You can price a deal perfectly, grow the portfolio company to the moon, and still walk away with less than expected — all because the waterflow didn’t flow in your favor.
The distribution waterfall is how private equity funds divide the profits. It’s technical, yes, but it’s also one of the most important levers of alignment between GPs and LPs. Structuring it wrong (or misunderstanding it) can lead to incentive drift, LP frustration, or GP clawbacks down the line.
This article walks through the standard four-tier model, highlights the differences between American and European approaches, and calls out the clauses that often go overlooked. If you’ve ever had a hunch that something looked off in a fund’s economics — but couldn’t quite put your finger on it — it probably ties back to the waterfall.
Whether you’re on the LP side reviewing a PPM, or a GP building fund economics, these insights are meant to help you read between the lines — with a bit of shared wisdom from those of us who’ve been through the negotiation trenches.
The standard model follows a four-stage flow. Think of it as a waterfall with each tier as a reservoir:
This is the base level. LPs get their money back first. No profit-sharing, no carried interest — just principal repayment. It’s non-negotiable in most cases, and for a good reason.
Example: If $100 million is committed, the first $100 million in distributions go to LPs.
This first tier is more than just arithmetic. It reflects a core principle: LPs put up the capital, so they get first call on the returns. GPs who try to reshape this tier usually raise red flags.
Next up: the hurdle. This is typically an 8% annual compounded return on capital invested. Until LPs clear this return, GPs don’t see any carry.
A well-structured hurdle filters out rent-seeking. It ensures that carry is a reward for actual outperformance — not just for having a good fundraising deck.
Source: cremodel
This is it speeds up for the GP. Once LPs receive their preferred return, the GP starts collecting 100% of distributions until they’ve “caught up” to their 20% share of total profits above the ROC.
Structure tip: Most catch-up clauses are 100% to GP until the target is hit, then revert to standard carry. But subtle drafting differences matter here.
This tier is where the fund’s drafting earns its keep. Even small language shifts can create big swings in the math — and you don’t want to be the one who finds that out at the back end of a fund.
After the catch-up? Remaining profits are split — typically 80/20 between LPs and GPs. This is the classic PE incentive structure.
| Tier | Flow of Funds |
|---|---|
| 1. Return of Capital | 100% to LPs until all capital is returned |
| 2. Preferred Return | 100% to LPs until hurdle is satisfied |
| 3. GP Catch-Up | 100% to GP until they reach agreed profit share |
| 4. Carried Interest | Profits split (typically 80% LP / 20% GP) |
These two models might sound technical — but in practice, they determine how early, and how often, GPs get paid.
Carried interest is calculated on each realized deal. If Deal A goes well, the GP gets carry — even if Deal B tanks later.
Why GPs like it: Faster compensation. It rewards early success and can help with internal team retention.
Why LPs push back: You might end up overpaying the GP if the rest of the fund performs poorly.
Clawback provisions are the backstop — but we’ve all seen how messy those can get in practice.
Carried interest only flows after the entire fund returns all capital and meets the preferred return.
Why LPs prefer it: It ensures full-fund success before the GP gets paid.
Why GPs grit their teeth: Carry is delayed, often by 5–7 years. Not ideal for team morale — or your CFO.
What some do instead: Add interim distributions or set up escrow accounts. Keeps everyone a little happier.
Source: moonfare
An 8% compounding hurdle might seem standard. But how it’s calculated—on committed capital, deployed capital, or something else—can change outcomes fast.
This is where good lawyers earn their fees. 100% catch-up sounds fine — until you see how it’s implemented.
In American-style structures, clawbacks are meant to protect LPs if carry is overpaid early.
But let’s be honest:
Escrow solves this partially — but it’s not always used. And once the money’s gone, recovery gets tricky.
Assumptions:
That contrast speaks volumes.
In frothy fundraising years, GPs can push through GP-favoring waterfalls. When capital gets tighter, LPs take the lead — and sharpen their pencils.
You’re not just setting economics. You’re setting tone.
Good GPs know when to hold the line—and when to meet LPs halfway.
In American waterfalls, timing of exits drives when (and how much) carry GPs get. That’s not just accounting — it’s strategy.
Overreaching on carry early in your track record can come back to bite you later. LPs remember.
These help protect both sides—and keep things professional.
The distribution waterfall doesn’t just show how returns are split. It shows how a fund sees fairness, performance, and partnership.
It’s one of the few areas where incentives, legal drafting, and finance all come together. Get it wrong, and the economics will feel wrong. Get it right, and you give everyone confidence that the fund is built to deliver — and share — success.
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