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).

There are two common types of waterfall structures - American, which favors the general partner, and European, which is more investor-friendly.

American Style Waterfall

The American schedule spreads the total risk over all the deals and is more beneficial to the general partners of the fund. This structure allows GPs to receive a promote prior to limited partners receiving all their invested capital and preferred return.

For the Limited Partner, the pro of the American waterfall structure is that the General Partner gets paid earlier, which means they can afford to take a longer term approach to a property’s business plan. This is important because it can take years to successfully complete a business plan.

European Style Waterfall

With this structure, 100% of all distributions will go to limited partners. The general partners will not participate in any profits until the LP’s capital and preferred return have been fully satisfied. In most cases, the GPs will not receive their promoted interest until a capital event (refinance or sale).

For the Limited Partners, the major benefit of the European waterfall structure is that they are paid first.

In addition, the General Partner’s incentive is to deliver a high return so they can get to the carried interest tier. If they can, the major benefit for the General Partner is that they often get a disproportionately high share of the profits at the carried interest tier.

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