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Distribution waterfall and carried interest

When a fund's investments return cash, the waterfall decides where each dollar goes and in what order, which makes it the single most important set of terms for understanding how LPs and the GP actually get paid.

Why a waterfall exists

A fund returns money over years, in uneven amounts, as companies are sold or go public, and the waterfall is the rulebook that turns those irregular inflows into a fair and predictable split. The fund's limited partnership agreement defines the split, and every dollar that comes back into the fund flows through this waterfall. The principle underneath most venture waterfalls is that investors come first, and the GP earns its share of the profit only after LPs have been made whole. When a distribution actually happens, the split is typically computed by the fund administrator and reviewed by the GP before any wires go out.

The tiers, in order

Carried interest, where the GP earns its share

Carried interest, or carry, is the GP's share of the fund's profit, and it lives near the bottom of the waterfall by design. Because return of capital comes first, the GP earns carry only once LPs have their money back and the fund is genuinely in profit. That ordering is what keeps the two sides aligned, since the GP only does well once the LPs have done well. It is also why the headline economics of a fund cannot be read from the management fee alone, because carry is where most of the GP's upside actually sits.

Deal by deal versus whole fund

There are two traditional waterfall. In a whole fund waterfall (sometimes referred to as a European waterfall), LPs get all of their committed capital back across the entire fund before the GP takes any carry. In a deal by deal waterfall, often called American, the GP can earn carry on individual winners earlier, before every dollar of fund capital has been returned. The whole fund approach is more LP friendly and is the common choice for venture funds, while deal by deal is more often seen in buyout funds. The trade between them comes down to how protective the structure is for LPs and how soon the GP sees its carry.

The clawback safeguard

A deal by deal structure creates a particular risk, which is that the GP could take carry on early winners, then watch later investments lose money, and end up having been paid more than its true share of the fund's total profit. The clawback is the safeguard against that outcome, requiring the GP to give back carry it was paid earlier so the final split matches what was agreed. Some LPAs also require part of the carry to be held back or escrowed against this risk. A clean clawback calculation depends on accurate capital accounts kept across the whole life of the fund, which makes it a back office job as much as a legal one.

Waterfalls in practice

At Graph Advisors, we check fund waterfalls every quarter and are often involved in modeling future waterfall outcomes for our client's funds. Each distribution is run through the agreed tiers, the capital accounts are kept current, and any carry is tested against the whole fund picture so there are no surprises at the end. Eric Friedman and Nate Snow have built and reviewed these calculations inside funds, and the recurring lesson from that work is that waterfall mistakes are both expensive and visible to every investor, so the math has to be exact and traceable. The returns that flow through the waterfall are also what drive the DPI and TVPI LPs track, and the same capital accounts sit behind the fund's NAV.

Frequently asked questions

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