≡ Menu

Every MBA student in a private equity or real estate or venture capital elective course will encounter building an investment cash flow distribution waterfall for the private equity or or real estate or venture capital investors. Our finance tutors can assist you understand investment returns and the investment distribution waterfall structure. We outline the key building blocks and steps to build a private equity or real estate or venture capital investment cash flow distribution waterfall.

In the world of private equity of real estate investing, a “waterfall” is a description of how the cash flows from an investment is paid out to the different types of investors involved. The description of how the cash flows will be paid out to the different types of investors can be done visually in graphs or charts or in a spreadsheet or in words. In this article we will show you how the distribution is built in a Microsoft Excel spreadsheet.

Waterfall structures are common in a variety of industries but most commonly found in real estate, private equity investing and venture capital industries.

Objectives of Structuring a Waterfall Distribution

A waterfall structure of remuneration addresses the agency problem or the principal-agent problem by aligning the interests of investors and managers.

The ‘agency problem’ is a concern for investors. The agency problem is also referred to as the principal-agent problem. A conflict of interest arises when managers are incentivized in a manner, not in the best interests of the owners. If managers are rewarded for spectacular returns but not penalized for losses, they will likely take on high-risk investments to earn high returns without suffering the consequences of risk. A principal-agent conflict occurs when the investment managers are not working in the best interest of the investors who are principals or owners. A waterfall structure of manager remuneration addresses the agency problem or the principal-agent problem by aligning the interests of the investors and managers.

There are a number of terms you need to understand. We have addressed those relevant to a PE or VC waterfall later in this article.

Steps in Building a PE or VC Waterfall

Understand the Terms Outlined in the PE or RE or VC Investment Contract

A PE or RE or VC distribution waterfall is governed by the deal’s investment contract. These contracts maybe referred to as term sheets, investment agreement, MoU, etc. This document is signed between the participants at the start of the deal. Each waterfall must be built according to the terms agreed upon in this contract. So the first step is to read and understand the terms of the investment contract. If this is a business school project, these terms are outlined in the HBS case study or professors notes.

Focus on Free Cash-Flows

Since the “waterfall” is a description of how the cash flows from an investment is paid out to the different types of investors involved, the free cash flow is the starting point in building a VC or PE waterfall. We do not cover the different types of cash flows in this article but you have a refresher on the different types of free cash flows on this page.

Building Cash flow Tiers

Once you have identified the free cash flow available to investors and sponsors, you can start appropriating cash flows to the different tiers. Each tier is cash flows that are split between investors and sponsors at specified ratios. In the distribution waterfall example below:

  • Tier 1 is a return of the initial investment made by the investors or limited partners.
  • Tier 2 is the minimum targeted return of 8% promised to the investors or limited partners.
  • Tier 3 is the cash flows over and above the cash flow required to get the promised 8% return for the limited partners. This maybe referred to as excess returns and split 90:10 between the limited and general partners.
  • Tier 4 is is the cash flows over and above the cash flow required to get the 15% return for the limited partners. This maybe referred to as extraordinary returns and split 75:25 between the limited and general partners.
Different tiers of cash flows in a private equity or real estate or venture capital distribution waterfall
Different tiers of cash flows in a private equity or real estate or venture capital distribution waterfall

Investment Returns

Most contracts are split between investors and sponsors at specified ratios usually based on achieving specified cash levels (eg: initial investment recovery), or hurdle rates (IRR) or specific events (eg: acquisition/investments/sale). These contracts have multiple target IRRs such as promised base IRR, target IRR, etc. at which cash flows move to different tiers. Therefore it is important to compute the IRR for the appropriate cash flows and tiers for the different types of investors and deal sponsors. Here is a spreadsheet that provides you an example of a real estate or venture capital or private equity cash flow distribution waterfall with the tiers illustrated in the above picture.

Spreadsheet Functions Used in Building a Real Estate Waterfall

MBA students expect to see complicated spreadsheet/Microsoft Excel functions when learning how to build RE/VC/PE waterfalls. They are surprised to learn that you can build venture capital or private equity waterfalls using only a few spreadsheet/Microsoft Excel functions!

Most RE/VC/PE waterfalls only require the IF, IRR, NPV, Min, and Max functions. You can learn the top 10 spreadsheet/Microsoft Excel functions for MBA students here or feel free to join our free quarterly Microsoft Excel boot camps.

Waterfall Related Terms

Some waterfall related terms in the world of private equity and venture capital include the following. Please read the definitions in every term sheet or contract as these definitions of these terms can vary between investment contracts.

Sponsors vs investors and Limited Partners (LPs) vs General Partners (GPs)

A sponsor is the management firm or individual who finds and manages the investment opportunity. The Sponsor is often called the General Partner (GP). The sponsor or GP also usually has responsibility (liability) for the debt taken in the deal.

The people who put in the money are called the investors. The investors are often called Limited Partners (LPs) The investors or LPs have limited liability with regards to the debt taken in the deal.

Investment Tiers

Investors and sponsors agree to a set of operating and financial terms and conditions in every investment deal or fund. A key aspect agreed on is the terms and timing of the repayment of the cash flows from the investment. The repayment of capital, profits and fees are based on achieving specified return milestones or hurdle rates and will vary based on the nature of the investment. These different types of payout levels are called investment tiers.

Residual Split

The residual split is a term describing the how the cashflows/profits/payment will be distributed to the different types of investors after the capital and target or promised returns are obtained by the investors.

What is Carried Interest in Private Equity?

Carried interest is the share of profits that goes to the general partners or sponsors of a private equity or venture capital deal. The carried interest is defined in the investment contact and the terms and conditions of the carried interest will vary widely. Carried interest is usually paid out only after the initial capital is paid back and the promised return is obtained by the limited partners.

What is the Catch Up Clause in Private Equity?

The catch-up clause is a clause added in private equity of venture capital term sheet which allows the general partner or sponsor or another investment tier to get a targeted share of the profits are achieved. For example, the deal terms may require that all the cash flows first be paid to investors till the capital has been repaid and a target return of 10% is achieved. The GP and LP are paid an agreed distribution of the subsequent cash flows, say 60:40 or 80:20. However, if a catch-up clause is added, the GP may get all the subsequent cash flows till he gets a 20% share of the return. After the 20% share is paid to the GP, GP and LP are paid an agreed distribution of the subsequent cashflows, say 60:40 or 80:20.

What is the difference between European waterfall and American waterfall?

Remember that the waterfall is just describing the agreed terms and conditions under which investment cash flows are distributed between the GP and LP. There are no government regulations or rules that must be followed. So, every investor and sponsor may agree to different terms between themselves!

However, common practices have evolved in the industry. And these practices diverged in the US and Europe and so are commonly referred to as the European waterfall and American waterfall. Please note that these terms and conditions are not set-in stone and can be changed on every PE or VC deal.

European waterfall

In a European waterfall, all the initial cash flows are paid to the investors or limited partners till they recover their initial investment and hurdle rate/targeted returns. Only after that is the sponsor or general partner entitled to his share of cash flows.

Another difference between the American and European distribution waterfalls is that in a European waterfall, the cash flows and hurdle rates are evaluated on a fund level, whereas in an American waterfall, the cash flows and hurdle rates are evaluated on a deal-by-deal basis. And therefore the performance of a fund and sponsor is computed using the returns at the fund level in a European distribution waterfall and on a deal-by-deal basis in an American distribution waterfall.

An example of a European waterfall’s terms may look as follows.

  • Tier 1: 100% of the cash flow goes to the investors or LPs till they get paid back their initial capital invested.
  • Tier 2: 100% of the cash flows goes to the investors or LPs till they achieve the targeted returns or hurdle rate or a preferred rate or minimum rate.
  • Tier 3: After the preferred rate is achieved in tier 2, the distribution goes to the sponsors and GPs at an agreed rate say 90:10 till the LP reachs the 8% of IRR mark. Note: If there is a catch-up clause, 100% of the cash flows in tier 3 may be paid to the sponsors or GPs till they reach the 20% of profits mark.
  • Tier 4: After tier 3 targets are achieved, cash flows are split between the LPs and GPs at a predetermined rate which can vary from 50:50 to 80:20.

American waterfall

In an American waterfall, the initial cash flows are paid to the investors and sponsors at a predetermined rate. The predetermined rate paid to the sponsors may be lower till the limited partners recover their initial investment and hurdle rate/targeted returns. After the limited partners recover their initial investment and achieve their return hurdle rate the sponsor or general partner is entitled to a larger share of cash flows. The American waterfall model is preferred by the sponsors or limited partners as they get a payout earlier than they would in the European waterfall model. A claw-back clause is often added to protect the investors. Despite a claw-back clause the American waterfall model is preferred by the sponsors or limited partners as they get a payout earlier than they would in the European waterfall model.

An example of an American waterfall’s terms may look as follows.

  • Tier 1: Tier 1 cash flows are the cash flows till the investors or LPs are paid back their initial capital invested. These cash flows are split between the GPs and LPs in a 90:10 ratio.
  • Tier 2: Tier 2 cash flows are the cash flows till the investors or LPs are paid back the targeted returns or hurdle rate or a preferred rate or minimum rate. These cash flows are also split between the GPs and LPs in a 90:10 ratio.
  • Tier 3: After the preferred rate is achieved in tier 2, 80 or 90% of the distribution goes to the sponsors or GPs till they reach the 20% of profits mark. Note: If there is a catch-up clause, 100% of the cash flows in tier 3 may be paid to the sponsors or GPs till they reach the 20% of profits mark.
  • Tier 4: After tier 3 targets are achieved, cash flows are split between the LPs and GPs at a predetermined rate which can vary from 50:50 to 20:80.

Another difference between the American and European distribution waterfalls is that in an American waterfall, the cash flows and hurdle rates are evaluated on a deal-by-deal basis, whereas in a European waterfall, the cash flows and hurdle rates are evaluated on a fund level. And therefore the performance of a fund and sponsor is computed using the returns at the fund level in a European distribution waterfall and on a deal-by-deal basis in an American distribution waterfall.

Please do email or call if our finance tutors can assist you understanding or building real estate or private equity or venture capital investment cash flow distribution waterfalls.