A share of the profits of an investment or investment fund that is paid to the investment manager as compensation. It is given in exchange for creating value or bearing a disproportionate share of downside risk.
By way of a simple example, assume a limited partnership is formed to acquire a $5,000,000 industrial property and is capitalized with a $3,500,000 mortgage and the $1,500,000 balance from equity. The partnership may be structured such that the limited partners contribute 90% of the equity or $1,350,000 and the general partner or sponsor contributes the remaining 10% or $150,000. Terms of the partnership may call for the limited partners to receive an 8.0% preferred return, followed by a 70/30 split of all cash flow in favor of the limited partners. If the property produces cash flow of $180,000, resulting in a cash-on-cash return of 12.0%, the cash flow distribution may be calculated as follows: $108,000 to the limited partners which is equal to an 8.0% return on their investment of $1,350,000. The remaining $72,000 of cash flow would be distributed 70% to the limited partners ($50,400) and 30% to the general partner ($21,600). In aggregate, the limited partners have received $158,400 which equates to an 11.7% cash-on-cash return for the limited partners while the general partner receives $21,600 which equates to a 16.0% cash-on-cash return on their investment of $150,000. In this case, the general partner has received 12.0% of the cash flow despite investing only 10% of the equity. However, the general partner did not receive any cash flow until after the limited partner had received a preferred return. Note that this is a simplified example and that such “waterfall” distribution structures can take many forms and involve complex models and operating agreements.