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Fund Waterfall: Method

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Fund Waterfall: How It Works

What it does

A private equity or venture fund is a partnership. The investors, called limited partners (LPs), commit money; the manager, called the general partner (GP), calls it when it finds investments (contributions) and pays it back as investments are sold (distributions). The partnership agreement fixes the order in which each distribution is shared between the LPs and the GP. That order is the waterfall: money fills one tier, then spills into the next. The page takes a list of dated contributions and distributions, runs the waterfall, and shows what each side receives and what the LPs earn after the GP's share. Every step is printed as formula, numbers put in, answer.

The method

Symbols. KLP is the capital the LPs have contributed and DLP the distributions on their side; gc the GP's own commitment as a share of the fund; rp the preferred return (hurdle), a yearly rate; ci the carried interest (carry), the GP's share of profit; kc the catch-up share; T1 … T4 the amounts distributed in each tier. Percentages are used as decimals: 8 % is 0.08. Time t is in years from the first date, counted in whole anniversaries plus the fraction of the next year.

The GP's own commitment is treated as an investor that pays no carry and no fee: it funds gc of every contribution and receives gc of every distribution. The waterfall is applied to the rest: KLP = (1 − gc) × contributions, DLP = (1 − gc) × distributions.

Whole-fund (European) waterfall. Each distribution runs through the tiers in order, starting where the last one stopped:

Tier 1, return of capital: 100 % to the LPs until they have back all capital contributed so far.
Tier 2, preferred return: 100 % to the LPs until the preferred return accrued on their unreturned capital is paid.
Tier 3, GP catch-up: kc to the GP and 1 − kc to the LPs until the GP holds ci of all profit distributed. From kc T3 = ci (T2 + T3):   T3 = ci T2 / (kc − ci).
Tier 4, residual split: 1 − ci to the LPs and ci to the GP:   T4 = DLP − T1 − T2 − T3.

Carry = kc T3 + ci T4. With a completed catch-up this equals ci × (DLP − KLP), the carry rate times the whole profit. With no catch-up (kc = 0, a hard hurdle) tier 3 is empty and the GP earns ci only on profit above the preferred return.

The preferred-return account. The page keeps one account for the LPs: unreturned capital plus unpaid preferred return. Between two dates Δt years apart it grows by the factor (1 + rp)Δt (yearly compounding) or (1 + rp/4)4Δt (quarterly). Contributions add to it; tier 1 and tier 2 payments reduce it. When it reaches zero, the LPs' IRR on those payments is exactly rp, which is why this form is called an IRR hurdle. With the simple-interest hurdle (Advanced) the preferred return accrues as rp × unreturned capital × Δt and earns nothing itself.

Remaining value and multiples. The entered remaining value is run through the same tiers as if it were distributed on the last date; VLP is the LPs' share and the rest is carry accrued but not paid. With RLP the cash the LPs have received:

DPI = RLP / KLP   (distributions to paid-in)
RVPI = VLP / KLP   (residual value to paid-in)
TVPI = DPI + RVPI   (total value to paid-in)

IRR. The internal rate of return is the yearly rate r that solves Σ CFj / (1 + r)tj = 0 over the dated cash flows CFj. Gross IRR: the fund's flows (contributions out, distributions and remaining value in). Net IRR: the LPs' flows (their contributions and fees out, their receipts and VLP in). The root is found by bisection.

Advanced mode. Management fee: a yearly percentage of the LPs' commitment during the investment period and of their contributed capital not yet returned after it. It is charged on each dated row for the time since the row before and called from the LPs on top of the entered contribution, so it is capital to be returned in tier 1 and earns the preferred return. Second carry tier: a second account runs at the higher hurdle and is reduced by every payment to the LPs; tier 4 pays at the first carry rate until it is empty, then tier 5 pays at the second rate, with no second catch-up. Deal-by-deal (American) waterfall: the same tiers applied to each deal's own contributions and distributions, with fees allocated to deals in proportion to their contributions. The GP is paid carry on each profitable deal as it is sold. Clawback = max(0, carry paid deal by deal − whole-fund carry): what the GP must return so that it ends with no more than the whole-fund amount.

What it assumes

  • One class of LPs that all contribute and receive pro rata; no side letters, no separate fee terms.
  • Carry is computed on the LPs' share only; the GP's commitment bears no carry and no fee.
  • Each hurdle account is floored at zero: once the preferred return is paid, later capital calls start a new accrual and earlier profit paid to the LPs is not counted against it.
  • Same-day contributions are booked before the distribution. Fees are charged in arrears on the dated rows, so a fund with few rows pays its fees in few lumps.
  • The remaining value is taken as entered and as if sold on the last date. The clawback test covers the distributions actually made and ignores taxes, escrow and interest.
  • No recycling of distributions, no fee offsets, no fund expenses other than the management fee, no subscription credit line.

When it misleads

  • Real agreements differ in the details. Whether the preferred return compounds, whether fees are returned before carry, how the catch-up is worded and when the clawback is tested are all negotiated. The ILPA Principles describe the whole-fund model as best practice; a fund's own agreement governs.
  • RVPI and TVPI rest on a valuation. The remaining value is the manager's estimate until the investments are sold. Only DPI is cash.
  • IRR is sensitive to timing. An early distribution raises the IRR far more than the multiple, and a credit line that delays capital calls raises it without changing what the investments earned. The IRR also says nothing about what the money earned before it was called or after it was returned.
  • A clawback is a promise, not cash. After the clawback the deal-by-deal totals match the whole-fund totals, but the GP held the money in the meantime and must be able to pay it back, usually years later and after tax.
  • Yearly rows are coarse. A fund calls and distributes many times a year; a table with one row a year moves every flow to that date, which shifts the preferred return and the IRR.

Worked example

The default case is an illustrative fund, not a real one. Committed capital 100, GP commitment 2 %, preferred return 8 % compounded yearly, carry 20 %, full catch-up. Contributions of 40, 30 and 20 at the start of 2021, 2022 and 2023; distributions of 75, 45 and 8 at the start of 2024, 2025 and 2026; remaining value 12.

LPs' side: KLP = 0.98 × 90 = 88.20; DLP = 0.98 × 128 = 125.44.

Account: 39.20 grows to 42.34 and 29.40 is added: 71.74. That grows to 77.47 and 19.60 is added: 97.07. A year later it is 104.84; the first distribution of 73.50 is all return of capital and leaves 31.34. A year later it is 33.85: 14.70 of capital and 19.15 of preferred return.

Tier 1 = 88.20. Tier 2 = 19.15. Tier 3 = 0.2 × 19.15 / (1 − 0.2) = 4.79, all to the GP. Tier 4 = 125.44 − 88.20 − 19.15 − 4.79 = 13.30: 10.64 to the LPs, 2.66 to the GP.

Carry = 4.79 + 2.66 = 7.45, which is 20 % of the profit 125.44 − 88.20 = 37.24. The LPs receive 125.44 − 7.45 = 117.99.

Remaining value: the LPs' side is 0.98 × 12 = 11.76, all in tier 4: 9.41 to the LPs, 2.35 of carry accrued.

DPI = 117.99 / 88.20 = 1.34; RVPI = 9.41 / 88.20 = 0.11; TVPI = 1.44. Gross IRR (flows −40, −30, −20, +75, +45, +20) = 16.85 % a year; net IRR to the LPs (−39.20, −29.40, −19.60, +73.50, +38.22, +15.68) = 14.16 % a year.

In Advanced mode the same fund with a 2 % fee and each row given a deal number: deal 3 returns 8 on 20, deals 1 and 2 are profitable, and the deal-by-deal waterfall pays the GP 8.86 of carry against 6.19 for the whole fund, a clawback of 2.67.

A calculator for education and analysis, not investment advice.