Understanding the European Waterfall Structure in Venture Capital Funds

Understanding the European Waterfall Structure in Venture Capital Funds

In venture capital, the distribution of profits (or "carried interest") to the fund managers and investors is governed by what's known as a "waterfall structure." One of the most common approaches is the European waterfall structure, which is known for its investor-friendly nature. Here’s an overview of how it works:

What is a European Waterfall Structure?

The European waterfall structure is a method for distributing profits in a venture capital fund where the investors (Limited Partners or LPs) must be fully repaid their initial investment, plus any preferred return (often called a "hurdle rate"), before the fund managers (General Partners or GPs) can receive any carried interest. This structure ensures that investors are prioritized in the distribution of profits.

Key Features of the European Waterfall:

• Investor Priority: In a European waterfall structure, LPs receive 100% of their capital contributions back before any performance fees or carried interest is distributed to the GPs. This means that investors are first in line to recoup their investments.

• Preferred Return (Hurdle Rate): After the LPs have received their initial investment, they are typically also entitled to a preferred return. This is a minimum rate of return that the fund must achieve before the GPs can start earning carried interest. The preferred return is often set at a rate of 8% per annum, although this can vary.

• Catch-Up Clause: Once the LPs have been paid back their capital and the preferred return, a "catch-up" phase begins. In this phase, the GPs can receive a higher percentage of profits until they "catch up" to the agreed-upon profit split. Typically, the catch-up allows the GPs to receive a significant portion of the next profits (often 100%) until their share aligns with the carried interest agreement.

• Carried Interest Distribution: After the catch-up phase, any remaining profits are split between the LPs and GPs according to the carried interest arrangement, usually on an 80/20 basis. This means 80% of the profits go to the LPs, and 20% to the GPs.

Example of a European Waterfall Structure:

1. Return of Capital: LPs receive the return of their original investment first.

2. Preferred Return: LPs receive a preferred return on their capital (e.g., 8% per year).

3. Catch-Up: GPs receive 100% of profits until they receive 20% of the total profits.

4. Remaining Profits Split: Any remaining profits are split 80/20 between LPs and GPs.

Benefits of the European Waterfall:

• Investor Protection: This structure is designed to ensure that LPs are fully compensated before GPs can earn their carried interest, aligning the interests of the fund managers with those of the investors.

• Transparency: The clear, step-by-step process of the European waterfall provides transparency in how profits will be distributed, which can build trust between GPs and LPs.

The European waterfall structure is favored by many investors for its conservative approach, ensuring that their capital is protected and that fund managers are incentivized to generate strong returns before they receive their performance fees. Understanding this structure is crucial for both venture capital fund managers and investors as it plays a significant role in determining how and when profits are shared.