Happy Friday, Funds Family!

We’ve written extensively about waterfalls in private investment funds. For a deep dive, take a look at our 🛠️ series on carried interest. This article will focus on the American waterfall, and whether it really offers a “deal by deal” carry structure.

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🔄 A quick refresher on American versus European waterfall

First, we should note that American waterfalls aren’t used in most investment funds in 2025. It is much more common to see European waterfalls these days (even if you’re in America).

In a 🛠️ European waterfall, all investments are netted when they flow through the waterfall. Winners and losers are both accounted for before the GP’s carried interest kicks in. The hurdle is analyzed over the entire fund, not just individual deals or investments that have been realized. An example of a European waterfall is below.

In an 🛠️ American waterfall, however, returns are calculated (and cash is distributed) on a deal-by-deal basis. So, if one particular deal is successful, the cash to be distributed might exceed the hurdle, and the GP will then receive carried interest. This is where the nuance comes into play. A possible American waterfall is shown below.

Now, let’s look at two variations of an American waterfall. One is a true “deal by deal” structure and the other…isn’t.

🚪 Door #1: American Waterfall With Loss Carryforward

The American waterfall comes in two major forms: one with a loss carryforward and one without. 

A loss carryforward clause requires the GP to return capital to an LP on all realized investments (e.g., sold or permanently written off), not just the particular investment that generated the cash and triggered the waterfall. 

Consider the following scenario: an LP contributed $200 to the fund, and the fund deployed the cash into 4 investments ($50 each). Investment number one is a total loss (-$50), but investment number two is a homerun and generates $150. ⚾️ 

An American waterfall with a loss carryforward clause might look like this (note the underlined language):

🚪 Door #2: American Waterfall Without Loss Carryforward

An American waterfall without a loss carryforward clause might look like this:

🚶‍♂️ Walking through the example

Back to our scenario. There is $150 to distribute. Let’s assume a simple 80/20 LP/GP split in step 2 of the example waterfall above, with no preferred return. The math looks like this.

American Waterfall With Loss Carryforward:

Step 1: $100 to the LP ($50 return of capital for investment 1 and $50 return of capital for investment 2).

Step 2: $40 to the LP (80% of the remaining $50) and $10 to the GP (20% of the remaining $50).

American Waterfall Without Loss Carryforward:

Step 1: $50 to the LP ($50 return of capital for investment 2).

Step 2: $80 to the LP (80% of the remaining $100) and $20 to the GP (20% of the remaining $100).

As you can see, without the loss carryforward language the GP collects $10 more than under the waterfall that includes carryforward language. Also, note that under a European waterfall 100% of the distributable cash in the above example would go back to the LP, which is more LP-favorable than either version of the American waterfall.

In summary, American waterfalls are GP-friendly. Further, the American waterfall without loss carryforward language is extremely GP-friendly. Sophisticated LPs are unlikely to accept an American waterfall that does not include loss carryforward language. So, although American waterfalls aren’t used often, when they are utilized, they generally include loss carryforward language.

✅ The difference between European waterfalls and American waterfalls with loss carryforward

In a European waterfall, the return of capital clause requires the return of 100% of the LP’s capital contributions (regardless of whether the underlying investments have been realized or are still held by the fund) before the GP carried interest kicks in. 

With an American waterfall with a loss carryforward clause, the return of capital clause in the waterfall only requires the return of 100% of the LP’s capital contributions related to investments that have been realized or permanently written off before the GP carried interest kicks in. So, the GP can reach the carried interest before returning LP capital contributions related to investments that have not been realized or written off.

⚠️ Warning! Many fund agreements include a GP clawback provision, requiring the GP to return any excess carried interest to the fund. We’ve discussed the clawback in detail in this 🛠️ article. In summary, the clawback provision requires the fund to re-test the waterfall at the end of the fund’s life. If you elect to include an American waterfall, you should expect sophisticated LPs to require that you include a clawback clause. In these cases, the GP might want to hold some of their carried interest in reserve at the GP entity level until a clawback is no longer likely.

/ WRAPPING THE CASE

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