Distribution Waterfall (European and American)

Mechanism

A European (whole-of-fund) waterfall requires the fund to return contributed capital before the general partner receives carried interest. An American (deal-by-deal) waterfall may pay carried interest after a realized investment if conditions are met (Cooley, 2026).

The ILPA Model Limited Partnership Agreement (whole-of-fund, July 2020) sets four tiers in Section 14.3, with bracketed figures (Model LPA).

1. Return of capital. 100% to the limited partner until cumulative distributions equal its capital contributions.
2. Preferred return. 100% to the limited partner until it receives the preferred return, modeled as [8]% a year, compounded annually from receipt of each contribution.
3. General partner catch-up. [80]% to the general partner and [20]% to the limited partner until the general partner holds [20]% of the profit distributed under tiers two and three.
4. Carried interest split. Thereafter [20]% to the general partner and [80]% to the limited partner.

In ILPA's deal-by-deal version, tier one returns only contributions that funded the realized investment, earlier realized investments, aggregate unrealized losses and fund expenses (DBD Term Sheet). ILPA defines a clawback as "a limitation on the GP's ability to collect a greater share of the fund's cumulative profits over the life of the fund than the specified percentage stipulated by the LPA" (Principles 3.0). Internal Revenue Code Section 1061 separately requires a three-year holding period for long-term capital gain on an applicable partnership interest (26 U.S.C. 1061(a)), a rule Cooley reports the 2025 tax legislation left unchanged.

Worked Example

Amounts are in $ thousands, rounded. This hypothetical $100 million fund has one limited partner, calls 100,000 at the outset and invests 25,000 in each of four companies. Terms are the model's bracketed figures: an 8% preferred return compounded annually, an 80% catch-up and carried interest of 20%. ILPA reports an 8% hurdle as standard in 67% of funds sampled (ILPA, 2021). Fees are excluded.

Company A sells in year 3 for $80,000, Company B is written off in year 4, Company C sells in year 5 for $45,000 and Company D sells in year 7 for $25,000. Profit is $50,000, of which 20% is $10,000.

European Computation

The hurdle balance is 100,000 × 1.08³ = 125,971 before year 3, 53,621 before year 5 and 10,055 before year 7. The catch-up is 20% × 35,055 ÷ (80% − 20%) = 11,685. The general partner receives 9,348 + 652 = 10,000, 20% of profit, all in year 7.

With a catch-up tier, the preferred return is a soft hurdle: once the catch-up is complete, the general partner holds 20% of all profit, including the portion that paid the preferred return. Under a hard hurdle, which ILPA Principles 3.0 favor, carried interest is calculated only on profit above the preferred return (Principles 3.0), and the general partner here would receive 20% of (50,000 − 35,055), or 2,989.

Deal-by-Deal Computation

This stylized American waterfall tests each company alone, without ILPA's loss protections.

Company A's preferred return is 25,000 × (1.08³ − 1) = 6,493; Company C's is 25,000 × (1.08⁵ − 1) = 11,733.

Clawback Computation

The deal-by-deal general partner receives 15,000 against an entitlement of 10,000; the 5,000 excess equals 20% of Company B's 25,000 loss. A 5,000 clawback restores the limited partner to 140,000. An escrow at the model's bracketed 30% would hold 4,500, leaving 500 of the shortfall with the general partner.

What It Means for a Limited Partner

A limited partner reads a waterfall for when the general partner is first paid and how reliably that payment is recoverable. ILPA's preferred structure returns all committed capital to limited partners before the general partner accrues carried interest, and ILPA calls an "all capital back" structure the best approach to minimizing clawback liabilities (Principles 3.0).

Where carry is paid deal by deal, ILPA's deal-by-deal term sheet offers an optional escrow of [30]% of carry and an interim clawback test, and its Principles recommend clawbacks gross of taxes, repaid within two years, outlasting the fund and backed by joint and several liability or a guarantee. The model whole-of-fund term sheet instead caps the clawback at carry received less taxes paid or payable (WOF Term Sheet).

In Life Sciences and Healthcare

Clinical-stage assets produce binary outcomes. BIO, Informa and QLS Advisors found that 7.9% of drug development programs entering Phase I reached FDA approval over 2011 to 2020, and that the average Phase I asset needs 10.5 years to reach approval (BIO, 2021). Such a portfolio can show early winners and later write-offs, the pattern Cooley identifies as the cause of clawbacks, and a long hold stretches the preferred return: $1.00 compounding at 8% for 10.5 years grows to about $2.24.

Governing Authority and Sources

• ILPA Principles 3.0 (2019).
• ILPA Model LPA, Whole-of-Fund (July 2020).
• ILPA Model LPA Term Sheet, Whole-of-Fund.
• ILPA Model LPA Term Sheet, Deal-by-Deal.
• ILPA, What Is Market in Fund Terms (2021).
• 26 U.S.C. 1061.
• Cooley, Primer: Carried Interest in Private Equity and Venture Capital Funds (June 10, 2026).
• BIO, Clinical Development Success Rates 2011-2020.

Frequently Asked Questions

What is a distribution waterfall?

A distribution waterfall is the sequence that decides who receives each dollar a private fund distributes. In the ILPA model agreement, proceeds return contributions, pay a preferred return, let the general partner catch up, and then split remaining profit, with 20% to the general partner in the model's bracketed terms.

What is the difference between a European and an American waterfall?

A European waterfall pays carried interest only after the fund has returned all contributions plus the preferred return, while an American waterfall may pay carry deal by deal as investments are realized. Cooley's 2026 survey, which states no fund count, found approximately 90% of reviewed funds used a European waterfall. ILPA's 2021 report, on a Colmore data set of 695 funds, put that share at 58% in North America and 73% in Europe. The samples differ.

What does a distribution waterfall example look like?

In a hypothetical $100 million fund returning $150 million, a European waterfall with an 8% preferred return, an 80% catch-up and carried interest of 20% pays the general partner $10.0 million, all in year 7. A stylized deal-by-deal waterfall pays $15.0 million across years 3 and 5, leaving a $5.0 million clawback.

Related Reference

Pillar: Growth Equity. Related entries:

• Carried Interest
• Capital Call
• Key Person Provision