What Does Waterfall Structure Mean?
Waterfall structure refers to the order in which a private equity fund pays out distributions after investments have been liquidated. The traditional waterfall structure entails having the limited partners receiving their invested capital for investments and management first, then getting the preferred return, with the last tranche being the excess return net of the carry to the GP.
Divestopedia Explains Waterfall Structure
In the traditional waterfall structure, the GP receives a carry after the invested capital and preferred returns have been paid back. This assures the GP will receive its carry early in the life of the fund. However, in the more non-traditional, "European style" waterfall structure, GPs must pay back the invested capital on the investments liquidated as well as the invested capital on investments that have not been sold yet. This precludes the carry from being paid to the GP until the later years of the fund when all invested capital has been repaid back first.
In the mid 2000s, when private equity was hot, waterfall structures used to pay carry on a deal-by-deal basis. With additional competition for LP commitments, the waterfall structure is moving more toward a full pooling of returns rather than on a deal-by-deal basis. This approach also results in the GPs getting their carry later in the fund's life, once the LPs are assured that their entire invested capital and preferred return are collected.