European vs American waterfalls, with the numbers worked

The mechanism, briefly

Both structures distribute money through the same four tiers, in the same order. What differs is what the tiers are measured against.

1. Return of capital. Investors get their contributions back.
2. Preferred return. Investors receive a hurdle, commonly 8%, before the manager participates in profit.
3. Catch-up. The manager receives most or all of the next dollars until it holds its full percentage of profit, typically 20%.
4. Split. Everything after that divides at the carry rate, commonly 80/20.

In a European waterfall, those tiers are measured across the entire fund. No carry is paid until investors have received back all contributed capital and their preferred return on it.

In an American waterfall, the tiers are measured deal by deal. A profitable exit can pay carry while other investments are still outstanding, and while the fund as a whole has returned nothing.

The same fund, both ways

Take a fund of $100M in commitments, 20% carry over an 8% preferred return. It makes two investments and incurs $20M of fees and expenses across its life.

Across the whole fund the arithmetic is simple. Investors put in $100M and $120M comes back. Total profit is $20M, so carry at 20% should be $4M. That figure is not in dispute under either structure. What differs is when the manager gets paid, and what happens in between.

American: the manager is paid in year 3

Deal A exits for $100M on $40M invested. Under a deal-by-deal waterfall, the tiers run against that deal.

The manager has now received $10M of carry, and on the evidence available in year 3 that looks entirely earned. Deal A was excellent.

Then Deal B exits in year 5 for $20M against $40M invested. All $20M goes to investors; there is no profit to share. The fund is over.

The manager took half of the fund's $20M profit, on a deal structured to pay 20%. Investors are owed $6M back.

European: the manager is paid in year 5

Same deals, same order, tiers measured across the fund.

Deal A exits for $100M in year 3. Investors have contributed $100M, so the entire distribution returns capital. Capital is now repaid in full, but the preferred return has not been satisfied and no profit has been recognized. The manager receives nothing.

Deal B exits for $20M in year 5. Capital is already back, so this is the first money available for the later tiers.

$4M of carry on $20M of profit. Exactly 20%, arrived at without anyone needing to give money back.

The difference in one line

Neither structure changed what the manager earned. The American waterfall changed when it was paid, and created a $6M obligation that has to be honored years later.

Which brings us to clawback

Every American waterfall carries a clawback provision requiring the manager to return excess carry at the end of the fund. On paper this makes the two structures equivalent. In practice it is the weakest part of the arrangement, for reasons that have nothing to do with anyone's good faith.

• The money was taxed on receipt. Carry distributed in year 3 was income in year 3. Returning the gross amount in year 5 means the manager repays money it never fully kept, unless the agreement provides for after-tax clawback, which shifts the shortfall to investors.
• Carry is distributed to individuals. By year 5 some of those people have left, retired, divorced, or died. The obligation may sit with the management entity while the money sits with individuals, and collecting it is a governance problem rather than an accounting one.
• It arrives at the worst moment. A clawback is triggered by the fund underperforming, which is the same condition under which the manager is least able to pay.

The standard mitigations are worth knowing because they are negotiable. Escrow holds back a percentage of each carry distribution, often 20% to 30%, until the fund is wound up. Interim clawback tests run the whole-fund calculation periodically rather than only at the end, so an overpayment surfaces in year 4 instead of year 8. Guarantees from individual principals make the obligation personal rather than corporate.

Most funds are neither, exactly

The two-way split is a teaching device. Real agreements sit on a spectrum, and the interesting terms are the ones that move a fund along it.

• Deal-by-deal with a loss carryforward. American in timing, but realized losses on other investments must be recovered before carry is paid. Removes much of the exposure in our example.
• Deal-by-deal with return of all invested capital first. Carry waits until every dollar deployed to date has come back, not just the dollars in the exiting deal.
• Whole-of-fund with an early carry release. European by default, but permitting carry once coverage tests are met, such as remaining holdings being valued at some multiple of unreturned capital.
• Catch-up rates that are not 100%. A 50% or 80% catch-up changes the split materially and is easy to miss when reading quickly.

What to check in the agreement

If you are modeling a fund and want to know which structure you actually have, these determine it:

1. Are the tiers measured against the fund or against each investment?
2. Does the preferred return compound, and on what base? Does it accrue on fees as well as capital?
3. Is there a loss carryforward, and does it cover unrealized write-downs or only realized losses?
4. What is the catch-up rate, and is it 100%?
5. Is there an escrow, at what percentage, and when does it release?
6. Is clawback gross or after-tax, and is it guaranteed by individuals?
7. How often is the interim clawback test run?

Those seven answers reconstruct the waterfall. Everything else is detail around them.