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.
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
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.