfalls can be categorized based on the types of cash flows and events that trigger distributions.

Available cash flow or operating cash flow waterfalls involve distributions that come from the ongoing profits generated by a business. These are commonly used in stable, cash-generating businesses such as real estate or mature companies with steady income streams. The goal of this type of waterfall is to ensure that investors receive consistent returns from operational profits before any excess cash is reinvested or distributed further.

Capital event waterfalls are triggered by a significant transaction, such as a sale, merger, refinancing, or recapitalization. These events provide a major influx of capital, and the proceeds must be distributed according to a predetermined allocation structure. In these scenarios, investors are often prioritized based on their investment class, preferred returns, and any negotiated distribution preferences before residual amounts are shared among other stakeholders.

Liquidation waterfalls occur when a business is sold, dissolved, or undergoes a liquidity event. This structure ensures that investors with senior rights, such as preferred shareholders, recover their investments before common equity holders receive distributions. Liquidation waterfalls play a crucial role in protecting early-stage investors and institutional stakeholders who may have invested with specific downside protections in place.

Combined waterfalls blend aspects of operational distributions and capital events or liquidations. These hybrid structures allow different distribution rules to apply depending on the nature of the cash flow. For example, an investment fund might distribute quarterly profits using an available cash flow waterfall while applying a separate capital event waterfall for a large asset sale or fund exit. This ensures both short-term and long-term investor objectives are met within a single framework.

Vanilla Waterfalls: Pro Rata Distributions

In the simplest form, a vanilla waterfall distributes cash pro rata—in proportion to ownership stakes. All investors receive returns in direct proportion to their equity percentage without special preferences.

For example, if Investor A owns 40% and Investor B owns 60%, and the company distributes $10 million, Investor A receives $4 million, and Investor B receives $6 million.

This structure works well when all investors share equal risk and return expectations. However, in more complex deals, investors often negotiate preferred returns, liquidation preferences, and carried interest, leading to more sophisticated waterfalls.

Complex Waterfalls: Multiple Security Classes and Preferences

When multiple security classes exist, waterfalls prioritize distributions to certain investors before others. The complexity of these structures allows for a more nuanced allocation of investment returns, ensuring that different investor classes receive appropriate risk-adjusted compensation.

Preferred returns, often referred to as “pref,” ensure that investors receive a minimum return before general partners (GPs) (or managers, if the investment vehicle is structured as a limited liability company), sponsors, or common equity holders share in the profits. A typical hurdle rate is 8% per year, meaning investors must earn this annual return on their capital before any profit-sharing with fund managers, sponsors, or other equity holders begins. However, the hurdle rate may vary depending on investor leverage, the type of investment (i.e., real estate, operating company, etc.), investor return expectations, and market conditions. The preferred return acts as a safeguard for investors, ensuring that their capital is efficiently deployed and that they receive a predictable return before additional profits are distributed.

Preferred returns can be cumulative or non-cumulative. Cumulative preferred returns accrue over time, meaning that if the hurdle is not distributed in one period, it carries forward to future periods until distributed in full. Non-cumulative preferred returns, on the other hand, reset each period, and any shortfall is lost if not satisfied within the designated timeframe.

Additionally, preferred returns can be compounding or non-compounding. Compounding preferred returns accumulate based on previously accrued but unpaid returns, meaning that any unpaid pref continues to grow at the specified rate. Non-compounding preferred returns, in contrast, only accrue on the original invested capital, without additional pref accruing on unpaid returns. The choice between compounding and non-compounding prefs significantly impacts investor returns and the timing of distributions.

Liquidation preferences dictate how proceeds are allocated in a liquidation or exit event, often providing downside protection for investors. The most common structures include 1x, 2x, or 3x liquidation preferences, where investors receive one, two, or three times their initial investment before common equity holders receive any distributions.

A participating preferred structure allows investors to receive their liquidation preference and still share in remaining distributions alongside common equity holders. This effectively enhances investor upside potential by allowing them to double-dip in the payout structure. In contrast, a non-participating preferred structure typically entitles investors to receive the greater of their liquidation preference or their pro-rata share of total proceeds, ensuring downside protection while providing upside potential.

Internal Rate of Return (IRR)-based waterfalls structure distributions around predefined IRR hurdles. Investors receive cash until they achieve a specified IRR, typically in the range of 8-12%. Once this threshold is met, GPs or sponsors begin to share in profits through a promote structure. The IRR-based method incentivizes fund managers or sponsors to generate high-yielding investments while ensuring that investors achieve their target return thresholds first.

Multiple on Invested Capital (MOIC)-based waterfalls operate on a different principle. Instead of an annualized return rate, investors are entitled to receive a multiple of their original investment before additional distributions occur. For example, an investor might recover 2x their invested capital before any profit-sharing begins. MOIC-based waterfalls provide a straightforward return framework that is often favored in private equity buyout deals and long-term investment strategies.

Promotes and Carried Interest

At higher return thresholds, promotes or carried interest (carry) come into play. This is the portion of profits allocated to the GPs and sponsors as compensation for, among other things, managing the investment, achieving strong financial performance, and/or sourcing and structuring the investment.

A common structure might grant the GP or sponsor a 20% carried interest after achieving an 8% IRR hurdle. This incentivizes fund managers or sponsors to generate returns above the minimum hurdle, aligning their interests with those of investors. The promote structure can also include tiered carry percentages, where the GP’s or sponsor’s share increases at higher performance levels. For instance, if returns exceed a second threshold (i.e., a 20% IRR), the GP or sponsor may receive 30% or more carry as an enhanced incentive.

Carry structures can also be subject to a clawback provision, which ensures that GPs or sponsors do not receive excess profits prematurely. If the fund or investment underperforms in later stages, investors may be entitled to recoup portions of previously distributed carry, ensuring that compensation remains fair and aligned with the long-term performance of the investment.

Conclusion

Waterfall structures play a crucial role in private equity and venture capital, serving as the backbone for profit distribution among investors and fund managers or sponsors. While simple pro-rata distribution models work well in straightforward investments, more sophisticated multi-tiered models are essential for balancing risk and reward in complex deals.

Preferred returns provide investors with specified baseline returns before other stakeholders share in profits, while liquidation preferences offer critical downside protection. IRR-based and MOIC-based waterfalls create structured incentives that drive fund or investment performance, ensuring that both investors and fund managers or sponsors are appropriately rewarded. The promote and carried interest mechanisms align GP and sponsor incentives with investor interests, motivating fund managers to achieve superior returns.

Ultimately, understanding waterfall structures is essential for investors, fund managers, sponsors, and dealmakers looking to optimize returns and mitigate risks. By carefully structuring these distribution mechanisms, stakeholders can create a balanced investment framework that fosters long-term success and profitability.

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