Waterfall Structure

In securitizations, such as mortgage-backed securities, collateralized loan obligations and other asset-backed securities, money from the underlying assets flows down through a series of steps. Senior obligations are paid in full before lower levels receive anything, much like water filling one level before spilling over to the next.

A typical waterfall pays fees and expenses first, then interest to senior noteholders, then interest to mezzanine noteholders, then principal according to the rules, with anything remaining going to the equity holders.

For example, if a pool of loans generates 10,000,000 in a period, and senior interest and fees need 7,000,000, senior investors are paid in full, mezzanine investors share the remaining 3,000,000, and equity investors receive nothing until mezzanine payments are complete.

Waterfalls often include tests, such as coverage tests, that redirect cash from junior to senior investors if the pool's performance deteriorates. In private equity funds, a distribution waterfall works on similar principles, setting the order of payments between investors and the manager.