Waterfalls are an integral component of the real estate investment terminology that determines how money is distributed between the investors and the deal’s sponsors. When properly designed and with the right incentives, they make sure that your discount will be intended to be a huge success.
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How Do Waterfalls Work?
A waterfall structure may be described as a set of pools in which cash flows from an asset fill a particular section before flowing into the next. Each collection is a contract on how the asset’s profits will be divided. Here is an illustration of the way a waterfall model appears visually when it is in use.
Recalling the concept of pools and providing one example: the initial pool could split profits between the sponsor and the investor 90%/10%, whereas the second pool could favor the sponsor by a 50:50 split. This kind of graduated profit-sharing structure encourages the company to perform better to compete with the more lucrative pools. The specifics of the profit-sharing agreements between the various pools are known as “promote structure.”
How can you tell when a sponsor is promoted? It all depends on the kind of waterfall structure employed. Two significant types of waterfall structures are utilized to invest in real estate. The first one is based on the return of all capital to investors and an anticipated rate of return (aka”the “hurdle rate”); the second is based upon the preferred rate of return (aka “the pref”) regularly.
The Hurdle Rate
Hurdle rates typically are dependent on the IRR. When a goal IRR is attained, the sponsor is “promoted” and begins to enjoy better returns. While two-tier promotions are the easiest to comprehend, I generally see three-tier structures as most commonly used in my work. With a hurdle percentage, investors must get all the capital they need before the first promotion.
In this type of arrangement, the sponsor is not paid any of the earnings until the investor has been paid in complete. Sometimes, however, the investor might also be one of the investors in the arrangement. In the average LP (limited partnership) structure, the sponsor holds the LP as well as GP (general partners) shares, and their LP shares will be treated the same as any investors (often called pari passu (which is Latin meaning “on equal footing”). GPs investing through their funds could arise from several situations, but most often, when they have to make a financial commitment to show “skin in the game” to outside investors.
If a hurdle rate is set that is set, investors receive the entire amount of capital they invested and an inevitable minimum return before the promotion can take place. This is a good option in cases with large cash flows expected in a single period and can be paid to investors fully.
However, real estate investments often generate lower cash flows over a more extended period before the sale is completed. In these instances, the waterfall structure is typically created with an initial pref.
The pref identifies a rate of return the investor could expect each year depending on the frequency of payments. If the investor deposits $1 million, the rate of return is 8 percent a year. In the event of a single dividend every year, an investor will receive an initial $80,000, before which the investor gets to share in any earnings.
After the pref, the rest of the cash is divided according to the promotion, which in our instance is 50:50. If, for example, the dividend was $100,000, the investor would receive the sum of $80,000 (for the amount of pref) plus the $10,000 (based upon the promotion) and an amount of $90,000. The company would then get the rest of the $10,000.
Other Terms Included in Waterfalls
If this was all you needed to know about the waterfall model, the world of finance would be much more straightforward. The waterfall structures typically include added complications built-in; in reality, you can add anything you’d like into the framework. I’ve witnessed some very complex techniques added to what appears to be a basic model. Here are a few of the most commonly used terms you’ll encounter:
A catchup provision favors the GP in that it ensures that all money flows (after the threshold rate has been reached) are distributed to the GP until the GP’s share in profits is equal to the amount of promotion. If we consider a $100 million one-year commitment with an 8% hurdle and a 20% boost, this scenario would occur if a profit of $15 million is made:
Hurdle Rate High-Water Mark
If there is a delay between large cash flows, the IRR could fall below the threshold rate, causing a “demote” of the sponsor. In some cases, waterfall agreements include a clause known as a “high-water mark” or “high-water mark” stating that the sponsor can’t be relegated once a sponsor is promoted. The return would have to meet the desired IRR for the particular tier to move on to the next level. This is a benefit for the sponsor.
On the other hand, investors frequently request a “lookback.” If the IRR falls below the promotion threshold and the investor cannot meet it, the company may be required to repay the amount received when the IRR threshold is met.
Investors are not treated equally with Transparency
Confident investors can get better prefs due to their bargaining ability. Although this might be acceptable and essential to complete the transaction, issues arise when other investors aren’t aware of the deal beforehand.
I frequently include a clause in my contracts that states that if a particular investor is receiving an advantage, everyone else in the group must be informed and given the right to first refusal. This prevents negative feelings from either party and makes things fair to all the parties.