Closed-Ended Fund Waterfalls

Subsequent to our guide on management fee, this article will be focusing carried interest waterfall; one of the most important KPI to assess the success of fund managers.

This article outlines the various types of carried interest waterfall, and how each type of waterfall protects the investors / limited partners (“LPs”) while incentivising the fund managers / general partners (“GPs”).

This guide is a continuation of a series of educational post on fund management. If you would like to find out more about how a fund works, please visit our Expert Guide.

Overview

Distribution waterfall in close-ended funds dictate how proceeds flow between LPs and GPs. In general, we can classify into four broad models—

1. American (deal-by-deal);

2. European (whole-of-fund);

3. Hybrid (American and European characteristic); and

4. Evergreen—differ in timing (no fixed term), risk allocation, and incentive alignment.

Understanding these structures is critical during the initial evaluation of fund terms, as well as the overall fund performance.

Types of waterfall models

American Waterfall (Deal-by-Deal)

In the American model, GPs receive carried interest after each profitable deal, provided capital and preferred return are returned to the LPs. This accelerates GP compensation as American Waterfall allows GPs to receive the carried interest sooner (does not require the LPs to fully recoup their capital contribution). American Waterfall are more GP friendly, and tends to have a higher risk of clawback when subsequent deals underperform.

As the name suggests, American waterfall is a widely used structure in U.S, specifically in PE/VC funds.

Clawback provisions

A clawback provision is a contractual clause that allows the fund to reclaim monies (in this case, carried interest) paid from the fund to the GP.

European Waterfall (Fund level)

In the European model, GPs carried interest are accrued, and are only realised/paid when all LPs capital contribution and preferred return are returned across the entire fund. This structure aligns GP incentives with long-term performance of the fund, thereby reducing the risk of clawback.

As the name suggests, European waterfall is a widely used structure in Europe, specifically in PE/VC funds.

Hybrid Waterfall (Bridging American and European Models)

Hybrid Waterfall structures combine the best of American and European features, introducing mechanisms that combine early GP incentives with strong LP protections, thereby reducing clawback risk while maintaining flexibility.

Common mechanisms found in hybrid waterfall includes:

• Tiered Distribution: Early exits follow deal-by-deal carried interest with partial escrow, which is released only upon achieving fund-level hurdles.

• Escrow and Holdback: A portion of carried interest is withheld until fund-level return of capital contributions and preferred return are met.

• Interim True-Up: Periodic recalculations to ensure GPs accrued carried interest aligns with overall fund performance.

As investor preferences evolve, many funds are adopting hybrid waterfalls to balance the benefits of American and European models.

Evergreen Waterfall

Evergreen funds operate without a fixed term and use NAV-based calculations for performance fees. Evergreen Waterfalls accommodate continuous capital flows, periodic liquidity windows, and capital recycling. It is gaining popularity with investors who are looking for long term deployment.

Due to the flexibility of allowing LPs the option to redeem while investing into private assets, a liquidity pool is normally set aside to ensure the fund is able to meet its obligatory requirement when LPs redeem.

The complexity of operating a evergreen fund is higher and requires complex fund accounting and operations. Accordingly, the cost of maintaining such a model is typically highest among the four models.

Comparative Table of Waterfall Models

Feature	American	European	Hybrid	Evergreen
Carried interest timing	Per deal	After full return of capital across fund	Tiered/ Deferred	NAV-based and/or w. high-water mark
Capital Return Requirement	Per deal	Fund-level	Mixed	Ongoing
Preferred Return	Per deal	Fund-level	Per deal with Fund-level true-up	NAV-based hurdle rate
Clawback Risk	High	Low	Moderate	Low
GP Incentive Alignment	Short-term	Long-term	Balanced	Long-term
Investor Protection	Low	High	Moderate	Moderate
Administrative Complexity	Moderate	Low	High	Highest

Case Studies

American-Style Example

A $500M U.S. middle-market buyout fund executed early profitable exits. GPs received carried interest after returning capital and hurdle per deal. Later deals underperformed, triggering clawback provisions. LPs faced recovery challenges.

Illustrative computation

Total Capital Called: $250m

Deal 1 Exit: $50M

• Return LP Capital: $30M

• Preferred Return: $2.4M

• Remaining: $17.6M

• GP carried interest: $3.52M (20%)

• LP Residual: $14.08M

European-Style Example

A $500m U.S. growth fund deferred GP carried interest until full fund-level capital and hurdle were returned. LPs achieved full recovery before GP participation, reducing clawback complexity.

Illustrative computation

Total Capital Called: $250m

Aggregate Proceeds: $50M

• Return LP Capital: $50M

• Preferred Return: $0

• Remaining: $0

• GP carried interest: $0

• LP Residual: $0

Hybrid Example

A $500M fund uses tiered carried interest with escrow. GPs received partial carried interest early, with remainder released after fund-level hurdle. Balanced liquidity and protection.

Illustrative computation

Total Capital Called: $250m

Early Exit Example: $50M

• LP Capital: $30M

• Preferred Return: $2.4M

• Remaining: $17.6M

• GP carried interest: $3.52M split → $1.76M now, $1.76M escrow

• LP Residual: $14.08M

Evergreen Example

An open-ended infrastructure fund allowing quarterly redemptions. Performance fees are calculated on NAV growth with high-water marks. LPs benefited from long-term compounding and periodic liquidity. 

Illustrative computation

Total Subscription: $250m

NAV Growth: $250M → $270M

• Gain: $20M

• Incentive Fee: $0M

• LP Residual: $20M

Illustrative example of the case studies

Model	Contribution / Subscription	Capital Returned	Preferred Return	GP carried interest	LP Residual
American	$250m	$30M	$2.4M	$3.52M	$14.08M
European	$250m	$50M	$0M	$0M	$0M
Hybrid	$250m	$30M	$2.4M	$1.76M1	$14.08M
Evergreen	$250m	N/A	N/A	$0M2	$20M

¹Partial carried interest released early; remainder in escrow.

²Assuming 8% hurdle rate

Illustrative breakdown of the $20M Gain for each waterfall model

Summary

	American Waterfall	European Waterfall	Hybrid Waterfall	Evergreen Waterfall
Risk Management	Expose LPs to potential clawbacks	Minimises clawback risk	Escrow and holdbacks significantly reduce clawback risk.	Fund liquidity risks
GP/LP Alignment	Primarily aligns with the interests of the GP by providing earlier access to carried interest; Clawback risk if later deals fail.	Prioritise LP recovery by aligning GP incentives with overall fund performance; Strong LP protection	GPs gain earlier access to carried interest without compromising LP recovery; Balances liquidity for GP and protection for LP	Long-term alignment of GP and LP interests, providing GP the ability to continuously reinvestment while offering the LPs flexibility in subscription and redemption; Periodic liquidity, NAV-based fees
Complexity	Moderate complexity due to the need to track carried interest payout for each respective deals across the fund life	Lower administrative complexity due to tracking of overall fund performance before carried interest payout.	Require robust accounting and legal frameworks, increasing administrative costs.	Highly complex due to the need to combine both opened-ended (hurdle rate; high watermark mechanism) for liquid asset portion and close-ended (preferred return; carried interest) for long term, private investments.

 Conclusion

Each waterfall model presents trade-offs in risk, alignment and complexity. The choice between American and European waterfalls reflects trade-offs in timing, risk, and alignment. Hybrid and evergreen structures offer flexibility but require robust systems and governance.

LPs should evaluate carried interest timing and administrative complexity as well as scrutinising waterfall terms in fund documentation, including negotiating provisions like clawback guarantees and escrow mechanisms to mitigate risks.

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How Kai Global Consulting can help

Computation of carried interest, including designing of the waterfall model doesn’t have to be complicated. At Kai Global Consulting, we do more than provision of services— we bring hands-on experience and a practical guidance, delivering tailored advice and scenario analysis of what works best for your fund structure.

Have questions? Reach out for a non-obligatory consultation.

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