In the world of Alternative Investment Funds (AIFs) —from private equity to venture capital—, understanding how profits are distributed is crucial. This mechanism, known as the “distribution waterfall”, determines how and when investors (LPs) and fund managers (GPs) receive returns.
The waterfall defines a clear order: first, capital recovery; then a preferred return for investors; and finally, performance-based incentives for the management team.
What Is a Distribution Waterfall?
The distribution waterfall is the framework that governs the allocation of profits in an investment fund. Its main goal is to ensure that investors recover their capital and a minimum return before fund managers receive any performance fees.
The most common structure in Europe is the whole fund waterfall, while the deal-by-deal waterfall dominates in the United States.
The Four Main Stages
1️⃣ Return of Capital
All income generated by the fund is first distributed to investors until they have fully recovered their invested capital. No performance fees are paid at this stage.
2️⃣ Hurdle Rate — Preferred Return
Once capital has been returned, LPs are entitled to a preferred return, compensating them for the cost of capital and risk.
Typical hurdle rates:
- 4% for conservative real estate funds
- 8% or higher for private equity and venture capital funds
3️⃣ Catch-Up
After the preferred return is achieved, the fund manager (GP) receives 100% of the next profits until they reach their agreed carried interest share —for example, 20%. This step aligns incentives between investors and fund managers.
4️⃣ Carried Interest
After completing the previous stages, all remaining profits are split between LPs and the GP —typically 80/20.
This performance fee rewards the GP for generating value beyond the hurdle rate.
European vs. American Waterfalls
| Model | Calculation Basis | Who Gets Paid First | Main Advantage | Risk |
|---|---|---|---|---|
| European (Whole Fund) | Based on total fund performance | LPs | Ensures full investor recovery before GP payout | Delays GP incentive |
| American (Deal-by-Deal) | Based on each individual investment | GP | Allows faster reward to managers | May require clawbacks if fund underperforms |
A well-structured distribution waterfall creates balance between risk and reward, ensuring fairness and long-term trust between investors and fund managers.
At Flyxchain, we believe incentive design is a cornerstone of strategic fund management —it’s not just about profits, it’s about building sustainable alignment between capital and leadership.
