What One Should Know About Equity Waterfalls in Multi Family RE
Specialist · USA · Member since 2016 · 226 posts · 51 votes
Good evening BP World,
I was hoping that through your collective responses and examples, we as a community could learn more about the common real estate waterfall components.
In layman's terms, could a few of you kindly explain:
1. The return hurdle
2. The preferred return
- who gets the preferred return?
- is the preferred return cumulative?
- is the preferred return typically compounded?
3. The lookback provision
4. The catchup provision
5. When does return of capital typically occur?
6. What is a promote, how does it work, and at what stage for different execution strategies does it make sense to implement?
7. Do you present this in your Investment Memorandum or do you need to write out an owner's agreement?
Many, many, many thanks!
Let’s use the example of an 8% preferred return, followed by a 70/30 split to a 12% return, followed by a 60/40 split to a 15% return, then 50/50 thereafter.
1. This is the rate of return the investor needs to achieve in order to cash to flow to the next tier of the waterfall. In Our example, the return hurdles are 8%, 12%, and 15%.
2. The investors get the preferred return. If the sponsor is also investing (called a “co-invest”) the sponsor also gets the preferred return in pari passu with the other investor(s). The preferred return is typically cumulative. It may or may not be compounded, that depends on the operating agreement. I’ve seen it done both ways.
3. The look back provision isn’t really a provision, it’s more of a concept. What it means is that in our example above, you have to track the required distributions to achieve each of the hurdles and your future cash flows have to “look back” to fill the required cash flow. Let’s say that your first hurdle after the pref is 12% as in our example here. If you have $1MM invested, you need 120,000 per year to achieve this hurdle, or 360,000 by year 3. If by year 3 you haven’t distributed 360,000 and you now have more than $120,000 to distribute in year 4, the cash still flows 70% to the investor until the 12% total is met. It doesn’t jump to the next tier and split 60/40 as it would if the 12% was fully satisfied.
4. A catch-up is where the sponsor gets the cash flow (or some specified disproportional portion) after the pref hurdle is met. It is meant to neutralize the pref, essentially. It might look like this: 8% pref to the investor, then sponsor gets the next 8%, then everything after that is split 50/50, or some such arrangement. At the end of the day it’s really a 50/50 split unless the deal underperforms.
5. When the operating agreement says it does. Sometimes it’s first, sometimes it’s after the pref, sometimes it’s only at Capital events such as refinance or sale. This is up to the sponsor to decide and draft the operating agreement accordingly.
6. The promote is the sponsor’s profit split. Just an obscure word for a common concept.
7. All of this is contained in the operating agreement or limited partnership agreement, as the case may be.
Finally, you have to make sure that your waterfall calculations exactly match the language of your operating agreement. I’d bet that a large percentage of inexperienced syndicators have mismatched waterfalls where their operating agreement says one thing and their excel model does another. Not a good scenario for either the sponsor nor the investor!
Let’s use the example of an 8% preferred return, followed by a 70/30 split to a 12% return, followed by a 60/40 split to a 15% return, then 50/50 thereafter.
1. This is the rate of return the investor needs to achieve in order to cash to flow to the next tier of the waterfall. In Our example, the return hurdles are 8%, 12%, and 15%.
2. The investors get the preferred return. If the sponsor is also investing (called a “co-invest”) the sponsor also gets the preferred return in pari passu with the other investor(s). The preferred return is typically cumulative. It may or may not be compounded, that depends on the operating agreement. I’ve seen it done both ways.
3. The look back provision isn’t really a provision, it’s more of a concept. What it means is that in our example above, you have to track the required distributions to achieve each of the hurdles and your future cash flows have to “look back” to fill the required cash flow. Let’s say that your first hurdle after the pref is 12% as in our example here. If you have $1MM invested, you need 120,000 per year to achieve this hurdle, or 360,000 by year 3. If by year 3 you haven’t distributed 360,000 and you now have more than $120,000 to distribute in year 4, the cash still flows 70% to the investor until the 12% total is met. It doesn’t jump to the next tier and split 60/40 as it would if the 12% was fully satisfied.
4. A catch-up is where the sponsor gets the cash flow (or some specified disproportional portion) after the pref hurdle is met. It is meant to neutralize the pref, essentially. It might look like this: 8% pref to the investor, then sponsor gets the next 8%, then everything after that is split 50/50, or some such arrangement. At the end of the day it’s really a 50/50 split unless the deal underperforms.
5. When the operating agreement says it does. Sometimes it’s first, sometimes it’s after the pref, sometimes it’s only at Capital events such as refinance or sale. This is up to the sponsor to decide and draft the operating agreement accordingly.
6. The promote is the sponsor’s profit split. Just an obscure word for a common concept.
7. All of this is contained in the operating agreement or limited partnership agreement, as the case may be.
Finally, you have to make sure that your waterfall calculations exactly match the language of your operating agreement. I’d bet that a large percentage of inexperienced syndicators have mismatched waterfalls where their operating agreement says one thing and their excel model does another. Not a good scenario for either the sponsor nor the investor!
@Jared Carpenter Great response, as always, by @Brian Burke.
I wrote a blog post about this exact topic recently which should be helpful: The Promote – How the Real Money Is Made In Real Estate Private Equity
This should answer all your questions plus provide you with a working solution to compare/contrast different types of promote structures.
Brilliant and extremely well put together response, thank you.
A few questions/clarifications:
Thank you Brian.
Omar, hope you're well! I am going to read through this tonight, appreciate the head's up on this.
1. Yes, the Sponsor is the Syndicator/promoter/operator—the one who finds the property, puts the deal together and runs it through the hold period. What you are referring to as to the loan stuff is a guarantor, carve-out guarantor or Key Principal.
2. Pari Passu means that the distribution is proportional to the amount invested. So if the sponsor contributed 10% of the capital, the distribution in the pref and return of capital tiers would be 90/10. Whether return of capital happens before or after pref depends on how the operating agreement is worded. I’ve seen it first, second, and unrelated (in the case of return of capital only from capital events such as refinance and sale). If return of capital happens first it can reduce the amount of the preferred return because the capital account shrinks with every distribution. Some investors might not like that. Others won’t care, and others won’t understand the difference. It’s up to you...
3. The look-back has the most to do with modeling out the capital account and tracking accruals at every tier. Think of it this way—how can you promise the investor that they will get 70% of the cash flow until they reach a cumulative 12% if you aren’t tracking how much must have been distributed to get to that 12%?
4. The best example I can give for a catch up is the one I gave in #4 of my previous post. How do sponsors justify them? It depends on the deal. I’ve only used a catch-up once, in a blind-pool development fund where there was a straight profit split but I built in a pref with a catch-up just to give the investors a safety net if the fund under-performs. And that’s exactly how I explained it. A pref with a catch up is better than no pref at all. But only use this in very specific circumstances because investors typically don’t like catch-ups, and I don’t blame them. They tend to disfavor the investor.
5. As seen through the lens of a sponsor, I suppose you could make a case for them being the same thing. They are both splits of the profit. But from the lens of the investor a catch-up is very different than a promote because the sponsor is getting a disproportionate share of the income in the next tier after the pref so it cuts deeply into what would have been the next tier of their distribution, if that makes sense.
6. How do I present it? I show the calculations in the deal’s initial slide deck so the investors can see the flow of funds. Then, it’s broken down from math to English in the operating agreement and PPM. Transparency is key, here. One of my pet peeves is sponsors hiding fees and splits in convoluted structures and in footnotes to exhibits—I’ve seen some pretty crazy and underhanded stuff. Don’t do that—just keep it simple and understandable, be transparent and clear and your investors will appreciate that.
Brian, thank you. This has been a tremendous help.
Would you be willing to share with me a deck you used for a prior deal, one that outlines the flow of funds and then translates from math to english?
@Jared Carpenter happy to share stories and advice, but unfortunately I can't share our and our counsel's proprietary work product. That's the bad news, but I suppose the good news is that doesn't matter, really, because these are always highly-customized for the sponsor and the deal and anything that you get from someone else is probably a lot less useful to you than the answers I gave above. :)
Understand Brian! In no way was I trying to duplicate it, simply wanted to read through one. I am thankful for your advice and guidance that you have so willingly shared.
What @Brian Burke said!
1. Yes, the Sponsor is the Syndicator/promoter/operator—the one who finds the property, puts the deal together and runs it through the hold period. What you are referring to as to the loan stuff is a guarantor, carve-out guarantor or Key Principal.
2. Pari Passu means that the distribution is proportional to the amount invested. So if the sponsor contributed 10% of the capital, the distribution in the pref and return of capital tiers would be 90/10. Whether return of capital happens before or after pref depends on how the operating agreement is worded. I’ve seen it first, second, and unrelated (in the case of return of capital only from capital events such as refinance and sale). If return of capital happens first it can reduce the amount of the preferred return because the capital account shrinks with every distribution. Some investors might not like that. Others won’t care, and others won’t understand the difference. It’s up to you...
3. The look-back has the most to do with modeling out the capital account and tracking accruals at every tier. Think of it this way—how can you promise the investor that they will get 70% of the cash flow until they reach a cumulative 12% if you aren’t tracking how much must have been distributed to get to that 12%?
4. The best example I can give for a catch up is the one I gave in #4 of my previous post. How do sponsors justify them? It depends on the deal. I’ve only used a catch-up once, in a blind-pool development fund where there was a straight profit split but I built in a pref with a catch-up just to give the investors a safety net if the fund under-performs. And that’s exactly how I explained it. A pref with a catch up is better than no pref at all. But only use this in very specific circumstances because investors typically don’t like catch-ups, and I don’t blame them. They tend to disfavor the investor.
5. As seen through the lens of a sponsor, I suppose you could make a case for them being the same thing. They are both splits of the profit. But from the lens of the investor a catch-up is very different than a promote because the sponsor is getting a disproportionate share of the income in the next tier after the pref so it cuts deeply into what would have been the next tier of their distribution, if that makes sense.
6. How do I present it? I show the calculations in the deal’s initial slide deck so the investors can see the flow of funds. Then, it’s broken down from math to English in the operating agreement and PPM. Transparency is key, here. One of my pet peeves is sponsors hiding fees and splits in convoluted structures and in footnotes to exhibits—I’ve seen some pretty crazy and underhanded stuff. Don’t do that—just keep it simple and understandable, be transparent and clear and your investors will appreciate that.
@Brian Burke I think I need to make a new tinfoil hat, my old one may be wearing out since someone is reading my thoughts and this thread showed up on BP :). I just received an offering where the operator is offering pref as return OF capital two days ago, and I was wondering the effect it would have on IRR and return. the way I see it is that the return of capital would reduce the pref total, while keeping the percentage the same (ie. 100k investment would pay 8k the first year on 85 pref, but the second year would only pay 8% of 92k - $7360 and so on, and so on). what I want to know is what effect that would have on IRR, my thought is that it would make IRR higher, since your initial investment is in for a shorter period of time, so you lose less time value of that money since you can redeploy. is my thinking correct here?
the second thought I would have would be that it would have a huge effect on the waterfall if there are levels (the offering I received was a constant split, and ownership % remained the same even with return of capital). say if there were a second level where the split became 50/50 after 20% return, wouldn't that be really in favor of the sponsors, because it is easier to get to a 20% return if you are returning capital?
or am I way off base here?
mahalo (thanks) for any answer you can give to my ramblings
aloha
steve
1. Yes, the Sponsor is the Syndicator/promoter/operator—the one who finds the property, puts the deal together and runs it through the hold period. What you are referring to as to the loan stuff is a guarantor, carve-out guarantor or Key Principal.
2. Pari Passu means that the distribution is proportional to the amount invested. So if the sponsor contributed 10% of the capital, the distribution in the pref and return of capital tiers would be 90/10. Whether return of capital happens before or after pref depends on how the operating agreement is worded. I’ve seen it first, second, and unrelated (in the case of return of capital only from capital events such as refinance and sale). If return of capital happens first it can reduce the amount of the preferred return because the capital account shrinks with every distribution. Some investors might not like that. Others won’t care, and others won’t understand the difference. It’s up to you...
3. The look-back has the most to do with modeling out the capital account and tracking accruals at every tier. Think of it this way—how can you promise the investor that they will get 70% of the cash flow until they reach a cumulative 12% if you aren’t tracking how much must have been distributed to get to that 12%?
4. The best example I can give for a catch up is the one I gave in #4 of my previous post. How do sponsors justify them? It depends on the deal. I’ve only used a catch-up once, in a blind-pool development fund where there was a straight profit split but I built in a pref with a catch-up just to give the investors a safety net if the fund under-performs. And that’s exactly how I explained it. A pref with a catch up is better than no pref at all. But only use this in very specific circumstances because investors typically don’t like catch-ups, and I don’t blame them. They tend to disfavor the investor.
5. As seen through the lens of a sponsor, I suppose you could make a case for them being the same thing. They are both splits of the profit. But from the lens of the investor a catch-up is very different than a promote because the sponsor is getting a disproportionate share of the income in the next tier after the pref so it cuts deeply into what would have been the next tier of their distribution, if that makes sense.
6. How do I present it? I show the calculations in the deal’s initial slide deck so the investors can see the flow of funds. Then, it’s broken down from math to English in the operating agreement and PPM. Transparency is key, here. One of my pet peeves is sponsors hiding fees and splits in convoluted structures and in footnotes to exhibits—I’ve seen some pretty crazy and underhanded stuff. Don’t do that—just keep it simple and understandable, be transparent and clear and your investors will appreciate that.
@Brian Burke I think I need to make a new tinfoil hat, my old one may be wearing out since someone is reading my thoughts and this thread showed up on BP :). I just received an offering where the operator is offering pref as return OF capital two days ago, and I was wondering the effect it would have on IRR and return. the way I see it is that the return of capital would reduce the pref total, while keeping the percentage the same (ie. 100k investment would pay 8k the first year on 85 pref, but the second year would only pay 8% of 92k - $7360 and so on, and so on). what I want to know is what effect that would have on IRR, my thought is that it would make IRR higher, since your initial investment is in for a shorter period of time, so you lose less time value of that money since you can redeploy. is my thinking correct here?
the second thought I would have would be that it would have a huge effect on the waterfall if there are levels (the offering I received was a constant split, and ownership % remained the same even with return of capital). say if there were a second level where the split became 50/50 after 20% return, wouldn't that be really in favor of the sponsors, because it is easier to get to a 20% return if you are returning capital?
or am I way off base here?
mahalo (thanks) for any answer you can give to my ramblings
aloha
steve
@Steve K. yes definitely repair that hat because I saw that question coming from a mile away.
The answer is, it depends. There are two ways to define hurdle rates, IRR and annualized return. If the hurdle is IRR the priority won't change the total dollars because by definition achieving an IRR includes the return of capital and the priority of pref vs. capital doesn't matter. But if the waterfall is based on an annualized return the amount of pref due will decline as the capital shrinks with each return of capital distribution.
That said, while the total dollars of pref does decline, the total due to the investor doesn't decline dollar-for-dollar because what happens to the excess dollars is they drop to the next tier. So if the next tier is an 80% split to the investor, you'll get 80% of the extra dollars that would have been pref if the priority was pref first and return of capital later. At the end of the day the effect on the IRR is probably not as significant as one might assume. But the only way to know for sure is to model it because the structure of the subsequent tiers matters and so does the timing of the cash flows, etc.
I'm not convinced that going through the exercise of modeling alternative structures is worth the effort--if the sponsor isn't offering the other structure how does it benefit you to model it out? You model it and find out you could get 50bps in additional IRR if the investment were structured differently, but it's not, so you can't have it, so what do you do? LOL
And yes, requiring fewer dollars to reach hurdles does benefit the sponsor by making it easier to achieve the hurdles. But again, we're not talking a world of difference here. Since the tiers only divide cash flow remaining after preceding tiers are satisfied the dollars to the sponsor in this scenario won't be the difference between them retiring or not. Instead, it'll be the difference on them getting 50% of those last dollars versus say 40% or 30% as the case may be in the preceding tiers. So, a benefit, yes, but earth shattering, probably not.
This is the dirty little secret in the syndication world--the IRR is really an act of financial engineering because the property-level cash flows can be divided in so many ways and these details do matter. But then again, rather than focusing on the nuances of the waterfall I'd be more inclined to focus on what really moves the IRR needle, and that's the cash going IN to the waterfall. If the assumptions made for rent & expense growth, post-renovated rents, economic vacancy factors and expenses are way off, the IRR you are looking at isn't worth the paper it's printed on no matter how the waterfall is designed. Same goes for sponsors that don't execute well...they won't achieve their projected IRRs either unless the market bails them out. But it's easy to want to focus on the nuances of the waterfall because those things are quantifiable and calculable, whereas sponsor skill, execution, and assumptions are far more elusive.
@Steve K. yes definitely repair that hat because I saw that question coming from a mile away.
The answer is, it depends. There are two ways to define hurdle rates, IRR and annualized return. If the hurdle is IRR the priority won't change the total dollars because by definition achieving an IRR includes the return of capital and the priority of pref vs. capital doesn't matter. But if the waterfall is based on an annualized return the amount of pref due will decline as the capital shrinks with each return of capital distribution.
That said, while the total dollars of pref does decline, the total due to the investor doesn't decline dollar-for-dollar because what happens to the excess dollars is they drop to the next tier. So if the next tier is an 80% split to the investor, you'll get 80% of the extra dollars that would have been pref if the priority was pref first and return of capital later. At the end of the day the effect on the IRR is probably not as significant as one might assume. But the only way to know for sure is to model it because the structure of the subsequent tiers matters and so does the timing of the cash flows, etc.
I'm not convinced that going through the exercise of modeling alternative structures is worth the effort--if the sponsor isn't offering the other structure how does it benefit you to model it out? You model it and find out you could get 50bps in additional IRR if the investment were structured differently, but it's not, so you can't have it, so what do you do? LOL
And yes, requiring fewer dollars to reach hurdles does benefit the sponsor by making it easier to achieve the hurdles. But again, we're not talking a world of difference here. Since the tiers only divide cash flow remaining after preceding tiers are satisfied the dollars to the sponsor in this scenario won't be the difference between them retiring or not. Instead, it'll be the difference on them getting 50% of those last dollars versus say 40% or 30% as the case may be in the preceding tiers. So, a benefit, yes, but earth shattering, probably not.
This is the dirty little secret in the syndication world--the IRR is really an act of financial engineering because the property-level cash flows can be divided in so many ways and these details do matter. But then again, rather than focusing on the nuances of the waterfall I'd be more inclined to focus on what really moves the IRR needle, and that's the cash going IN to the waterfall. If the assumptions made for rent & expense growth, post-renovated rents, economic vacancy factors and expenses are way off, the IRR you are looking at isn't worth the paper it's printed on no matter how the waterfall is designed. Same goes for sponsors that don't execute well...they won't achieve their projected IRRs either unless the market bails them out. But it's easy to want to focus on the nuances of the waterfall because those things are quantifiable and calculable, whereas sponsor skill, execution, and assumptions are far more elusive.
@Brian Burke mahalo (thanks) for such an comprehensive answer
you are right that it is an intellectual exercise only, but I like to see where the money is flowing and what/how the GP is thinking
going to Costco tonight to buy the jumbo 2-pack of xtra wide tin foil :)
aloha
steve