A distribution waterfall is the set order, laid out tier by tier in a fund’s partnership agreement, in which a private fund’s cash gets distributed to limited partners and the general partner as investments are sold.
In plain terms
Money doesn’t get split 80/20 the moment a deal closes. It flows down through tiers like water down a set of steps, and each tier has to fill before the next one gets anything. LPs are paid first, then a minimum return, then the manager gets a turn to catch up, and only after all of that does the ordinary 20% carried-interest split apply to what’s left.
How it works
A standard waterfall runs four tiers. First, return of capital: every dollar LPs put in comes back to them before anyone discusses profit. Second, the preferred return, or hurdle rate — commonly 8% annually — accrues to LPs on their invested capital. Third, the GP catch-up: the manager receives most or all of the next dollars distributed until its cumulative share of profits reaches the agreed carry percentage, as if the preferred return had never applied. Fourth, carried interest: remaining profits split by the fund’s stated ratio, classically 80% to LPs and 20% to the general partner.
The tier structure is only half the story — the other half is when it’s measured. A European, or whole-fund, waterfall applies these four tiers across the entire fund’s cash flows, so the GP collects no carry until LPs have gotten all their capital back across every deal. An American, or deal-by-deal, waterfall runs the tiers separately for each individual investment, letting the GP collect carry on an early winner even while later deals in the same fund are still underwater. The Institutional Limited Partners Association identifies the European structure as the more LP-protective standard, precisely because it prevents that mismatch.
The numbers
- Standard tiers: 4 — return of capital, preferred return, GP catch-up, carried interest.
- Typical preferred return: 8% annually in buyout and growth-equity funds.
- Typical GP catch-up: commonly structured to give the manager 100% of the relevant tranche until it reaches its full carry share; ILPA’s model agreement recommends capping it closer to 80%.
- Typical final split: 80% LPs / 20% GP, the same ratio that gives “two and twenty” its name.
- Waterfall type: European (whole-fund) is the ILPA-recommended standard; American (deal-by-deal) remains common, especially among smaller managers.
What people get wrong
That “80/20” describes every dollar a fund distributes. It only describes the last tier. Before any carry is paid, LPs are made whole on capital and the preferred return — so a fund that never gets there, because its worst deals offset its best ones, may pay the GP no carried interest at all, regardless of what any single portfolio company returned. The waterfall type matters just as much as the split: an American, deal-by-deal structure can let a manager pocket carry on an early exit that later turns out, fund-wide, to have been a net loser — which is exactly what a clawback provision exists to unwind.
Related
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See also: Hurdle rate · Two and twenty · Clawback · LP and GP