What is an American Waterfall?

The American Waterfall is a distribution waterfall structure commonly employed in private equity funds. A distribution waterfall outlines the systematic process through which profits generated by the fund's investments are distributed among different stakeholders. The American Waterfall is distinct in its approach to profit-sharing compared to other waterfall structures, such as the European Waterfall or the deal-by-deal waterfall.

In an American Waterfall, the distribution of profits occurs on a deal-by-deal basis, allowing general partners to participate in the profits from each investment opportunity without waiting for the entire fund to generate profits. This structure contrasts with other waterfall models that prioritize the return of capital to limited partners before general partners participate in profit sharing.

Components of the American Waterfall

The American Waterfall comprises several key components, each delineating a stage in the distribution of profits:

1. Hurdle Rate: The hurdle rate, also known as the "preferred return," is the minimum rate of return that limited partners must receive on their invested capital before general partners are entitled to a share of the profits. The hurdle rate is typically expressed as a percentage, such as 8% or 10%, and serves as a benchmark for determining when profit-sharing begins.
2. Carry or Carried Interest: Carried interest, often referred to as "carry," represents the share of profits that general partners receive once the hurdle rate has been surpassed. The carry is typically expressed as a percentage of profits, such as 20%. This component incentivizes general partners to maximize the profitability of the fund's investments.
3. Deal-by-Deal Basis: One distinctive feature of the American Waterfall is its deal-by-deal basis. This means that profits are distributed and carried interest is calculated separately for each investment opportunity or deal within the fund. This structure allows general partners to participate in profits from successful deals as they occur.
4. No Return of Capital Requirement: Unlike some other waterfall structures, the American Waterfall does not necessitate the return of capital to limited partners before general partners participate in profit-sharing. General partners can receive carried interest on profits generated by successful deals without waiting for the entire fund to achieve a certain level of profitability.

Mechanics of the American Waterfall

The American Waterfall operates based on the following mechanics:

1. Deal-Specific Profit Calculation: Profits generated by each individual investment or deal are calculated independently. This includes realized gains, unrealized gains, interest, and any other income generated by the specific deal.
2. Hurdle Rate Determination: The hurdle rate is applied to the profits of each deal to determine whether limited partners have achieved their preferred return. If the profits surpass the hurdle rate, general partners become eligible to receive carried interest.
3. Carried Interest Allocation: Once the hurdle rate is met, general partners are entitled to receive carried interest on the profits of the specific deal. The carried interest is typically calculated as a percentage of the profits after the hurdle rate has been satisfied.
4. Deal-by-Deal Distribution: Profits and carried interest are distributed to limited partners and general partners on a deal-by-deal basis. This allows general partners to participate in the success of individual deals without waiting for the entire fund to achieve profitability.
5. Cumulative Profit Tracking: The American Waterfall may involve tracking cumulative profits and carried interest across all deals within the fund. This cumulative approach allows general partners to receive carried interest on the aggregate profits of the fund, considering the success of multiple deals.

Advantages of the American Waterfall

1. Timely Profit Participation: One of the primary advantages of the American Waterfall is that general partners can participate in the profits generated by successful deals as they occur. This timely profit-sharing aligns with the performance of individual investments and provides incentives for fund managers to maximize returns.
2. Flexibility and Deal Independence: The deal-by-deal structure of the American Waterfall offers flexibility and independence for each investment opportunity. General partners are not constrained by the need to return capital to limited partners before participating in profit-sharing, allowing for a more dynamic and responsive approach to deal-specific opportunities.
3. Enhanced Alignment of Interests: The American Waterfall enhances the alignment of interests between limited partners and general partners by directly linking profit-sharing to the success of individual deals. This alignment incentivizes general partners to focus on generating favorable returns on each investment within the fund.
4. Potential for Increased Motivation: General partners may find the American Waterfall structure motivating, as it allows them to realize the financial benefits of successful deals without delays associated with waiting for the entire fund to achieve profitability. This potential for quicker and more frequent distributions can enhance motivation and commitment.

Considerations and Potential Challenges

1. Impact on Fund-Level Returns: While the American Waterfall facilitates timely profit-sharing on a deal-by-deal basis, it may impact the overall fund-level returns. Limited partners should carefully evaluate how the structure aligns with their investment objectives and whether it allows for effective diversification across multiple deals.
2. Complexity in Calculation: The deal-by-deal nature of the American Waterfall can introduce complexity in the calculation of profits, hurdle rates, and carried interest for each individual deal. This complexity may necessitate robust tracking and reporting mechanisms to ensure accurate and transparent distributions.
3. Potential for Varied Profitability: The success and profitability of individual deals can vary within a fund. While the American Waterfall allows general partners to benefit from the success of prosperous deals, it also means they may not participate in the profits of less successful or negative-performing deals.
4. Alignment with Investor Preferences: Investors should consider their preferences regarding profit distribution structures and align them with the characteristics of the American Waterfall. Some investors may prioritize a more traditional waterfall structure that emphasizes the return of capital before profit-sharing.

Comparison with Other Waterfall Structures

1. American Waterfall vs. European Waterfall: In contrast to the European Waterfall, which prioritizes the return of capital to limited partners before general partners participate in profit-sharing, the American Waterfall allows general partners to receive carried interest on successful deals without waiting for the entire fund to achieve profitability. The American Waterfall is often considered more favorable for fund managers.
2. American Waterfall vs. Deal-by-Deal Waterfall: The American Waterfall and the deal-by-deal waterfall are terms often used interchangeably, as they both refer to structures where profits are distributed on a deal-by-deal basis. However, the American Waterfall may involve additional components such as a hurdle rate and carried interest.
3. Hybrid Waterfall Structures: Some private equity funds may adopt hybrid waterfall structures that combine elements of different waterfall models. For example, a fund may incorporate aspects of both the American and European Waterfalls to create a customized distribution framework that aligns with the preferences of investors and fund managers.

The Bottom Line

The American Waterfall represents a distinctive distribution waterfall structure in private equity funds, allowing general partners to participate in profits on a deal-specific basis. This structure emphasizes timely profit-sharing, flexibility, and enhanced alignment of interests between limited partners and general partners. While the American Waterfall offers advantages in terms of motivation and deal independence, investors and fund managers should carefully consider its implications on overall fund returns, complexity in calculation, and alignment with investor preferences. The choice of a waterfall structure is a significant aspect of fund formation, influencing the dynamics of profit distribution and shaping the relationships between stakeholders in the private equity landscape.