In most private equity real estate (“PERE”) syndications, the distributions of income between investors and the manager are allocated via what is commonly referred to as a “waterfall.” The waterfall is designed to align economic interests of investors and the manager by incrementally rewarding the manager as investor profits increase. There is vast diversity in how waterfalls are structured, which we will not delve into here. We will focus on the overall premise of a waterfall and some of its most relevant aspects to an investor.
The most common waterfall structure includes the following components:
- Payment of a Preferred Return (commonly referred to as “Pref”)
- Calculated as the stated percentage multiplied by your equity contribution
- If the Pref accrues, and the project does not produce sufficient cash flows needed to cover these payments, your equity balance grows by the accrued Pref amount payable to you
- Return of Capital (“ROC”) to investors
- Refund of your original equity investment (e.g., you invest $1, you receive $1)
- Excess profit distributions above the Pref and ROC
- The manager may set performance targets (called “Hurdles”) that, if achieved, grant the manager a larger share of the excess cash flows as a reward for its outperformance (otherwise known as “Promote” or “Carried Interest”)
- For example, the manager may stipulate a 14% hurdle – this indicates that all profits generated in excess of a 14% internal rate of return (“IRR”) return would receive a higher allocation to the manager as a performance incentive
- Opportunities may feature multiple hurdles and can be based on different return metrics (IRR driven vs. equity multiple based, for example)
The following tables depict the split of cash flows to investors (also called “LP Investors”) and the manager (also called the “GP Investor”) for each of the three categories referenced above. This hypothetical example assumes an 8% Pref and then a 50% profit split after the ROC on a project requiring $10M in equity.
- Payment of the Pref to investors
- Both investor groups would expect to receive an 8% return on their invested capital (For LP Investors, this translates to: 8% * $9,000,000)
Preferred Return Distributions
- ROC to Investors
- At this level both investor groups receive 100% of their invested capital
Return of Capital Distributions
- Excess profit distributions to a specified IRR
- Assuming no performance hurdles, once both investor groups receive the Pref and ROC, the LP Investors would receive 50% of their pro-rata share (90% equity investment * 50% split = 45% allocation of all excess cash flows after the ROC)
- The manager would continue to receive its pro-rata share of the cash flows (10% equity investment), with the remaining 45% paid as a promote to the manager
As an example, the following table assumes $1,000,000 of excess cash flows to be distributed after the Pref and ROC.
Tier 1 Distributions
This is a simple waterfall example. Sometimes there are multiple hurdles that consider timing of investments and distributions, generally identified as performance targets. Typically, as the hurdle rate increases, the percentage distributed to the manager as a promote rises. The rationale is that as LP Investors receive greater overall returns, the manager’s share of profits should increase as a reward for its execution of the business plan.
As an LP Investor, it is important to review the terms of the waterfall in any investment and consider whether the manager’s targeted Promote payments are commensurate with the skill and operational acumen necessary to execute on the business plan.
Managing Director, Fund Management
About the Author
Barry is Fairway America’s Managing Director of Fund Management and oversees all fund investments, including underwriting, portfolio management and asset disposition and is a voting member of investment committee. Prior positions at Fairway include Vice President of Investments and Senior Portfolio Manager. Since joining Fairway Barry has been responsible for underwriting more than 150 fund investments totaling nearly $200 million in fund capital.
Before Fairway, Barry spent 10 years at Integra Realty Resources as Director of Commercial Real Estate Appraisal. Barry holds real estate finance and master’s degrees from University of Denver and MAI, CCIM and SRA real estate designations.