Comparing American and European Equity Waterfalls: Structures, Preferences, and Implications

Equity Waterfalls: A Comparison between American and European

In the world of private equity investments, understanding how funds distribute profits is crucial for investors and sponsors alike. An equity waterfall serves as a blueprint for cash flows within a private equity fund, with the specifics outlined in the limited partnership agreement that every investor must agree to before committing capital.

The essence of an equity waterfall revolves around a tiered structure. Imagine these tiers as stacked pools; higher levels fill up first, preventing the overflow into lower pools. This concept is centered around rates of returnknown as hurdle rateswhich define each level and ensure certn financial obligations are met before proceeds move down to subsequent layers.

Most waterfalls include four primary tiers:

1. Capital Return: Limited partners first receive full distributions until they recover their original investment.

2. Preferential Rate: continues with limited partners collecting additional distributions up to a preferred return rate, typically set between 7 and 9, deping on the agreement terms.

3. Sponsor Catch-up: Once the preferential returns are met, sponsors step in to receive full distributions until they achieve their catch-up point, usually at an agreed upon percentage often 20 of profits.

4. Carried Interest: Finally, any leftover cash is split between sponsors as carried interest while limited partners collect the remnder.

These structures can broadly be categorized into two mn types: American or European.

European Equity Waterfalls

The European waterfall model focuses on ensuring that capital contributions and preferred returns are fully recovered for all investors before sponsors receive a share of profits. This distribution follows a pro-rata basis, meaning allocations are proportionate to each investor's initial investment. For instance, an investor holding 20 stake would collect exactly this portion until their capital contribution and preferential return are reached.

This structure is more advantageous from the limited partners' perspective as sponsors face prolonged wt times before receiving carried interest. The emphasis on recovering all funds and preferred returns first encourages a focus on long-term performance rather than immediate profits.

American Equity Waterfalls

Contrary to European waterfalls, Americanalso known as deal-by-dealallocate carried interest based on individual investments within the fund, not just at the fund's aggregate level. This means sponsors might earn carried interest from specific deals before limited partners are compensated fully.

In scenario with five investors each holding a 20 stake and targeting an 8 preferred return, while sponsors catch up to their 20 share of profits first, they might receive carried interest from certn investments ahead of the full recovery of capital contributions and preferential returns by limited partners.

This setup typically benefits sponsors due to shorter wt periods before receiving carried interest. However, it increases risk for investors as they may not achieve their preferred rate before distribution begins. To mitigate this risk, many American-style funds include a 'clawback' clauseensuring that if the fund fls to meet its preferred return, sponsors give back previously earned carried interest.

Sponsor Preference: The American Model

American equity waterfalls are predominantly used by U.S.-based sponsors worldwide, while Europeanremn popular in Europe. Hybridcombining elements of both approaches have emerged but have not yet replaced either system as the primary frameworks.

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