American vs. European Waterfall: Which Distribution Structure Is Better for the Investor?

In the course of an analysis of a new private equity fund that we reviewed for a client, a substantive discussion arose regarding the distribution waterfall. While many investors tend to view the American waterfall as categorically detrimental to the investor’s interests, in practice there are situations in which this structure may also have advantages.

Using an American distribution waterfall – that is, the fund charging carried interest based on a calculation at the deal level (deal by deal) rather than at the level of the fund as a whole – appears on its face to be a bad deal for the LP. In a deal-by-deal calculation, successes and failures within the fund are not netted against each other; in other words, carried interest is charged on the successes without taking the failures into account. This is in contrast to a European waterfall (carried interest charged at the fund level), which effectively aligns the interests of the LP and the GP with respect to carried interest.

At the same time, an American distribution waterfall may help achieve higher returns, as it allows teams to be rewarded in a more targeted, performance-based manner. In addition, it creates positive pressure on the fund to achieve early successes, since in this way the fund manager can collect carried interest sooner (whereas under a European waterfall – that is, carried interest based on the performance of the fund as a whole – the fund manager’s carry arrives relatively late in any case, which makes it harder to create an incentive for early successes).

Over the years, a number of empirical studies have also examined the differences between the two methods:

1. Metrick & Yasuda (2010), The Economics of Private Equity Funds:

This paper examined 238 PE and VC funds from 1993–2006. The paper did not examine fund returns but rather the level of GP compensation, and found that empirically, more compensation was indeed paid to the GP under the early-carry method (American waterfall), mainly due to timing differences and incomplete repayment in cases of “overpayment.”

2. Several studies of LBO funds by Harris, Jenkinson & Kaplan:

These found that US funds generated higher returns than European funds, by approximately 2% in IRR terms, although it is difficult to say that this gap stems from differences in the carried interest mechanism rather than from other differences (as a rule, US funds tend to use an American distribution waterfall more often than European funds, but as noted there are other differences as well – mainly geographic focus).

3. Studies by Phalippou & Gottschalg (2009; 2021 Follow-Ups):

These studies found that a European waterfall offers investors greater protection, both in terms of the risk level of the fund’s investments and in that it “exempts” them from having to monitor the fund’s mechanisms for returning excess carry.

What should be checked in a fund with an American distribution waterfall?

In funds with an American distribution waterfall, it is necessary to verify that a clawback mechanism is in place, designed to ensure that the GP does not benefit from early carry beyond its rightful share if the fund as a whole fails to meet its return targets. Under an American waterfall, the GP can receive carried interest as early as after initial profitable exits, even if the overall fund performance has not yet become clear. This may create an incentive bias: the GP may prefer quick, safe realizations in order to “lock in” part of the profit for itself, rather than waiting for a larger exit later in the fund’s life. This is where the clawback mechanism comes in: it moderates the distortion of incentives by requiring the general partner to return to investors part of the profits it received early, if at the end of the fund’s life it turns out that the overall proceeds do not justify the level of carry that was charged. Although this mechanism does not completely eliminate the incentives for early exits or for risk-taking, it reduces the concern over material misalignment of interests over the life of the fund.

In summary, the research suggests that the European mechanism is generally preferable for the investor, in terms of total payments to the GP, in terms of the level of risk taken by the fund, and in terms of the “exemption” from monitoring and settling accounts with the GP. At the same time, the statistics also hint that the performance of funds with an American waterfall is higher, although it is difficult to attribute this necessarily to the carry mechanism.

Disclaimer:

Nothing in this publication constitutes an offer to the public or an invitation to make any investment; it is a publication and presentation of general information only. This article and its contents rely on information, publications and data received from third parties, which have been assumed to be accurate without the Company having reviewed or verified their accuracy. The information presented in this publication does not constitute investment advice/marketing or a substitute for investment advice/marketing tailored personally and specifically to each individual, taking into account their particulars, needs, financial situation, circumstances and investment objectives.