Here we’ll discuss European and American waterfalls in investment funds. A fund’s waterfall is a key deal term affecting both general partners (GPs) and limited partners (LPs).
Note: The fund’s waterfall is not determined by the physical location of the fund. We routinely form US-based funds with European waterfalls.
For background on how investment funds are formed, check out this article on how investment funds are structured.
What Is a Waterfall in an Investment Fund?
An investment fund’s “waterfall” governs how the fund’s earnings are distributed between the GP and the LPs.
Many funds have one waterfall that applies to all distributions of cash, securities, digital assets, or other property.
Other funds might have one waterfall for recurring income (such as rents in a real estate fund or interest income in a debt fund) and a separate waterfall for capital events (like selling or refinancing a property).
Basic 80/20 Waterfall Example
Here is a basic waterfall that is standard in many single-asset SPVs.
- First, 100% of distributions go to the LP until the LP has received all of its initial capital back – this is the “return of capital” step.
- Thereafter, 80% of distributions go to the LP and 20% to the GP.
Pretty simple.
Now let’s kick it up a notch.
European Investment Fund Waterfalls – Better for LPs
European waterfalls are one option for investment funds owning multiple assets.
In a European waterfall, 100% of the distributions go to the LP until the LP receives an amount equal to 100% of all the capital they’ve contributed to the fund. This is a full return of capital contributed for all investments, expenses, etc.
After the LP has received a return of its capital, the LP/GP profit split kicks in. In this example, 80% goes to the LP and 20% to the GP.
In the example above, the LP contributed $100 for investments in each of Company A and Company B. Even though Company B hasn’t been sold yet, the LP gets a return of its Company B contributions before the GP gets a dime from the sale of Company A.
In the example, there is $250 to distribute. $100 goes to pay back the investor’s contributions for Company A, $100 pays back the investor’s Company B contributions, and the remaining $50 is split 80/20.
If the fund had 10 investments and the LP contributed $100 to fund each investment, the European waterfall would require that the LP receive a $1,000 return of capital before the GP/LP split kicks in.
European waterfalls are more favorable to LPs than American waterfalls.
European Investment Fund Waterfalls – Better for GPs
American waterfalls are a more GP-friendly waterfall for an investment fund with multiple assets.
There are a few different flavors of American waterfalls, but the general theme is that Step 1 of the waterfall only gives the LP a partial return of capital before the GP/LP split.
In the example below, Company A ($100 cost) is sold for $250. Company B ($100 cost) has not been sold.
In a European waterfall, the LP would receive $200 before the carry split begins.
In a typical American waterfall, the LP would only receive a return of capital invested in Company A ($100) in Step 1. As a result, $150 is left to run through the GP/LP split, which results in the GP receiving $30 of carried interest in the American waterfall instead of $10 in the European waterfall.
As we mentioned, there are various ways to structure an American waterfall. The Step 1 return of capital might include any of the following (going in order of GP-friendly to LP-friendly):
- LP receives a return of contributions to fund (i) the cost basis of the investment sold and (ii) fund expenses related to the investment sold.
- LP receives a return of contributions to fund (i) the cost basis of all investments that have been sold or permanently written down to zero and (ii) fund expenses related to investments that have been sold or permanently written down to zero.
- LP receives a return of contributions to fund (i) the cost basis of all investments that have been sold or permanently written down to zero and (ii) fund expenses related to all investments.
All three options are more GP-friendly than a European waterfall because the GP receives carried interest faster.
Is a European or American Waterfall Better?
As we mentioned above, a fund’s waterfall is not chosen based on geography. European funds can have American waterfalls and American funds have European waterfalls.
Most venture capital funds have European waterfalls. Other asset types (such as private equity and real estate) are more likely than venture funds to have American waterfalls but many have European waterfalls as well.
The right waterfall for an investment fund depends on the bargaining power of the parties. If the GP has a lot of leverage, it might try for an American waterfall. If LPs hold the cards, a European waterfall is more likely.
For information about the timeline and process of forming an investment fund, check out our investment fund formation timeline.