In a waterfall with a preferred return, how would you verify that cash distributions allocate correctly over time?

• A. Ignore the hurdle and pay GP first.
• B. Build a test with sample cash flows; ensure LPs receive hurdle-first distributions; catch-up activates after hurdle; verify GP carry only after cumulative LPs’ preferred returns and catch-up thresholds are satisfied.
• C. Assume LPs and GP receive distributions in equal share from the start.
• D. Only check total distributions without testing timing.

Answer: (B)

This tests how you validate the timing and sequencing of cash distributions in a waterfall that includes a preferred return. The key idea is to back-test with example cash flows and check that distributions follow the intended order: first, the limited partners receive their accrued preferred return up to the hurdle; second, after the hurdle is met there may be a catch-up period that allocates distributions to the general partner until a specified ratio or threshold is reached; only after cumulative LP returns and any catch-up thresholds are satisfied does the GP receive carry.

To verify this, build a simple model with sample cash flows across multiple periods and apply the waterfall rules in sequence each period. In early periods, ensure LPs receive enough to meet their preferred return before any distributions go to the GP. Then confirm that once the hurdle is satisfied, the catch-up portion is allocated correctly until the agreed catch-up condition is met, and finally verify that carry to the GP only occurs after these cumulative conditions are fulfilled. It’s important to test across different cash-flow patterns (flush periods, down cycles, uneven timing) so the allocation logic holds in all cases, not just when totals look right.

This approach focuses on timing and order, not just totals, which is why it’s the best way to verify the distributions allocate correctly over time.