Define the Waterfall in a Hedge Fund

If you're a hedge fund investor, understanding the fund's waterfall policy is essential. A waterfall explains how a fund's investors and manager get paid. It outlines who gets paid first and how much of a fund's profits an investor will receive. Waterfalls are included in the founding documents of a fund.

What Is a Hedge Fund?

Hedge funds are invested aggressively and are often risky investments -- they carry high risks, but also the potential for high rewards. As they do with other investment products, investors put money into a hedge fund, which is run by a manager. However, unlike other investment products, hedge funds require investors to contribute a hefty sum, at least $250,000, as their initial investment. Additionally, hedge funds may have only 100 or fewer investors.

Waterfalls

In a hedge fund, the revenue from investments is distributed among investors and partners is distributed in a waterfall structure. In some cases, certain investors will have priority over other investors. In other cases, the hedge fund manager or the hedge fund partners will receive money as soon as the initial capital is repaid. Waterfalls are usually outlined in a fund's founding documents.

Differences Between American and Foreign Waterfalls

American and European waterfalls have some key differences. European waterfalls generally pay investors first, offering an average of 8 percent return on their investment. Once investors are repaid, the hedge fund manager will draw a profit. In an American waterfall, managers earn a share of profits as soon as they begin to turn a profit on their investments. In general, American fund managers get 20 percent of a funds profits at the end of the year; the rest is distributed among investors.

Considerations

The waterfall arrangements vary from hedge fund to hedge fund. After the 2008 financial crisis, many funds began to restructure the way their managers are paid. According to the Wall Street Journal, managers are receiving a smaller percent of the fund profits.

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About the Author

Amanda Erickson has been writing professionally since 2008. She has written for the "New York Times," "Christian Science Monitor" and "Chronicle of Higher Education." Before moving to New York, she worked as a political blogger at the "Washington Post." Erickson holds a Bachelor of Arts in urban history from Columbia University.

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