What is a standard waterfall structure payback(LP paid first etc)

Question

If $1m is invested by LP and annual cash flow is $200k for 5 years and asset sells for $2m, lets say for simplicity split 8% pref and 60/40 thereafter, so LP gets $150k in theory per year on cash flows before selling asset, would they get paid cash $150k a year and $50k to GP, or would they generally get paid in an accelerated front end manner?

And then is it standard procedure for asset sale to be calculated as part of year 5 cash flow, totaling $2,200,000 so the pref is $80k, and then the remaining $2,120,000 is split 60/40? Or is that not the most common way for the asset value to be split?

Brian Burke · Answer

It all depends on how the partnership agreement is worded, and there is no "standard procedure", it's really up to the sponsor and what their investors agree to.  There are three primary methods (using the splits in your example):

Some agreements might say that distributions first go to the investor until they have received an 8% return on their unreturned capital contributions (the preferred return), then, second, 60% to the investor and 40% to the GP.  If that's what it says, the investor would receive the $80,000 from the first tier and $72,000 from the second tier, for a total of $152,000.  The GP would receive $48,000.

Some agreements might say that distributions first go to the investor until they have received an 8% return on their unreturned capital contributions, then, second, to the investor until they have received 100% of their contributed capital, then, third, 60% to the investor and 40% to the GP.  If that's what it says, the investor would receive $200,000 and the GP would receive $0.  Of the capital distributed to the investor, $80,000 satisfies the preferred return and $120,000 is return of capital.  In the next period their committed capital is $880,000 so the preferred return is $70,400 for year 2.  So in year 2 the investor receives $70,400 for the preferred return and the rest is return of capital, and so on.

And other agreements might say that distributions first go to the investor until they have received an 8% IRR, then, second, to the 60% to the investor and 40% to the GP.  If it says this, the investors would receive $200,000 in each of the first five years and it would work mechanically just like in the previous example.  Note that this provision doesn't explicitly say that the investor is to receive return of capital prior to the GP receiving any split of the profits.  However, by definition, the only way to achieve an 8% IRR is if the capital is returned.

As to your second question, capital received from a sale typically runs through the waterfall just like any other capital.  Some sponsors do treat it differently but that's unusual and most likely not market terms.  You see this most with newer sponsors raising capital from unsophisticated investors, where they will offer, for example, one % split of the operating cash flow and a different % split of the cash flow from the sale.

Lane Kawaoka · Answer

Looking at spits is a bad way of vetting your deal.

Look at what really matters such as reversion caps used or rent increases.

John Fortes · Answer

I would ask how he got to that assessment. Ask him to show you visually and see if you can make sense of it. Ground up is a different animal as returns are definitely delayed because there is no income coming in during construction and if you are an investor in this deal what would it take for you to jump in knowing the returns will come later. GP seems to eat during the hold period and then everyone cash's out at the end. Investors want to see the velocity of their return. How fast is my money coming back to me?

Outside of that, consider your reputation on this. If you decide to walk and don't bring in your investors, you hold your investors interest over your own.

Joel Owens · Answer

Ground up is very different risk profile.

In syndication there is a risk/return ratio.

Typically for syndicates you have most risky to least risky as follows.

1. Investor at the land entitlement phase to get the site in a build ready condition.

2. Investor at the new development construction phase where you go vertical and depending on deal size might have to wait years to get  a distribution.

3. Value add on a half- occupied property. Might have enough cash flow to come in to service the debt or might have if paying all cash some cash flow to distribute to investors but not he full amount of the pref. until stabilized.

4. Fully stabilized properties already generating close to full cash flow with maybe some upside but typically not much unless markets below rent or other ways to unlock value.

Some investors need cash flow today and others want more back end equity upside. Investors have different capital objectives. Now some would argue that new development and value add with half vacant can become less risky as the stabilized value could be much higher than market pricing on fully performing properties. That can be true IF the sponsor has the ability to develop the project and meet projections or take something half vacant and get it fully performing again etc.

Hotels can be highly cyclical. Right now we are peaking in a cycle for economic conditions. Hotels a big part of REVPAR per room can be based on vacation travelers and also business conventions. When economic downturn happens many businesses cut back on travel and meetings/shows to save costs. Same thing with regular travelers when times get tough they take  a staycation in their state or might go 1 or 2 states over but not much farther. You need to know with the proposed hotel the track record of the sponsor with new build development, what existing product is on the market, how is it performing, how much new builds are slated to come online, are they national flag brands or more regional to mom and pop in nature, is the site you are developing an A++ compared to existing buildings in the area, what rent per room would be needed to justify the development and does the consumer base in the area and travelers support it for the amenities and quality of construction you will be providing. Where the property is being built also comes into play state by state as the approval process can be long sometimes years in some places. By the time something is built market conditions could have changed and projections are now out the window.

When you say (opportunistic new build hotel) it is not descriptive enough if this is just an idea, land entitled, vertical started, etc.

Brian Burke · Answer

Only if the operating agreement has a clawback provision.  Most operating agreements I've seen do not have clawback provisions, but they are out there on occasion.

Having said that, there's still no way to over-distribute if the GP is calculating the waterfall properly, and following the waterfall rules.  If the hurdles are IRR hurdles, the LP is getting 100% of the distributions until their capital is fully returned AND they have been fully caught up on pref.  No way to over-distribute to the GP when the GP is getting $0.

If the hurdles are annual return hurdles, not IRR hurdles, and the waterfall rules provide for return of capital only at sale, there is a chance that the GP could start receiving distributions and then the economics of the deal could subsequently go south.  If suddenly there is a reduction of cash flow and now the distributions are no longer enough to satisfy the annual return hurdle, the unpaid portion starts to accrue.  Then the investor starts receiving 100% again until the unpaid portion of the annual return hurdle is met, even if that comes from proceeds on sale.  If the sale proceeds aren't enough to return all capital AND satisfy unpaid annual return hurdles then there is either remaining unpaid return or a capital loss.  The GP was distributed some profit, because the rules said they were entitled to it at the time.  A subsequent change in cash flow does not change that the GP was entitled to the payment.  The only way to ask the GP to return that payment is with a clawback provision in the operating agreement.  And by then, the sponsor has probably already spent the money and if they don't have the financial strength to pony up the money, the clawback provision isn't all that valuable.

John Fortes · Answer

If you're trying to understand the structure then its based off the sponsor providing the deal. Everyone is different in how they run it.

If you're looking at the structure to determine if your going to invest then you are probably looking for reasons not to invest in the deal. If the opportunity is going to make you the returns and hit your goals and you trust the sponsor then focus on your target numbers in your seeking returns.

Brian Burke · Answer

Close.  Repayment of the invested capital is part of the waterfall, but it can occur at different points in time depending on how the waterfall is written.

So bearing that in mind your #1 & 2 are conceptually correct at a high level although there can be subtle differences that can have a material impact on the actual numbers.

As to a lookback, if the waterfall is calculated properly the lookback is a continuous calculation so it wouldn't be possible to over-distribute to the GP.

Any waterfall that has the return of capital occurring only at refinance or sale wouldn't be based on an IRR, it could only be based on an annual return, because IRR, by definition, is only achievable if the capital is returned.

Lane Kawaoka · Answer

You go ahead and invest in 99% / 1% LP to GP split...  if the deal makes jack you get jack (99% of 0%).

Brent Shields · Answer

I understand the theory behind a waterfall payout structure, and in theory it makes sense that if the general partner does something extraordinary they should get more money.

But looking at an investment opportunity as a limited partner I have passed on some deals because the waterfall seemed complicated and confusing and it was hard to tell who gets what.

If I read it twice and I still can't understand who gets what then I feel like the general partner is trying to intentionally suck extra money out of the deal and they just don't want the limited partners to understand how much they are trying to take.

This may not be fair or accurate but I have felt that way many times while trying to calculate who gets how much and passed on the deal.

For me the payout structure needs to be fairly clear and easy to understand.

Anders Jax · Answer

@Lane Kawaoka

Well the splits are going to determine how much of the rent increases and reversion capital go to the LP, and obviously those things are key to building the model of the cash flows. But the split is certainly important, and for some reason the GP Im doing a favor in intro’ing to serious friggin investors, is proposing a wild change to what seems like a pretty straight forward part of the deal (the waterfall)

What is a standard waterfall structure payback(LP paid first etc)

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