The waterfall is the mechanism that decides who receives what, and in what order, as money comes back from an investment. It is usually the most negotiated section of the documents and the least understood by the people signing them, which is a poor combination given that it determines the entire economic outcome for both sides.
Money in: the capital call
Before anything is distributed, capital has to be drawn. Investors commit an amount and the manager calls it as needed, with notice, which is more efficient than holding idle cash but creates an obligation the investor must be able to meet. The consequences of failing to fund a call are set out in the documents and are typically severe, dilution, forfeiture, or a penalty rate on a funding loan, because a vehicle that cannot rely on its commitments cannot transact.
An investor should read the default provisions before signing rather than after receiving a call at an inconvenient moment, and should understand how much notice they are entitled to.
Money out: the four tiers
The classic waterfall runs in four tiers. First, return of capital: investors receive back what they contributed. Second, the preferred return: investors receive a stated annual return on that capital, commonly in the high single digits, before the manager participates. Third, catch-up: the manager receives a disproportionate share until it has caught up to its agreed percentage of the profit above the preferred return. Fourth, the split: everything further is divided in the agreed ratio, commonly eighty to the investors and twenty to the manager.
The negotiation is never really about the twenty per cent. It is about what has to happen before the twenty per cent starts, and whether it can be taken back.
Whole-fund or deal-by-deal
The most consequential variation is whether the promote is calculated across the whole portfolio or asset by asset. Deal-by-deal pays the manager earlier, on each successful asset, regardless of how the others perform. Whole-fund pays only once the investors have received their capital and preferred return across everything. For an investor, whole-fund is materially safer; for a manager, deal-by-deal is materially better. Most negotiated outcomes sit somewhere between, with interim payments subject to a clawback.
Clawback, and whether it is worth anything
A clawback requires the manager to return promote it received early if the final outcome does not justify it. The provision is standard and is frequently worth less than it appears, because it depends on the manager still having the money and still existing. Investors who care about this ask for an escrow or a holdback, so that part of the early promote is retained rather than distributed and then chased.
The preferred return: compounding and on what
Two details change the arithmetic significantly. Whether the preferred return compounds, and if so how often. And whether it accrues on contributed capital only or also on unpaid preferred return. These are single words in a document and they can move the outcome by a meaningful margin over a five-year hold.
Where the waterfall meets the structure
The waterfall is an economic arrangement, and it has to be implemented through a structure that can actually deliver it, which means the vehicle, the tax treatment of distributions to investors in different countries, and the timing of cash all have to work together. A waterfall that is elegant on paper and produces withholding leakage at each tier has not been finished. The structural side is set out in our note on owning European real estate through a Dutch holding, and the club-deal context in our note on co-investment and club deals.
Montclare manages and structures European real assets for institutional and private investors, from acquisition through to exit. Our services are set out on our services page.
This article is informational and does not constitute investment, tax or legal advice. Asset management and investment advice are regulated activities and the treatment of any transaction depends on its facts. Each engagement is subject to scope and applicable regulation.