European vs American waterfall: how the math actually differs

A distribution waterfall is the ordering rule in the fund agreement: it determines the sequence, the priority and the proportions in which distributable proceeds move between the limited partners and the general partner. Everything else about the two named models follows from a single choice inside that rule — whether the carry test is applied to the fund as a whole or to each investment separately. Naming them by continent obscures that, which is part of why the terminology survives.

Under the whole-fund model the general partner receives no carried interest until all capital contributions across the whole fund, plus the preferred return, have been distributed. ILPA calls the all-contributions-plus-preferred-return-back-first model best practice. Under the deal-by-deal model carry is tested and paid investment by investment, so proceeds from a realisation can carry a promote before the fund as a whole has returned capital. ILPA's prescription for non-whole-fund models is not permissive: return of all realised cost for the investment, continuous make-up of partial unrealised impairments and write-offs, return of all fees and expenses to date, and valuation of unrealised holdings at the lower of cost or market.

The consequence is a timing difference that becomes a quantum difference the moment a fund contains a loss. On a fund where every investment returns more than cost, both structures pay the general partner the same carried interest in total; the deal-by-deal structure simply pays it earlier. On a fund where early winners are followed by later losers — the ordinary shape of a private equity portfolio — the deal-by-deal structure pays carry that the fund as a whole never earned, and the correction runs through the clawback rather than through the waterfall.

That is the whole analysis. Everything a negotiation adds to it — interim clawbacks, escrow percentages, lower-of-cost-or-market tests, a hybrid gate — exists to move a deal-by-deal structure back towards the whole-fund answer without giving up the cash timing. Reading the two models as opposites rather than as endpoints of one axis is what makes the middle of the market hard to price.

Both models fill the same tiers; they differ only in what the tiers are measured against. Tier one returns capital: one hundred per cent of proceeds to the partner until cumulative distributions equal that partner's aggregate capital contributions. United States drafting commonly extends that tier to contributions applied to offering expenses, organisational expenses and partnership expenses including the management fee, pro-rated to realised investments — which matters, because whether the fee sits inside tier one changes the size of the hole the fund has to climb out of before any carry is payable.

Tier two pays the accrued preferred return. The ILPA model defines it as an annual rate compounded annually and calculated daily on the limited partner's capital contribution, running from the fund's receipt of the contribution until the date of distribution or deemed distribution. Eight per cent is the industry standard at sixty-seven per cent of funds sampled, and seventy-eight per cent of waterfalls accrue it on a compounded basis. Both facts belong in the model before anyone argues about the rate.

Tier three is the catch-up: a disproportionately general-partner-weighted split running until the general partner's cumulative distributions equal its carry percentage of cumulative profit distributions to date. The rate is negotiated, not conventional. The ILPA Model LPA itself uses an eighty per cent catch-up; United States drafting frequently uses one hundred per cent. Tier four splits everything further at the carry ratio, conventionally eighty per cent to limited partners and twenty per cent to the general partner — the rate in the overwhelming majority of funds, and twenty per cent for seventy-one per cent of the funds ILPA sampled.

A three-tier construction omits the catch-up, which produces a hard hurdle: carry applies only to profits above the preferred return. A two-tier construction omits the preferred return entirely, and ILPA finds sixteen per cent of sampled funds have no hurdle at all. Tier counts are descriptive nomenclature rather than defined terms, so read the tiers in the agreement rather than the label in the term sheet.

Interim carry is the structural reason clawbacks and escrows exist. Limited partners want protection from overpayment because the manager often receives carry before final liquidation, and therefore before the fund's aggregate net gains can be calculated. Most United States funds run on the implicit assumption that unrealised investments will eventually produce proceeds at least equal to carrying value — an assumption that is not a fact and that the clawback exists to unwind when it fails.

The ILPA model sets two independent clawback triggers: the general partner has received cumulative distributions in excess of the carried interest it should have received, or any limited partner has received distributions of less than the sum of its capital contribution and the preferred return on it. The second trigger is the one that catches the structure described in the worked example below, and it is the reason a deal-by-deal fund with a healthy gross multiple can still owe money back.

Interim clawbacks and escrow are the negotiated answers. Limited partners win interim clawbacks more than half the time in deal-by-deal structures and more than seventy-five per cent of the time in whole-fund structures — a distribution worth reading twice, because it says the protection is easier to obtain in the structure that needs it least. Escrow is the credit support: the ILPA model requires thirty per cent of amounts otherwise distributable as carried interest to be deposited into a separate account until the partner has received distributions equal to its commitment plus the preferred return.

The middle of the market lives in hybrids: deal-by-deal carry gated by fund-level tests — return of all fees and expenses to date, cumulative loss make-up, a net asset value coverage floor, a capped early-carry percentage, or a limited partner election between waterfalls. A whole-fund waterfall can also permit limited pre-liquidation carry, most commonly tax distributions to the general partner to fund tax on carry allocated but not yet distributable, because a partnership must allocate income currently even where cash is deferred.

The whole-fund model is the dominant structure globally: seventy-seven per cent in the rest of the world, seventy-three per cent in Europe and fifty-eight per cent in North America, on ILPA's 2021 sample. The combined deal-by-deal and hybrid category runs twenty-three to forty-two per cent depending on region. Those figures are the honest frame for a negotiation — the deal-by-deal structure is a real market position in North America and a minority one everywhere, which is a different argument from either side's preferred version.

The number to bring to the table is not the prevalence figure. It is the dollar difference the worked example below computes: how much carry the deal-by-deal structure pays out early, and how much of that is exposed to a clawback that arrives after the money has been distributed to individuals and taxed. Once that figure is on the page, the escrow percentage and the interim-clawback frequency stop being boilerplate and start being the two terms that determine whether the protection is real.