The distribution waterfall in a fund's Limited Partnership Agreement sets out the order in which cash flows to LPs and the GP as investments are realised. The tiers are broadly similar across most funds; what genuinely changes the economics — and the risk each side carries — is whether the waterfall is calculated deal-by-deal or across the whole fund.
The standard tiers
- Return of capital — LPs receive back their contributed capital before anything else is distributed as profit
- Preferred return (the "hurdle") — LPs receive a minimum return on their capital, commonly expressed as an IRR, before the GP participates in any profit
- GP catch-up — once the hurdle is cleared, the GP receives a disproportionate share of the next distributions — often, though not always, 100% — until its cumulative share of profits reaches the target carry percentage
- Carried interest split — remaining profits are split at the agreed ratio, commonly 80/20 in favour of the LPs
American (deal-by-deal) waterfall
The tiers above are applied separately to each realised investment. If an early deal in the portfolio is highly profitable, the GP can receive carry on that deal well before the fund has returned all LP capital across the entire portfolio. This gets carry into the GP's hands sooner — but it creates real clawback risk: if later deals underperform, the GP may end up having received more carry over the life of the fund than the whole-fund result actually entitled it to, and the LPA's clawback provision requires the excess to be returned, typically to LPs directly or into an escrow established for that purpose.
European (whole-of-fund) waterfall
Here, LPs must receive back all contributed capital across every investment in the fund, plus the preferred return calculated on the whole committed or invested capital, before the GP receives any carry at all. This is materially more LP-favourable: the GP is only paid once the fund as a whole has proven profitable, which sharply reduces — though doesn't always eliminate — clawback exposure. The tradeoff is that GP carry arrives much later in the fund's life, often only as the fund approaches full realisation.
Despite the names, "American" and "European" describe the calculation structure, not the fund's geography — either can appear in an LPA anywhere, and the base or side letter for any specific fund should be read to confirm which actually applies rather than assumed from the fund's domicile.
Clawback: only as strong as its security
A clawback obligation on paper is only as reliable as what backs it. LPAs vary widely on this point — some require an escrow holding back a portion of carry as it's earned, some rely on a several (or joint and several) personal guarantee from the individual carry recipients, and some provisions are comparatively weak. When reading an LPA's clawback clause, the security mechanism matters as much as the clawback obligation itself.
Where this typically goes wrong
- Assuming the GP catch-up is always 100% — the percentage and mechanics are drafted per LPA and must be read from the actual clause
- Treating "American" or "European" as a geographic label rather than checking the LPA's actual calculation mechanics
- Confusing the preferred return hurdle with the carried interest split itself — they are two distinct tiers with different roles
- Not identifying whether catch-up and clawback are calculated per-deal or per-fund, which isn't automatically implied by the waterfall type alone
- Overlooking that a side letter granted to one LP can alter waterfall mechanics for that LP specifically, and may trigger an MFN election for others