Insights

Key Differences Between European and American Waterfall Models.

A distribution waterfall is a term used in real estate and equity investing that describes how capital gains of a fund are allocated between the limited partners (LPs) and the general partner (GP).

The distribution waterfall model establishes the hierarchy by which payouts are given to LPs and GPs.

There are a few important differences between the American waterfall distribution model and the European waterfall distribution models in the ways they allocate and distribute the fund’s capital gains and returns to limited partners, general partners and other investment participants involved.

Why Call it a ‘Waterfall?
It is called a “waterfall” simply because the calculation mimics how water cascades down a waterfall, flowing from high ground into a series of pools or buckets at various heights. Each pool fills up and then the excess water overflows and fills the next lowest pool. The same applies to the distribution waterfall, the distributable money flows and fills in each tier, and is distributed in a pecking order.

Tiers in a Distribution Waterfall
Although waterfall schedules can be modified, a distribution waterfall typically has four tiers:

• Return of Capital: Investors receive their initial capital investments back, along with some additional costs and fees.
• Preferred Return: Investors receive 100% of further payouts in full, up until they receive the preferred rate of return on their investment.
• Catch-up: The general partner will benefit from the catch-up bucket. Up until they obtain a specified percentage of profits, they will receive all or a sizable share of the gain.
• Carry-On Interest: This is how the remaining sum is divided between the limited and general partners.

Which is Better? The American or European Waterfall Distribution Model?
Typically, the American waterfall model favours the fund manager, and the European model favours the investor. It is not a question as to which is better – because it mostly depends on the conditions and environment in which they both operate. Additional differences between the two distribution models are spelt out below:

Key Differences of the European Waterfall Distribution Model
In a European waterfall, the General Partner is not entitled to receive any portion of the carried interest tier until the Limited Partners have received all of their capital back, plus the preferred return.

Here, it is applied in ‘total.’ According to this, investors receive all distributions first, and the manager does not share in any profits until the investor’s capital and preferred return have been entirely paid.

Key Differences of the American Waterfall Distribution Model
The American waterfall is a little bit different than the European waterfall model in the sense that the fund manager can start participating in profits (or perceived profits) on day one even though the investor has not received 100% of their capital back. That’s the biggest difference between the two distribution models.

Also, the general partners would receive their fees in a much shorter time when compared to the European model. The GPs are entitled to their fee, irrespective of whether an investor’s invested capital & preferred return has been completely returned or not.

The American waterfall is more suitable for income funds and debt funds- things that have a lower risk nature and lesser capital risk, where the investment itself might be for 10 or 15 years in nature and the capital may not be returned for 8 to 10 years. So, in those cases, the manager may start to participate in the cash flow of the investment on day one, but what investors want to look for is the clawback feature in that. Meaning – if the deal does not go as planned, there is more risk or the deal suffers a loss if the manager has taken an incentive fee, then in that case the investors have a way to get that back and have the manager pay them back.

Now, the reality is that the clawback feature depends on the net worth of the manager. If you have a manager who has truly little net worth or no balance sheet that the clawback is not even worth the paper that it is written on. So, if you are in an investment that might be debt or income, but you have a manager who doesn’t have a balance sheet or net worth, in that case, it’s more suitable to go with a European waterfall.

If you are an investment company aspiring to achieve a better view into your ROI or looking to make your fund calculations simpler and at scale, ThoughtFocus can help. Reach out to our team of financial and technology solution experts at betterfuturefaster@thoughtfocus.com for more information and we will get back to you at the earliest.