Meaning
A structured method allocates investment returns among various classes of equity holders and managers according to pre-determined rules. The application of distribution waterfalls occurs during a liquidity event or a significant capital distribution. This process dictates the sequence and the proportion of cash that each investor receives.
It ensures that senior tranches are satisfied before junior equity receives any funds.
Payment Priority
The initial tiers of cash distribution focus on returning the original capital to the principal investors. Through distribution waterfalls, these investors also receive a specified preferred return before the sponsors or founders share in any profit. Once this hurdle is cleared, subsequent payments flow to the general partner or the common equity holders.
This protects the early capital of the external funders.
Incentive Calculation
The allocation shifts to performance-based incentives for the management team once the initial hurdles are passed. These distribution waterfalls often contain a catch-up clause that allows sponsors to receive a percentage of the profits once investors have received their preferred return.
Capital Return
The final remaining proceeds are split according to the long-term equity split. Under most distribution waterfalls, this step ensures that the final incentives align with the long-term appreciation of the assets.
