What is a 'Distribution Waterfall'?

The distribution waterfall is the order in which a private equity fund makes distributions to

limited and general partners. It is a hierarchy delineating the order in which funds are

distributed and may ensure different types of investors have priority of payment compared to

others within the same fund. A distribution waterfall describes the method by which capital is

distributed to a fund's investors as underlying investments are sold.

BREAKING DOWN 'Distribution Waterfall'

A distribution waterfall specifies, for example, that an investor receives his initial investment

plus a preferred return before the general partners can participate in the profits of the fund.

Such an arrangement can increase the investor's confidence in the equity fund and its potential profitability.

Typical Tiers in a Distribution Waterfall Schedule

Though tiers may be customized, in general, there are four tiers involved in a typical

distribution waterfall schedule. 

These are:

First Tier - The return of capital tier

Second Tier - The preferred return tier

Third Tier - The catch-up tier

Fourth Tier - The carried interest tier

The first tier is structured so 100% of distributions go to the investors until they recover all of

their initial capital contributions. The second tier is structured so 100% of further distributions

go to investors until they receive the "preferred return" on their investment. This preferred

return is also commonly known as a hurdle rate. Usually, the preferred rate of return for this

second tier is approximately 7 to 9%. The third tier, the catch-up tranche, is structured so 100%

of the distributions go to the sponsor of the fund until it receives a certain percentage of profits.

The fourth tier is structured so the sponsor receives a stated percentage of distributions as

American style distribution schedule is applied on a deal-by-deal basis, and not at the fund


The American style schedule spreads the total risk over all the deals and is more

beneficial to the general partners of the fund.

Hurdle rates for the schedule may also be tiered, depending on the total amount of carried

interest of the general partners. Typically, the more carried interest, the higher the hurdle rate.

Real Estate Tier

Classifications: Tier 1, Tier 2, and Tier 3

subordinated and have a minimum maturity of two years.

Cities are categorized as Tier I, Tier II, or Tier III depending on the stage of development of their

real estate markets.

Each real estate tier has defining characteristics:

Tier I cities have a developed, established real estate market. These cities tend to be

highly developed, with desirable schools, facilities, and businesses. These cities have the

most expensive real estate.

Tier II cities are in the process of developing their real estate markets. These cities tend to

be up-and-coming and many companies have invested in these areas, but they haven't

yet reached their peak. Real estate is usually relatively inexpensive here; however, if

growth continues, prices will rise.

Tier III cities have undeveloped or nonexistent real estate markets. Real estate in these

cities tends to be cheap, and there is an opportunity for growth if real estate companies

decide to invest in developing the area.

BREAKING DOWN 'Real Estate Tier Classifications: Tier 1, Tier 2, and

Tier 3'

Many businesses see Tier II and Tier III cities as desirable destinations, particularly in times of

economic strength. These areas present opportunity for growth and development and allow

businesses to expand and provide employment to people in growing cities. Additionally, the

cost to operate in prime Tier I real estate is expensive, and companies often see

underdeveloped areas as a way to expand and invest in future growth.


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