Bridger Pennington explains how private equity firms distribute profits to investors and managers through waterfalls, comparing American deal-by-deal structures with European fund-level ones. American waterfalls typically favor managers with 2% GP catch-up and 80/20 carried interest, while European models favor investors. Clawbacks and IRR calculations add complexity to both approaches.
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Hey guys, welcome back. So in this episode, we're going to talk about the difference between an American and European waterfall. So for a quick review, what is a waterfall? A waterfall is essentially how your limited partner and general partner are paid. So just to review, you guys have probably seen this, this is how my fund runs. We do an 8% pref that goes to the limited partners. We do a 2% catch-up that goes to the GP, and then we do an 80/20 split above that. And right now we go 80/20 to a 20% IRR and then we do a 50/50 above that. So 80/20, 80% to the limited partners, 20% to the general partner. That is a basic waterfall structure. Now what's the difference though between American and European? American waterfalls, I'll put a little arrow right here. American waterfalls are on a deal-by-deal basis. Meaning, so for us, I'll use my example. We're in a debt fund. I do lots of loans and lending on different assets, different properties, different materials. When we do that in an American style, every time a deal pays out, right? We gave someone $1 million, they paid us back, let's say $1.2 million over a 6-month time period. We calculate our IRR and our IRR, if you watched our IRR versus yield video, IRR is based on a yearly schedule. So if it was a 6-month time period, you double how much your return was. So if we got a 20% return in 6 months, it'd really be a 40% IRR. IRR. We'd calculate it on just one deal and we'd run this pref, we'd run this model. We'd go, okay, first 8% goes to LPs, next 2% to GP, 80/20 split, and then everything above 20 is 50/50. That would be our waterfall schedule on an American system, deal-by-deal basis. Okay, Bridger, so what's a European system? A European system right here is a conglomerate. I'm just going to put a column right here. This is a conglomerate of all the deals. So, And this is how we run our funds. In a European model, you take— this year we did 50 loans, 48 went good, 48 were good, 2 were bad. We take the conglomerate of that total IRR in 1 year. We had 48 go good, 2 go bad. What's the average? The 2 that weigh out. Hopefully we ended up with a good IRR and we take the conglomerate, all of them together. Now you might say, Bridger, this seems kind of the same, right? What's the difference, right? If you had 50 deals and you did them deal-by-deal basis and split them out versus conglomerate, why does it make a difference? It actually does make a difference. The American waterfall actually favors fund managers while the European waterfall favors investors. Why? So in American waterfall, if you had 2 or 3 deals go just really bad and made a 2%, 1% return, you just kind of wipe your hands clean and say, hey, those deals are bad, and the other deals that do really well, you get a split on that carried interest. And investors might say, well, over the whole year, We only had a conglomerate 10% return because we had a couple of deals go bad at the beginning of the year and then a couple of deals go really well at the end of the year. But you as the fund manager take home a lot more money on those last deals because they got a higher return on that deal-by-deal basis. Some LPAs will have a clawback measure where they actually can claw back your returns from other investments to even this out. Now, a European system, it smooths this whole process out. So if you had 2 loans go bad at the beginning of the year and 8 go well in the rest of the year and it evens out to about a 10% IRR, that is split according And your investors and you get paid. Most funds I see as they get bigger run on a European model because investors like to see that. They want to be diversified across 20 or 30 different deals inside of your fund versus a deal-by-deal basis where it's very feast and famine. When calculating your IRR on a deal-by-deal basis, first off, it's a lot more accounting if you're doing a lot of deals. Typically Americans— American waterfall I see with real estate deals where they do maybe 3 or 4 big real estate deals a year. Yes, American waterfall makes total sense. A European model also takes time to calculate, but it's a little bit easier to take all of it together and distribute accordingly. Now it all comes down to how your documents, your LP and PPM are written. And this will— in those documents, it'll determine how you're going to pay out, what system you're going to use. Now, another quick note, this terminology, American versus European waterfall, very few people actually know what this means. And you can stand out in a room. You can ask people, do you run an American waterfall or a European waterfall? And you really stand out in a crowd when talking to other people in finance or fund managers. But this is a little nugget that's helped me structure my funds. I currently run on a European waterfall. Typically, if we had a couple deals go bad at the beginning of the year, we're in the negative, but we had, you know, a lot of deals go good in the end of the year, it helps even things out versus an American is very cut and dry with how you're giving returns. You're gonna have feast and famine type of times. Hope that helps. See you on the next episode. Bye. Bye.
