TL;DR: The order in which a fund's profits are paid out: investors get their money back first, then a preferred return, then the manager catches up, then everyone splits 80/20.

Every fund's cash goes down the same staircase. 1. Return of capital to the LPs. 2. Preferred return (“pref” or “hurdle”), often 8% a year, also to the LPs. 3. GP catch-up: the manager takes most or all of the next dollars until it has its 20% of total profit. 4. Carried interest split: everything after that goes 80/20.

It matters for tax because a partnership allocates taxable income to match who gets the cash — often using “targeted” capital accounts. When the waterfall and the tax allocations don't line up, LPs get K-1s that don't match their distributions and everyone ends up in the tax team's inbox. European waterfalls run on the whole fund; American ones deal by deal, paying carry earlier.

A simple waterfallFund returns $160 on $100 invested: $100 back to LPs, $8 preferred return to LPs, $2 GP catch-up, then $50 split $40 LP and $10 GP.1 · Return of capital$100 → LPs2 · Preferred return 8%$8 → LPs3 · GP catch-up$2 → GP4 · 80 / 20 split of $50$40 → LPs · $10 → GP$160$60$52$50Total: LPs $148 · GP $12GP = 20% of $60 profit ✓
Cash cascades top to bottom; each step fills before the next one starts.

Worked example

LPs invest $100; after one year the fund has $160 to distribute. LPs take $100 back, then an $8 pref. The GP catches up $2 (so it has 20% of the $10 distributed as profit so far). The last $50 splits $40/$10. Totals: LPs $148, GP $12 — exactly 20% of the $60 profit.

Where you'll see it: LPA Article on distributions, waterfall models, and capital account reconciliations behind every K-1.

Code: IRC § 704(b); Treas. Reg. § 1.704-1(b) · Related: Carried interest, Schedule K-1 (and K-3)

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This glossary is general information, simplified for learning. It is not tax, legal or investment advice, and real structures turn on facts and documents not shown here.