🛠️ Investment Fund Key Terms, Part 18

🎉 Happy Friday, funds family!

Today, we have Part 18 in our many-part series walking through each term in an investment fund term sheet in detail.

Here’s the index of each article in this series (so far):

• Part 1: Naming your entities

• Part 2: Investment objectives

• Part 3: Fund size

• Part 4: LP minimum check size

• Part 5: GP commitment

• Part 6: Fund term

• Part 7: Fundraising period

• Part 8: Investment period

• Part 9: Capital recycling

• Part 10: Investment limitations

• Part 11: Leverage Limitations

• Part 12: LP Withdrawals

• Part 13: Key Person Event

• Part 14: Successor Funds

• Part 15: Carried Interest

• Part 16: Preferred Returns

• Part 17: GP Catch-Up Provisions

This week focuses on American vs. European Waterfalls. 

Time to get political (not really, don’t worry).  

Today, we'll discuss the two dominant models: (1) the American waterfall (“deal-by-deal”); and (2) the European waterfall (“fund-as-a-whole”). 

They can produce dramatically different economics — even with the same preferred return and carry percentages.

➡️ What’s the Difference?

At a high level:

🔸 American Waterfall: Carry is calculated deal-by-deal.
🔸 European Waterfall: Carry is calculated only after the LP has been fully returned across all deals.

 This seemingly small difference creates massive variations in timing and risk allocation.

➡️ American Waterfall Setup

Under an American 🇺🇸 waterfall, each investment has its own mini waterfall:

1. Return of capital (for that deal)
2. Preferred return (for that deal)
3. GP catch-up (for that deal)
4. Profit split (for that deal) 

Once a single deal performs well enough to clear its mini waterfall, the GP can receive carry even if other deals are underwater. That’s the positive for GPs.

However, there’s no free lunch. Most fund documents have a “clawback” provision. If a GP takes carry from an early deal and later deals lose money, the GP may have to return previously paid carry to the LPs.  

Note that there are many flavors of American waterfalls. For example, some are truly “deal by deal” but most are a bit more complicated – essentially serving as a European waterfall for realized (sold or written down) investments only. Plus, American waterfalls treat fund expenses differently. Some require a return of all fund expenses in step 1, while others only require a return of expenses allocable to the investment at issue. 

➡️ European Waterfall Setup

 In a European 🇪🇺 waterfall, everything aggregates at the fund level. So it looks something like this: 

1. Return of capital (for the whole fund)
2. Preferred return (for the whole fund)
3. GP catch-up (for the whole fund)
4. Profit split (for the whole fund)

The GP cannot earn any carry until the return of capital and preferred return are cleared with respect to all LP capital contributions – not just those for the deal that was sold. 

➡️ Which Is “Better”? 

It depends on who you ask! GPs generally prefer American waterfalls (faster payouts, more predictable cash flow). LPs almost always prefer European waterfalls (greater protection, cleaner economics). First time fund managers often opt for European waterfalls, but not always! I would say roughly 85% of our clients opt for European waterfalls. 

🗓️ Next up in Part 19: Split Waterfall

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.