The waterfall determines how the cash flow and profits are split up. This is where the fun comes in, but most people don’t fully understand what a waterfall is. In this article, we will be discussing the Equity Waterfall, and what every investor should understand.
What is an Equity Waterfall?
A Waterfall is sort of what it sounds like, if you were pouring water (‘cash’), who gets paid when, and how much? The waterfall is outlined in the operating agreement and will be different for every operator, and deal.
Waterfalls contain three things; the Split, the Hurdle, and the Sponsors Promote.
The Split is how the cash flow/profit is split between the General Partners (GP) and the Limited Partners (LP).
The Hurdle is a benchmark that represents a performance target. The purpose of the Hurdle is to first give priority of profits to the Limited Partners. Once a Hurdle is reached, the Sponsor will receive an increased share of the cash flow.
The Sponsors Promote is how the sponsor or operator is compensated. Once the Preferred Return or a Hurdle is reached, the sponsor or operator will receive a bonus share of the cash flow and profits.
Waterfalls can be very simple; with a 10% Preferred Return, and a 70/30 split (Limited Partners get 70%), or they can be more complex and have multiple hurdles.
Here is a Waterfall example with multiple hurdles:
- First, 10% Preferred Return up to a 10% IRR Hurdle.
- Second, 70/30 Split (LP gets 70% of excess profits) up until a 14% IRR Hurdle.
- Third, 60/40 Split up until a 18% IRR Hurdle.
You might be asking yourself, “Why should the sponsor get a promote”?
Keep in mind that investors rely on the sponsor or operators to execute the following (and more):
- Sourcing Assets
- Underwriting and Locating Value
- Negotiating and Pursuing Acquisitions and Development
- Securing Financing
- Developing Asset Business Plans
- Manage and Executing Capital Expenditures
- Conducting Due Diligence
- Managing the Closing Process
- Asset Management
- Executing Business Plans
- Disposing of Assets
- Delivering Investment Returns
How are Equity Waterfalls Determined?
Equity Waterfalls are ultimately determined by the Sponsor or Operator and are configured on a per deal (Partnership or Fund) basis.
The Waterfall is designed to incentivize both the Limited Partners and General Partners.
Whether you’re an experienced limited partner, or new and just getting into the game for passive income from commercial real estate, it is essential to understand the Equity Waterfall. Here are some of the important questions you should be asking:
- Is the sponsor’s co-investment subordinate to common equity? Or is it Pari Passu? (Who is paid back first)
- How is cash flow split after the debt is paid?
- Are there multiple Hurdles?
- Is there a second Promote?
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