What is a Waterfall Structure?
A waterfall structure defines the order in which cash flows from an asset pool are distributed to different classes of investors. Like water flowing over a series of ledges, payments cascade from one level to the next, ensuring senior investors are satisfied before junior investors receive anything.
How Waterfalls Work
Payment Waterfall (Cash Inflows)
- Operating expenses and fees
- Senior interest payments
- Senior principal repayment
- Mezzanine interest
- Mezzanine principal
- Junior/equity residual
Loss Waterfall (Defaults)
- Junior tranche absorbs first
- Mezzanine absorbs next
- Senior absorbs last
Waterfall Components
- Priority of Payments: Order for distributing cash
- Coverage Tests: Triggers that redirect cash flows
- Reserve Accounts: Buffers for payment shortfalls
- Acceleration Events: Conditions changing payment order
DeFi Waterfall Examples
Centrifuge Pools
- TIN (junior) receives excess spread
- DROP (senior) has priority on principal/interest
- Losses reduce TIN value first
Goldfinch
- Backers (junior) take first loss
- Senior Pool has priority claims
- Interest split based on leverage ratio
Benefits of Waterfall Structures
- Creates different risk/return profiles from same assets
- Enables risk-averse investors to participate
- Aligns incentives through first-loss positions
- Provides structured credit enhancement
Evaluating Waterfall Terms
- Subordination levels (junior percentage)
- Coverage ratio requirements
- Fee priorities (can erode investor returns)
- Acceleration and default triggers
Smart Contract Implementation
DeFi waterfalls encode these rules in smart contracts, automatically distributing funds according to the defined priority.