Distribution waterfalls EXPOSED: The hidden hierarchy deciding who gets paid and when

One of the most important clauses of any joint venture or fund documents is that dealing with distributing profits to stakeholders. Understanding this clause, which sets out the distribution waterfall, is critical for investors and managers as the framework dictates how profits flow to them.

What is a distribution waterfall?

A distribution waterfall is a contractual, tiered framework that determines the sequence in which a portfolio company’s distributable cash (being the residual amount available after satisfying the portfolio company’s liabilities and working capital requirements) is allocated among stakeholders (typically the fund’s investors and general partner/sponsor, as owners of the portfolio company). The specific configuration of a payment waterfall can vary significantly depending on factors such as the fund’s investment strategy, legal structure, and jurisdiction. When working well, it operates to keep parties with different operational and investment profiles aligned, using mechanics that allow for distributions to be made based on investment performance.

When is one used and why?

Distribution waterfalls are frequently used in structured finance and real estate development projects when the investors have different roles i.e. the general partner/sponsor will typically be the party who has sourced the opportunity and manages the investment, whereas the investor body provide capital but are mostly passive. The mechanism ensures predictability of payments among multiple stakeholders.

Structuring payments through a waterfall mechanism ensures that stakeholders with the highest financial exposure are prioritised before others. These parties expect a preferred return, both in terms of timing and premium, on their investment. The ability to achieve this is contingent on the portfolio company’s overall success and residual cash flows, neither of which are guaranteed. This process creates an incentive for the sponsor to manage the investment efficiently with the prospect of a larger proportion of profits being allocated to it if performance is strong. This means that the investors will take less of the profits that they would otherwise be entitled to, but on the basis of the profit being “due” because of the work of the manager, this is considered appropriate.

What does a typical distribution waterfall look like?

The core principle is that net profits are paid out to limited partners first (which are typically the investors in the venture), followed by the general partner/the sponsor. Then, when all monies due under one limb of the distribution clause in the limited partnership’s limited partnership agreement (the “LPA”) have been distributed, the remaining cash available for distribution is distributed in accordance with the next limb of that clause.

A payment waterfall is commonly set out in a LPA, which may look as follows:

1. Repayment of capital – the limited partner(s) receive a payment of profits back up to an amount equal to their invested capital.

• Preferred return or hurdle rate/IRR – the limited partner(s) receive payment of profits beyond their invested capital. This is usually expressed as a percentage return on their invested capital per year. There are multiple factors which influence this percentage, but it is typically between 6 – 9%.

• Catch-up/General partner receives its profit share – once the limited partner(s) have received their invested capital plus the agreed percentage return on their investment (i.e. 1 and 2 above), the general partner then receives all or most of the incremental proceeds until its share of the profits reaches a specified percentage, typically around 20%. This is, in effect, the general partner “catching up” with the profits distributed to the limited partners.

• Further profits are split pro rata – any further profits are typically split according to an agreed carried interest ratio between the limited partner(s) and the general partner. Typically, this is 80% to the limited partner and 20% to the general partner.

What are the key considerations when drafting a waterfall provision?

A distribution waterfall provision should be clear and unambiguous.

Key terms should be defined and used throughout the provision.  For example, “Free Cash” or “Net Proceeds”, which are terms typically used to identify cash which can be extracted via the payment waterfall. These terms should specify any exclusions or deductions, such as reserves, tax liabilities, or contingent obligations.

The provision should also set out exactly how payments are to be calculated: whether via a board-approved business plan, audited accounts, or a specific formula in the provision itself. Any payments should not extract amounts in excess of that required for the operation of the portfolio company’s business and should not contravene any financing documents applicable to it.

There should also be provisions on the form of payments and whether they are subject to an audit or review.

In order to deal with the possibility of disagreements on the calculations of the payments due, a dispute resolution mechanism could be built in.

What are the consequences of getting it wrong?

Payment waterfalls are complex and any confusion or ambiguity in their terms could result in a breakdown in relationship between the parties, create disputes or pose litigation risk. These eventualities create unnecessary costs and risk impairing the operation of the portfolio company’s business (and, therefore, the ability to extract profit from the business).

Errors in the calculations of payments could also result in the underlying operational business being cash-strapped or with excess funds, so it is prudent to seek proper legal, financial and tax advice on the scope of such calculations.

American and European-style waterfall structures

As shown above, the typical structure for distributions provides for the majority of proceeds to be distributed to limited partners, with the general partner receiving a portion of proceeds through a “carried interest”.

In an American-style model, the general partner receives carried interest on a deal-by-deal basis, meaning they may start getting distributions on the first exit the venture/fund makes. Then, going forward, each time a sale is effected, a new calculation is undertaken.

In a European-style model, priority is given to the limited partners/investors. The carried interest is applied over the fund as a whole so that before the General Partner/sponsor receives its carried interest, the limited partners receive back their invested sums together with a return on that amount (the “hurdle”).

The European-style distribution waterfall, which is now considered standard for large buyouts, is understandably favoured by investors, but it does mean that the general partner has to wait longer to receive its carry.  If adopting an American-style model it will be important to provide for claw back provisions to allow recovery of sums overpaid to the General Partner/sponsor when a final true up of the entire fund is undertaken when the last asset is sold. This model also brings in tax complexities for the general partner as well as escrow provisions for portions of the carry the general partner receives. The risks inherent in this model mean that investors with a high degree of bargaining strength will tend to insist on the “whole fund” European-style model being used over the “deal-by-deal” American-style model, especially in volatile markets.

Conclusion and Our Experience

The current macroeconomic landscape, defined by elevated capital costs, compressed exit multiples, and heightened regulatory scrutiny, has placed the waterfall model at the centre of fund/JV performance, investor relations and profitability. Understanding how waterfalls operate in a world where capital costs have increased is important for strategic risk management and a key tool in aligning interests between managers and investors.

Burges Salmon’s Corporate Real Estate team have in depth experience in drafting and negotiating distribution waterfall clauses and other provisions within joint venture and fund documentation dealing with distribution of profits.

With a team of Built Environment lawyers qualified across England, Wales, Scotland and Northern Ireland, we support clients on real estate matters across jurisdictions and project types. Our Corporate Real estate team works closely with colleagues in construction, planning, tax, litigation, environmental and finance to provide integrated support throughout the lifecycle of real estate assets.

We have experience across many sectors including logistics, hospitality, office, residential (including build-to-rent and student accommodation), and large-scale regeneration schemes. If you would like to explore any of the topics discussed above, please contact Jonathan Cantor (Partner, Corporate and M&A), George Robinson (Associate, Corporate and M&A) or Harriet Lucas (Associate, Corporate and M&A).