3.1 Introduction and Principles

The term “waterfall” is used to refer to situations where the total value of an item needs to be divided into ordered “buckets” (which are often typically called any of “layers, bands, tranches, hurdles, or tiers”). The basic idea is that the total amount is allocated to the layers by starting with the first, and moving to the next layer only when the previous one is full.

The underlying concept behind these methods is quite straightforward, and the calculations to implement them generally also involve only basic arithmetic and functions (such as IF, MIN, MAX or SUM). Some applications have specific rules for how the size of the buckets may change over time, in which case the modelling of the bucket sizes may add more complexity. (This is the case for example in modelling profit sharing in private equity deals, which is discussed in the next section).

Areas of application include:

• Personal tax calculations.
• Incentive and profit-share schemes.
• Interest calculations based on using different interest rates for different seniority of borrowings.
• Royalty and production-sharing arrangements.
• Insurance and reinsurance.
• … and so on.
The next section uses simple examples to illustrate the core principles. It also contains a slightly more complex example related to cost recovery in project-based industries, such as oil and gas. The subsequent section covers profit-sharing in private equity, which is another frequent area of application that has specific features which also add some complexity.
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