Fund waterfalls can look like a calculation problem, yet the calculation is really the end of the story. Before any numbers are run, decisions have already been made about when performance should be recognised, when a manager should participate in profits and how the economics of success should be shared between a GP and its LPs.
For Shinobu Miyata, Head of Japan at Langham Hall, this is what makes waterfalls interesting. Their mechanics may be mathematical, but their origins are not. The structures used across private markets today have been shaped by decades of negotiation between investment managers and the investors whose capital they manage.
Seen in that light, a waterfall is more than a method of distributing proceeds. It is a record of how the market has tried to reconcile two sets of interests.
Behind the calculation is a judgement
Take one of the classic questions in waterfall design: deal-by-deal or whole fund?
Imagine a fund with ten investments, five of which perform exceptionally well and five of which lose money. Under a deal-by-deal waterfall, the GP may participate in the profits from successful investments before the rest of the portfolio has been realised.
The manager can reasonably argue that value has been created and should be recognised. The investor can equally ask what happens if gains on those investments are subsequently offset by losses elsewhere in the fund. Neither view is unreasonable; each simply approaches performance from a different starting point.
Whole-fund waterfalls assess returns at fund level. Investors generally receive their contributed capital and any preferred return before carried interest is paid. Adjusted deal-by-deal and other hybrid structures have developed in response to the tension between the two positions. This is why Shinobu describes a waterfall as “an incentive design mechanism” rather than a profit allocation formula.
Why the template is only the beginning
The same history sits behind many of the provisions that now appear routinely in fund documentation. Carried interest, hurdle rates, catch-ups and the choice between deal-by-deal and whole-fund structures can easily appear to be established features of the market. They did not arrive there by accident. Each reflects arguments about economics, incentives and what different generations of GPs and LPs considered fair.
This has particular resonance in Japan, where template LPAs are sometimes treated as the correct answer. Shinobu regards them differently: “Template LPAs are not answers. They are historical records.”
A familiar provision tells us where market practice has arrived; it does not, by itself, explain why that provision is appropriate for a particular fund. The more revealing questions lie underneath. What problem was this term intended to solve? Whose interests does it protect? What behaviour does it encourage? And does that reasoning make sense for this strategy and these investors?
What sits behind the hurdle?
An 8% hurdle rate is common in private markets and Shinobu’s instinct is to ask why.
Market convention is one answer, but it says little about the economics. Once capital has been called, it is tied up in the fund until it is distributed rather than being available for deployment elsewhere. Listed equities, real estate and other private funds all compete, in different ways, for that capital.
Strategies and asset classes vary, and there is no single correct hurdle rate. Shinobu does, however, pause when he sees a 0% hurdle. Investors can hold government bonds, investment-grade credit or an index fund, each offering an expected return. If they are being asked to commit capital for a decade with no minimum return before the manager participates in profits, that choice warrants scrutiny.
What matters is whether the chosen terms have a rationale that can be explained to investors. Framed that way, a technical negotiation over a percentage becomes a broader conversation about the opportunity cost of capital, the nature of the strategy and the basis on which a GP and its LPs share in the fund's success.
When the LPA meets real cash flows
Another side of waterfalls becomes visible once a fund is operating. The LPA may set out the agreed economics, but real cash flows rarely arrive in a neat sequence. Capital is called and investments are realised at different points in the fund's life. Distributions may be partial, while preferred returns accrue and, depending on the terms, may compound. At that point, timing matters.
Shinobu recently reviewed a case in which intuition pointed to one outcome and the mathematics to another. Anyone responsible for putting waterfall provisions into practice will recognise the problem: terms that appear straightforward on the page can produce unexpected results when applied across a series of actual cash flows.
This is where a fund administrator brings something different to the conversation. Its role is not to decide what is fair between the GP and its LPs. Its perspective comes from turning the commercial bargain into a calculation and applying it consistently over the life of the fund.
If the intended economics cannot be translated clearly into the mechanics of the waterfall, ambiguity can remain hidden until there is real money to distribute. For a GP, that argues for testing the waterfall against realistic cash-flow scenarios while the LPA is still being negotiated, rather than discovering its behaviour when the first proceeds arrive.
From negotiated principle to economic outcome
A waterfall sits at an unusual intersection: it begins with a commercial negotiation, is expressed through legal drafting and ultimately becomes mathematics. All three need to tell the same story.
Understanding a waterfall therefore means looking beyond the formula. A template shows how others have approached the question and market convention provides a reference point, but neither removes the need to examine the reasoning behind the terms or to consider them against the wider opportunity set available to investors.
For Shinobu, the evolution of waterfalls reflects successive attempts by GPs and LPs to recognise performance, account for the cost of capital and agree how the rewards of successful investment should be shared. The final calculation is where all of those choices become real.
The question, then, is not simply whether the waterfall has been calculated correctly. It is whether the calculation gives effect to the economic relationship that the GP and its LPs intended to create.
This article draws on Shinobu Miyata’s Slowsteps article and podcast episode: Episode 9 - Why Waterfalls Exist
