Waterfall
The order in which cash is paid out or losses absorbed. In a private fund: capital back first, then a preferred return, a catch-up and the profit split; in a securitisation, senior tranches are paid first.
Where you will meet it
Waterfall appears in 5 learning outcomes on the CFA syllabus. A few of them:
- Explain how structured securities are split by credit and by time
“Credit tranching allocates losses in a waterfall: the most subordinated tranche absorbs the first losses on the pool, and only when it is exhausted do losses reach the next.”
- Explain how a limited partnership is organised and governed
“The limited partnership agreement is the governing document, setting the investment period, fee terms, the distribution waterfall and key-person provisions.”
- Contrast analysing corporate debt for credit risk with the analysis that securitized debt requires
“The waterfall, credit enhancement and tranche seniority determine who absorbs losses.”
- Explain the mechanisms that tie a private manager's incentives to its investors' interests, and work out and assess the net returns limited partners keep after management fees and carried interest
“In a whole-fund (European) waterfall, LPs receive their paid-in capital and hurdle before any carry.”
See also
Practise it
Practise waterfall until it is automatic: questions that explain every wrong option.
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