In a debt context, it is commonly used to describe the seniority of debt liabilities. In the first instance, money flows to repay the most senior debt up to a predefined limit. Any left over is then paid against the next most senior debt, up to a predefined limit, and so on down the chain. This occurs until all the money has been used.
A waterfall arrangement might be put in place when a borrower runs into trouble. For example, the lender might impose an arrangement whereby all of the borrower’s income may be used to pay interest and maybe a portion of the principal up to a limit and only the income left over is available to the borrower.
The term is also used by private equity investors to specify when the general partner gets paid and how much it earns. For example, LP investors might be entitled to receive a return of the amount that they invested plus a preferred return before the GP can earn any carry.
With any waterfall arrangement, as the money flows down the waterfall, more and more of it is diverted.
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