What is a Deal-by-Deal Waterfall?

The Deal-by-Deal Waterfall is a distribution waterfall structure commonly utilized in private equity funds. Unlike some other waterfall models, such as the European Waterfall or the American Waterfall, the Deal-by-Deal Waterfall focuses on distributing profits on a deal-specific basis. In this structure, each investment or deal within the fund is treated independently in terms of profit-sharing, allowing stakeholders to participate in the success (or bear the consequences) of individual investments as they occur.

The Deal-by-Deal Waterfall is characterized by its flexibility and adaptability to the unique attributes of each deal. Rather than aggregating profits across the entire fund, this structure permits stakeholders, particularly general partners, to receive their share of profits and carried interest on a deal-by-deal basis.

Components of the Deal-by-Deal Waterfall

1. Deal-Specific Profit Calculation: The foundation of the Deal-by-Deal Waterfall is the deal-specific profit calculation. Profits are determined for each individual investment or deal within the fund, encompassing realized gains, unrealized gains, interest, and any other income generated by that specific deal.
2. Hurdle Rate (Preferred Return): The hurdle rate, also known as the preferred return, is a key component of the Deal-by-Deal Waterfall. It represents 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%.
3. Carried Interest: Carried interest, often referred to as "carry," is the share of profits that general partners receive once the hurdle rate has been surpassed. The carried interest is usually expressed as a percentage of profits, such as 20%. This component serves as a performance incentive for general partners, aligning their interests with those of limited partners.
4. Deal-by-Deal Distribution: The distinctive feature of the Deal-by-Deal Waterfall is the individualized distribution of profits for each deal. Rather than waiting for the entire fund to achieve profitability, stakeholders receive their share of profits and carried interest as each deal contributes to the overall success of the fund.

Mechanics of the Deal-by-Deal Waterfall

The Deal-by-Deal Waterfall operates based on the following mechanics:

1. Calculation of Deal-Specific Profits: Profits generated by each deal are calculated independently. This includes quantifying realized gains from exits, unrealized gains from the valuation of ongoing investments, interest income, and any other financial gains specific to the individual deal.
2. Hurdle Rate Determination: The hurdle rate is applied to the profits of each deal to ascertain 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 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 individualized distribution mechanism allows stakeholders to realize the financial benefits of successful deals without waiting for the entire fund to achieve profitability.
5. Cumulative Profit Tracking: The Deal-by-Deal 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 Deal-by-Deal Waterfall

1. Flexibility and Responsiveness: The Deal-by-Deal Waterfall provides flexibility and responsiveness to the unique attributes and outcomes of each deal. Stakeholders, particularly general partners, can quickly realize the financial benefits of successful deals without being constrained by the overall profitability of the entire fund.
2. Motivation and Incentives: The individualized profit-sharing structure serves as a strong motivator for fund managers and general partners. The ability to participate in the success of each deal incentivizes proactive decision-making and strategic management to maximize returns on individual investments.
3. Alignment of Interests: The Deal-by-Deal Waterfall enhances the alignment of interests between limited partners and general partners by directly tying profit-sharing to the success of individual deals. This alignment is crucial for fostering a collaborative and cooperative relationship between stakeholders.
4. Risk Mitigation: By distributing profits on a deal-by-deal basis, the Deal-by-Deal Waterfall allows stakeholders to mitigate risks associated with underperforming deals. Limited partners can realize returns from successful deals independently of the overall fund performance, providing a level of risk diversification.

Considerations and Potential Challenges

1. Impact on Fund-Level Returns: While the Deal-by-Deal Waterfall offers advantages in terms of flexibility and responsiveness, it may impact the overall fund-level returns. Investors should carefully evaluate how this 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 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. Alignment with Investor Preferences: Investors should consider their preferences regarding profit distribution structures and align them with the characteristics of the Deal-by-Deal Waterfall. Some investors may prioritize a more traditional waterfall structure that emphasizes the return of capital before profit-sharing.
4. Potential for Varied Profitability: The success and profitability of individual deals can vary within a fund. While the Deal-by-Deal 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.

Comparison with Other Waterfall Structures

1. Deal-by-Deal 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 Deal-by-Deal Waterfall allows general partners to receive carried interest on successful deals without waiting for the entire fund to achieve profitability. The Deal-by-Deal Waterfall offers more flexibility in terms of individual deal performance.
2. Deal-by-Deal Waterfall vs. American Waterfall: The Deal-by-Deal Waterfall and the American Waterfall both involve distributing profits on a deal-by-deal basis. However, the American Waterfall may include additional components such as a hurdle rate and carried interest, whereas the Deal-by-Deal Waterfall focuses on the individualized distribution of profits without specific prerequisites.
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 Deal-by-Deal and European Waterfalls to create a customized distribution framework that aligns with the preferences of investors and fund managers.

The Bottom Line

The Deal-by-Deal Waterfall represents a dynamic and responsive approach to profit distribution in private equity funds. This individualized structure allows stakeholders, particularly general partners, to realize the financial benefits of successful deals without waiting for the entire fund to achieve profitability. While offering flexibility and motivation, the Deal-by-Deal Waterfall introduces considerations regarding overall fund-level returns, calculation complexity, and alignment with investor preferences. Investors and fund managers should carefully evaluate these factors to determine whether the Deal-by-Deal Waterfall aligns with their objectives and supports effective portfolio management within the dynamic landscape of private equity investments.