Distribution Waterfall in Alternative Funds: How Profits Are Split
In alternative investment funds—private equity, venture capital, real estate vehicles—picking the right deals is only half the story. The other half is how profits are distributed once the fund starts returning cash.
That distribution is governed by a structure called the waterfall. It’s a tiered system that defines who gets paid first, when, and how much: investors (Limited Partners / LPs) and the manager (General Partner / GP) in a pre-agreed order.
The goal is to balance three things: return of capital, fair compensation for risk, and meaningful incentives for strong performance.
What is a distribution waterfall?
A distribution waterfall is the financial architecture that determines how a fund’s profits are allocated. Its main purpose is to ensure that investors get their capital back first and often receive a minimum preferred return before the GP earns performance fees.
In practice, there are two dominant models:
- European waterfall (Whole Fund Waterfall): calculated on the fund’s overall performance. Common in Europe.
- American waterfall (Deal-by-Deal Waterfall): calculated deal by deal. Common in the US.
The four core tiers (most common structure)
Details vary by fund, but most waterfalls follow these stages.
1️⃣ Return of Capital
First, the LPs receive back the capital they contributed. At this level, 100% of distributions go to the investors, pro rata.
This protects the investor’s principal before the manager starts collecting upside.
2️⃣ Hurdle Rate (Preferred Return)
After capital is returned, LPs may be entitled to a minimum return, known as the hurdle rate or preferred return. It compensates for opportunity cost and risk.
Typical examples:
- A conservative real estate fund might set 4% per year.
- A venture capital fund might require 8% per year or more.
Until the hurdle is met, distributions usually still go 100% to LPs.
3️⃣ Catch-Up
Once the preferred return is achieved, many funds include a catch-up tier. Here, the GP may receive most (sometimes 100% temporarily) of distributions until the GP “catches up” to the agreed performance fee percentage.
Example: if the GP is entitled to 20% carried interest, the GP may receive all distributions for a period until its cumulative share equals 20%.
Not every fund uses catch-up, but it’s common in private equity and venture capital to align incentives.
4️⃣ Carried Interest (Profit Split)
After capital, the preferred return, and catch-up (if applicable), remaining profits are split according to the agreed percentages. The classic structure is:
- 80% to LPs
- 20% to GP
That 20% is the carried interest—a performance-based fee. Depending on fund type, risk, and manager track record, carried interest can broadly range from 5% to 25%.
European vs American waterfall
| Model | Calculation basis | Who gets paid first | Main advantage | Main risk |
|---|---|---|---|---|
| European (Whole Fund) | Fund-level performance | LPs | Ensures full return before GP performance fees | Delays GP incentives |
| American (Deal-by-Deal) | Deal-by-deal results | GP (earlier) | Faster distributions to GP | GP may be paid before full fund performance is proven |
In the European model, the GP typically cannot receive carried interest until LPs have recovered capital plus the preferred return. In the American model, the GP may earn earlier, but clawback provisions often require the GP to return part of the carry if the fund underperforms at the overall level.
What really matters
The waterfall is the core of the LP–GP relationship. A clear, balanced, transparent structure reduces friction, strengthens trust, and avoids unpleasant surprises when distributions arrive.
At Ayram.es, we see incentives as strategy, not paperwork. A well-designed fund doesn’t only generate returns—it builds durable relationships between capital and management.