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Waterfall Structure

What is Waterfall Structure?

A Waterfall Structure is a method of distributing returns or cash flows among various stakeholders, such as investors, lenders, or fund managers, in a predefined order of priority. The term “waterfall” refers to how the cash flows trickle down through different levels, with each level (or “tier”) getting paid only after the one above it is satisfied.

This structure is widely used in private equity, venture capital, real estate, and M&A transactions.

Where it is used?

  • Private equity and venture capital funds
  • Real estate investment projects
  • Project finance
  • M&A earnouts
  • Debt repayment structures

Key Concept

The waterfall ensures that higher-priority stakeholders (e.g., senior lenders) get repaid first, and lower-tier participants (e.g., equity holders) are paid only after those obligations are met. This structure allocates both risk and return appropriately.

Typical Tiers in a Waterfall Structure

1. Return of Capital

  • Investors get back their original investment amount before any profit is shared.

2. Preferred Return (Hurdle Rate)

  • Investors receive a predefined annual return (e.g., 8%) before the fund manager earns a share of profits.

3. Catch-Up Tier

  • Once the preferred return is met, the sponsor (or GP - General Partner) receives a higher share of profits until they “catch up” to their agreed share.

4. Carried Interest (Profit Split)

  • Remaining profits are split between the LP (Limited Partner) and GP, often 80:20 or 70:30.

Example (Private Equity Fund)

A fund with ₹100 crore from investors agrees to the following waterfall:

  • Tier 1: Return original ₹100 crore (Return of Capital)
  • Tier 2: Provide 8% Preferred Return annually to LPs
  • Tier 3: Sponsor receives 100% of profits until they catch up to 20% of total profits
  • Tier 4: Remaining profits split 80% to LPs, 20% to GP (Carried Interest)

Real Estate Example

In a real estate development project:

  1. Lender receives interest and principal first
  2. Equity investors get their initial capital back
  3. Preferred return paid to investors
  4. Developer or sponsor gets a share of remaining profits

This structure aligns the developer’s incentives with the success of the project.

Why it Matters?

  • Fairness: Ensures investors are compensated before managers earn performance fees
  • Risk Allocation: Higher risk = lower in the waterfall but with higher potential returns
  • Transparency: Sets clear expectations for how profits will be shared

Waterfall Structure in India

  • Common in private equity and real estate investment trusts (REITs)
  • Also used in Alternative Investment Funds (AIFs) governed by SEBI
  • Helps align fund manager performance with investor returns