Distribution Waterfall

A Distribution Waterfall is the fund’s rulebook for allocating proceeds among LPs and the GP: returning capital, paying preferred return (if any), and distributing carried interest. Waterfalls determine not just economics, but governance risk — because they shape when carry is paid relative to final fund outcomes.

From an allocator lens, the waterfall is an alignment architecture: it exposes whether the GP earns carry only after LP outcomes are secured — or earlier, increasing the need for clawbacks and safeguards.

How allocators define waterfall risk drivers

Allocators evaluate waterfalls through:

• Structure type: European (whole-fund) vs American (deal-by-deal)
• Preferred return: rate, compounding, and catch-up mechanics
• Catch-up design: speed and magnitude of GP catch-up tiers
• Carry timing: when carry can be paid vs final fund certainty
• Clawback dependence: how much protection relies on clawback
• Escrow/holdback: presence and sufficiency of security mechanisms
• Expense treatment: what is netted before waterfalls apply
• Transparency: reporting on distributions, unrealized risk, and true-up logic

Allocator framing:
“How early does the GP get paid — and what protects LPs if outcomes reverse?”

Where waterfalls matter most

• high-volatility strategies where later losses are plausible
• funds distributing early carry through deal-by-deal structures
• strategies with leverage or complex valuation marks
• managers with limited escrow/holdback practice

How waterfall design changes outcomes

Strong waterfall design:

• reduces timing mismatch between GP economics and LP certainty
• lowers reliance on clawbacks and end-of-fund disputes
• improves governance trust and re-up momentum

Weak waterfall design:

• accelerates GP economics before fund outcomes are secured
• increases clawback exposure and enforcement risk
• creates allocator friction in IC approvals

How allocators evaluate alignment

Conviction increases when managers:

• use whole-fund distribution logic where appropriate
• pair early-carry structures with strong escrow/holdback protections
• disclose how unrealized marks influence carry timing
• provide clear scenarios showing clawback exposure under stress

What slows allocator decision-making

• fast catch-up tiers with early carry distribution
• heavy reliance on clawbacks without escrow
• unclear expense netting and reporting
• confusing language that obscures timing risk

Common misconceptions

• “European is always better.” → strategy context matters, but timing risk differs.
• “Clawback solves early carry.” → only if it is collectible.
• “Waterfall is just economics.” → it’s governance plus incentives.

Key allocator questions during diligence

• Is the waterfall whole-fund or deal-by-deal?
• When can carry be paid relative to remaining unrealized risk?
• How is preferred return calculated and compounded?
• What protections exist (clawback, escrow/holdback)?
• What does clawback exposure look like in a down scenario?