What is Waterfall Finance?
Waterfall Finance is a step by step process in which the capital allocation is done for receiving interest from the borrower. We name these capital partners as limited partners (LPs) and general partners (GPs). It's a kind of a plan between the investors and creditors of how to receive capital gains at all levels.
We say "waterfall" because of a specific reason. The reason is Waterfall Finance understanding is in a downward fashion just like the waterfall stream. If we take an example river or ponds from where the water comes into it. There is a proper process of filling. We can't skip a single phase because that doesn't work. Waterfall in business works in the same way.
Distribution of Waterfall
I mentioned above that capital partners are classified as Limited partners and general partners. Keeping these two in mind, we can imagine a waterfall stricture as a set of buckets and phases. The first bucket is allocated to the senior tier that is LPs and gradually another bucket is filled called as GPs.
In this way, this works and to attract more investors different charts and models are presented by LPs.
Buckets are just for example. In real, waterfalls include various phases named as follows:
Return of capital
Return of capital, as the name suggests in this the whole investment is returned to LPs.
Catch up
Here the ratio between the LPs and GPs is 2:5 means catch up is more in favour of GPs. All the capital and interest is first given to GPs.
Preferred Return (hurdle)
This is more favourable to LPs because all the capital is received to it even after 100% and it will be in the same process throughout the world.
Carried Interest
Now, after distributing, carried interest is about allocating the remaining amount between both the buckets.