An American waterfall, also called a deal-by-deal waterfall, is defined as a distribution waterfall structure where the general partner earns carried interest on each profitable investment as it is realized, without waiting for the entire fund to return all capital and clear the hurdle rate.
How the American Waterfall Works
In a pure American waterfall, each deal is treated as its own profit center. When the fund exits an investment at a profit, the proceeds flow through the waterfall for that specific deal:
- Return of capital. The LP receives back the capital invested in that specific deal.
- Preferred return. The LP receives the preferred return (typically 8%) on the capital invested in that deal.
- GP catch-up. The GP receives distributions until it has caught up to its carry percentage (typically 20%) of total profits on that deal.
- Carried interest split. Remaining profits split 80/20 between LPs and the GP.
The critical distinction from a European waterfall is that this calculation happens deal by deal, not at the fund level. The GP does not need to return all called capital across the entire fund before earning carry.
Why It Matters
Consider a fund that makes 10 investments. Three are home runs, four are modest winners, and three lose money. Under an American waterfall, the GP earns carry on each of the seven profitable deals as they exit, even if the three losses have not yet been realized and even if the total fund has not yet returned all capital to LPs.
This creates a timing advantage for the GP. Carry distributions begin earlier, often years before the fund is fully liquidated. For LPs, it means they are paying carry before knowing the fund’s final outcome.
The Clawback Protection
The primary LP protection in an American waterfall is the clawback provision. At the end of the fund’s life, if the GP has received more carry than it would have earned under a whole-fund calculation, the GP must return the excess.
In theory, the clawback makes the American and European waterfalls economically equivalent over the fund’s life. In practice, there are complications:
- Credit risk. The GP may have spent or distributed the carry to individual partners, making collection difficult.
- Tax friction. GPs paid taxes on carry received in earlier years. Returning carry does not automatically recover those taxes.
- Escrow mechanisms. Many LPs negotiate that 20-30% of carry distributions be held in escrow to fund potential clawback obligations.
- Timing. Clawback is typically calculated at fund termination, which could be 12-14 years after the first carry distribution.
Variations and Hybrid Structures
Pure deal-by-deal waterfalls have become less common as LPs have pushed for stronger protections. Common modifications include:
Loss carryforward. Losses on prior exits are netted against gains on subsequent exits before carry is calculated. This prevents the GP from earning carry on Deal 5 while Deal 3 lost money.
Interim clawback. The GP must return excess carry periodically (e.g., annually) rather than waiting until fund termination.
Aggregated netting. All realized and unrealized positions are considered when determining whether the GP has earned carry, blending toward a European-style approach.
These hybrid structures attempt to balance the GP’s desire for earlier carry with the LP’s desire to pay carry only on true fund-level profits. The specific terms are negotiated during fundraising and documented in the LPA. LPs evaluating a fund should read the waterfall provisions carefully, as the label “American waterfall” can mean very different things depending on the modifications included.
Frequently Asked Questions
What is the main advantage of an American waterfall for GPs?
The GP receives carried interest earlier because carry is calculated and paid on each profitable exit rather than waiting for the entire fund to clear its hurdle. This improves the GP's cash flow and provides incentive to realize winners quickly. For a fund with several early successful exits, the GP may receive significant carry distributions within the first few years of the harvest period.
What protects LPs in an American waterfall structure?
The primary protection is a clawback provision, which requires the GP to return excess carry at the end of the fund's life if total fund returns do not justify the deal-by-deal payments. Many LPs also negotiate escrow requirements, where a portion of carry (typically 20-30%) is held in reserve until the fund is fully liquidated. Some LPAs include a loss carryforward mechanism that nets prior losses against future gains.
Which waterfall structure is more common in the U.S.?
The American (deal-by-deal) waterfall is more common among U.S.-based private equity funds, which is how it got its name. However, LP pressure has shifted many funds toward hybrid structures that incorporate European-style protections, such as loss netting or interim clawback triggers. Pure deal-by-deal waterfalls without meaningful LP protections have become less common among institutional-quality funds.
