Distribution waterfall

A typical closed-ended waterfall runs in four tiers. First, return of capital: investors get their contributed capital back. Second, the preferred return: investors receive distributions up to the agreed rate. Third, the manager catch-up: the manager receives a disproportionate share until it has caught up to its agreed profit percentage. Fourth, the residual split: everything remaining is divided in the agreed ratio, commonly 80 to investors and 20 to the manager.

The order is what protects investors. Because return of capital sits at the top, the manager's profit share is genuinely subordinate to investors getting their money back, at least on paper. What varies between funds is whether the waterfall is applied deal by deal or across the whole fund, and whether there is a clawback if early distributions turn out to have been overpaid.

When comparing funds, read the waterfall before the headline rate. A high preferred return sitting above a weak waterfall is worth less than a modest one sitting above a strong one.