What is a Distribution Waterfall?
A distribution waterfall is the contractual sequence that determines how a fund's profits get divided between LPs (investors) and GPs (fund managers). Money flows down through tiers, each one filling up before the next kicks in.
The waterfall ensures LPs get their money back (and then some) before GPs earn their performance fee (carry).
Why Waterfalls Matter
The waterfall structure directly determines how much GPs earn and when. It aligns incentives: GPs only make carry after LPs are made whole. Different waterfall structures can dramatically change payout timing and amounts.
The Four Tiers
Most VC fund waterfalls follow this sequence:
- Tier 1 - Return of Capital: LPs receive 100% of distributions until they've gotten back their entire invested capital (sometimes including fees).
- Tier 2 - Preferred Return (Hurdle): LPs receive 100% of distributions until they've earned a preferred return on their capital, typically 8% annually.
- Tier 3 - GP Catch-Up: GPs receive 100% (or a majority) of distributions until they've "caught up" to their carried interest percentage of total profits.
- Tier 4 - Carried Interest Split: Remaining profits split 80/20 between LPs and GPs (the standard carry arrangement).
European vs. American Waterfall
- European (whole-fund): GPs earn no carry until LPs receive back all capital plus preferred return across the entire fund. GP-friendly only after fund success is clear.
- American (deal-by-deal): GPs can earn carry on individual profitable deals even if the overall fund hasn't returned capital. More GP-friendly, higher risk for LPs.
Example
$100M fund with 8% preferred return and 20% carry (European waterfall).
Fund returns $180M total.
- Tier 1: First $100M goes to LPs (return of capital)
- Tier 2: Next $8M goes to LPs (8% preferred return = $8M)
- Tier 3: Next $2M goes to GPs (catch-up so GPs have 20% of profits so far)
- Tier 4: Remaining $70M splits 80/20: LPs get $56M, GPs get $14M
Final totals:
- LPs receive: $100M + $8M + $56M = $164M (1.64x return)
- GPs receive: $2M + $14M = $16M in carry (20% of $80M total profit)