A waterfall distribution is the structured sequence in which a private fund allocates investment proceeds among its investors. The typical four-tier waterfall proceeds as follows: (1) Return of capital — LPs receive back all invested capital. (2) Preferred return — LPs receive their hurdle rate (e.g., 8% per annum) on invested capital. (3) GP catch-up — the GP receives 100% of distributions until it has earned its full carried interest percentage on all profits. (4) Carried interest split — remaining distributions are split 80/20 (or per the LP agreement) between LPs and the GP.
There are two main waterfall structures: European (whole-fund) waterfalls require the GP to return all LP capital and preferred return across the entire fund before receiving any carry — reducing the risk of carry clawbacks. American (deal-by-deal) waterfalls allow the GP to receive carry on each successful exit regardless of other portfolio performance, increasing GP cash flow but requiring robust clawback provisions to protect LPs.