Distribution Waterfall

SEC Release IA-1092

What is a distribution cascade?

A distribution cascade delineates the method by which capital gains are distributed among the participants in an investment. Commonly associated with private equity funds, the distribution cascade defines the order in which distributions are allocated to limited partners and general partners. Usually, general partners receive a disproportionately higher share of the total profits than their initial investment after the allocation process is completed. This is done to encourage the general partner to maximize profitability.

Understanding the distribution cascade

A distribution cascade describes the method by which the capital is distributed to the investors of a fund when the underlying investments are sold. The investment cascades are detailed in the distribution section of the private placement memorandum (PPM).

Essentially, the total capital earned is distributed according to a cascade structure made up of levels, hence the reference to a cascade. When the allocation requirements of one level are met, excess funds are subject to the allocation requirements of the next level, etc.

Although the levels can be customized, generally, the four levels of a cascading schedule are:

  1. Return of capital – 100% of the distributions go to investors until they recover all of their initial capital contributions.
  2. Favorite return – 100% of additional distributions go to investors until they receive the preferred return on investment. Usually the preferred rate of return for this level is around 7% to 9%.
  3. Catch-up slice – 100 percent of distributions go to the fund sponsor until he receives a certain percentage of the profits.
  4. Interest – a specified percentage of the distributions the sponsor receives. The percentage indicated in the fourth level must correspond to the percentage indicated in the third level.

The hedge rates for the calendar may also be staggered, depending on the total amount of interest borne by the general partners. In general, the higher the interest, the higher the obstacle rate. In addition, a feature called “recovery” is frequently included in the PPM and is intended to protect investors from paying higher incentive fees than necessary. In the event of such an occurrence, the manager is obliged to reimburse the excess costs.

Key points to remember

  • A distribution cascade delineates the method by which capital gains are distributed among the participants in an investment.
  • Generally, the four levels of a cascading distribution schedule are: principal repayment, preferred return, catch-up tranche and interest bearing.
  • There are two common types of cascading structures: the American, which favors the manager, and the European, which favors investors.

Cascading American and European structures

There are two common types of cascading structures: the American, which favors the general partner, and European, which is more favorable to investors.

An American distribution schedule is applied on a case-by-case basis, not at the fund level. The US schedule spreads the total risk across all transactions and is more beneficial to the fund’s general partners. This structure allows managers to be paid before investors receive all their invested capital and their preferred return, although the investor is still entitled to these.

A European style distribution schedule is applied to an aggregated fund level. With this schedule, all distributions will go to investors and the manager will not participate in any profits until the capital and the preferred return of the investor have been fully satisfied. One drawback is that the majority of the manager’s profits may not be realized for several years after the initial investment.

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