Waterfall — The Dollar Dictionary

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Finance

Waterfall

The order in which cash is distributed among different stakeholders in an investment or company — proceeds flow down through priority tiers like water down a series of buckets.

Waterfalls appear in multiple financial contexts. In PE funds, the distribution waterfall determines when and how the general partner (the fund manager) earns carried interest — their share of profits. A European waterfall pays carry only after investors have received all their capital back plus preferred return. An American waterfall pays carry deal-by-deal, creating earlier payouts to fund managers but more risk to investors if later deals underperform.

In structured finance (like mortgage-backed securities), waterfalls determine which tranches of the security receive principal and interest payments first. Senior tranches get paid before junior tranches, which is why senior tranches carry lower yields and lower risk — their position in the waterfall protects them from most scenarios of underlying loan defaults.

Picture a series of buckets stacked on top of each other. Money pours in at the top bucket. When it fills, the overflow drops to the next bucket. Each bucket represents a different class of investor or creditor. The top buckets — senior lenders, preferred shareholders — fill first. Only after every higher-priority bucket is full does money reach the bottom buckets — common shareholders, management, fund sponsors.

Real world: In a private equity buyout, the waterfall on exit might look like this: first, the bank lenders are repaid in full. Then, preferred investors get their capital back plus any accrued preferred returns. Then, all investors get their capital back. Then, investors receive a preferred return (say 8%) on their investment. Finally, remaining profits are split between investors and the PE firm's carried interest. Each layer must be fully satisfied before the next receives anything.

💡 The waterfall determines who gets paid first when money flows — your position in the waterfall is arguably more important than the headline return, because it determines what you actually receive when things don't go perfectly.

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