Happy Friday, Funds Family!

This is the second article in a series about how carried interest works in investment funds and SPVs. If you haven’t read Part 1, go check that out first.

Let’s keep the party going!

American vs. European Waterfalls

Last week we discussed distributing profits in a vehicle with one investment (an SPV/syndication).

But how do you distribute profits if you have a multi-asset investment fund? 🧐 

There are two styles of distribution waterfalls when you have more than one asset in your fund:

1. European Waterfall (also known as “netted” or “crossed”)

2. American Waterfall (also known as “deal-by-deal”)

➡️ Note: While I assume that, at some point, American waterfalls were common in America and European waterfalls were common in Europe, that is no longer the case. Paradoxically, most funds in the United States have a European waterfall.

💶 European Waterfalls

European waterfalls are simple enough.

All of the capital contributions made by an LP are treated as one big, fungible pool of money that must be returned to the LP before the GP gets any carried interest.

In other words, the capital contributions among all investments are “netted” or crossed.”

Let’s look at an example.

Example 🔍️ 

The example assumes a very simple waterfall, which is common in venture capital.

When an investment is sold:

Let’s walk through how the money flows:

• Capital Contributions: LP invested a total of $200 ($100 was used to buy Company A and $100 was used to buy Company B).

• Sale: The Fund sells Company A for $200.

• Step 1: Per the first step in the waterfall, $200 (the total capital invested by the LP) goes to the LP.

• Step 2: We don’t have any more money to distribute, so we don’t get to the second step of the waterfall, and the GP does not get any carried interest yet. 😭 

➡️ Note that if the Fund had sold Company A for more than $200, the GP would have received some carried interest. For example, if the Fund sold Company A for $225, $200 would have been returned to the LP and the remaining $25 would be split 80% to the LP ($20) and 20% to the GP ($5).

Assuming Company B is successfully sold for more than $0, the GP will receive carried interest once Company B is sold (because the LP already received a total return of capital upon the sale of Company A). 💸

🪙 Returning Expenses in European Waterfalls

Returning expenses is simple in European waterfalls.

In our example above, we oversimplified Step 1, saying the LPs get back all of their capital contributions to fund all investments.

In reality, LPs get back all of their capital contribution used to fund…anything. It looks something more like:

In other words, if an LP invests $100, $90 of which is used to fund investments, $8 of which is used to pay the management fee, and $2 of which is used to pay other fund expenses, the LP would receive the full $100 in Step 1 of the European waterfall.

💵 American Waterfalls

American waterfalls are a bit trickier, but I’m confident you’ll understand!

Unlike European waterfalls, American waterfalls calculate returns on a deal-by-deal basis.

In other words, an LP’s capital contributions used to fund different deals are segregated in the waterfall.

Let’s look at an example.

Example 🔍️ 

The example assumes a simple American waterfall.

When an investment is sold:

⚠️ Note that Step 1 is different than in a European waterfall.

Let’s walk through how the money flows (the first two bullets are the same as the example for the European waterfall):

• Capital Contributions: LP invested a total of $200 ($100 was used to buy Company A and $100 was used to buy Company B).

• Sale: The Fund sells Company A for $200.

• Step 1: Per the first step in the waterfall, $100 (the total capital invested by the LP to fund the purchase of Company A) goes to the LP.

• Step 2: The remaining $100 is split 80% to the LP ($80) and 20% to the GP ($20).

As you can see, the American waterfall is better for the GP. Here, with the exact same facts, the American waterfall yields $20 of carried interest 🥳 , while the European waterfall resulted in a big ol’ goose egg 🥚.

🪙 Returning Expenses in American Waterfalls

There are a couple of options for returning expenses in American waterfalls.

The more LP-friendly formulation is to return all fund expenses in Step 1 of the waterfall. It might look like this:

The more GP-friendly option allocates fund expenses on an investment-by-investment basis and only returns expenses allocated to the sold investment. It might look like this:

“Deal-by-Deal” vs. “Realized Investments” in American Waterfalls

A final wrinkle is that some American waterfalls aren’t really deal-by-deal after all. 🤷 

Instead of strictly segregating deals, the first step of the waterfall returns all capital contributed to fund investments that have been sold or permanently written off.

Example

Let’s say you have 5 investments. You sold Investment 1 yesterday. When you sold that investment, Step 1 of the waterfall required a return of LP capital used to fund Investment 1.

Today, you sell Investment 2. Now, Step 1 of the waterfall requires that you return capital used to fund Investment 1 and Investment 2.

It’s kind of a cross between a netted waterfall and a deal-by-deal waterfall, where it’s a European waterfall only for exited investments.

It might look something like this:

As you can see, there are many options for American waterfalls! 😅 

Selecting a Distribution Waterfall

While American waterfalls are better for GPs, European waterfalls are more common in the market.

For that reason, I often advise emerging managers to go with a European waterfall. In addition, American waterfalls are more likely to result in a clawback situation (which we’ll discuss next week).

American waterfalls are not unreasonable, but having a European waterfall is more LP-friendly and will make fundraising easier.

Up Next ⏩️ 

Next week, in Part 3, we’ll wrap things up with a discussion of:

• Preferred returns

• GP catchups

• Clawbacks

Will be a better ending than Game of Thrones (I promise).

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.