Not every waterfall is the same

In VC and PE funds, the distribution waterfall is a method used to allocate profits among LPs and GPs. The waterfall model outlines the sequence in which cash flows are distributed.

In the American-style waterfall, GPs can take carried interest payments from a fund on a deal-by-deal basis.

In contrast, in the European-style waterfall, GPs cannot receive any carry until LPs have recovered all of their capital contributions to a fund.

You do not need to be a math genius to realize that the American-style waterfall always provides a lower IRR than the European-style waterfall. Besides aligning the interests of GPs and LPs more closely, the European waterfall is much simpler. The most spoken excuse favoring American-style waterfall — “as a way to recruit and retain talents” — is nonsensical: first, HR issues are a GP internal management problem, hence it does not concern the LPs; and second, if the GP members have skin in the game, as they must, retention is a non-problem.

Now, given the downturn in exits (the lowest level in one decade), the distributions are falling short. Consequently, American-style waterfall funds are facing one more problem, since LPs are trying to recoup excess carried interest payments realized from earlier exits — clawbacks of carried interest payments, in the jargon.

Surprisingly, according to Pitchbook, 40% of the US PE funds still use American-style waterfalls. But, unsurprisingly (because large PE funds have become corporations. Pause: when Michael Lewis in Liar’s Poker asks his trading colleague why he was shorting their employer, Salomon Brothers, his answer couldn’t be blunter: look around, it has become a corporation!), American-style structures are overwhelming more prevalent among larger funds, with around 80% PE’s AuM covered by American-style waterfalls.

Conclusion

To reward individual deals performance (American waterfall), rather than incentivize the entire fund’s performance (European waterfall) is simply disingenuous.

Needless to say, that we, at Fabrica Ventures, employ the European-style waterfall, returning all the capital to the LPs (including management fees) before any carry.