Why "Profit" Doesn't Just Get Split Pro-Rata
When an AIF exits an investment and has proceeds to distribute, the money doesn't simply get split among investors and the manager based on ownership percentage. It flows through a structured sequence of tiers — the "distribution waterfall" — defined precisely in the fund's PPM, designed to align investor and manager incentives.
The Typical Waterfall Tiers
Tier 1 — Return of Capital
Investors first receive back the capital they've contributed (drawn-down commitments), before anyone — including the manager — receives any profit share.
Tier 2 — Preferred Return (Hurdle Rate)
Investors next receive a preferred return — a minimum annualised return (commonly expressed as a hurdle rate) on their contributed capital — before the manager participates in profits at all. This tier exists specifically to ensure investors earn a baseline return before the manager's carry kicks in.
Tier 3 — GP Catch-Up
Once investors have received their preferred return, a "catch-up" tier allows the manager (General Partner/Investment Manager) to receive a larger share of subsequent distributions until the manager's cumulative share reaches the agreed carry percentage of total profits above return of capital.
Tier 4 — Carried Interest Split
After the catch-up, remaining distributable proceeds are split between investors and the manager per the agreed carry ratio — commonly structured so the manager receives a defined percentage (see our dedicated article on carried interest) of profits, with investors receiving the balance.
Why Waterfall Structure Varies Fund to Fund
Not every AIF PPM uses all four tiers, and the precise hurdle rate, catch-up percentage, and carry split are all negotiated and fund-specific. Some funds use a "European" (whole-fund) waterfall, calculated only after all fund capital is returned; others use an "American" (deal-by-deal) waterfall, calculated exit by exit. This choice materially affects when the manager starts receiving carry.
Why Waterfall Accuracy Matters at Audit Time
Distribution waterfall calculations are one of the most error-prone areas of AIF accounting, precisely because they involve multiple tiers, cumulative calculations across time, and — for deal-by-deal waterfalls — potential clawback provisions if later losses mean the manager was over-paid on an earlier exit.
Modelling Your Fund's Waterfall Correctly
We build distribution waterfall models tier-by-tier, directly off PPM language, so that every exit distribution can be validated against what investors were actually promised.
This article is for general informational purposes. The exact waterfall mechanics applicable to any specific fund are governed entirely by that fund's PPM.