Real estate syndications employ ‘waterfalls’ to structure and recompense principals and investors, and once a developer constructs a framework that works for them, they are seldom changed. However, there are a wide variety of waterfall designs, and this article analyzes the most popular and the most intricate.
In its simplest form, a waterfall shows how funds available for distribution and profits in a project cascade via a series of computations to pay the developer and their investors in a predetermined hierarchical order.
The desired and internal rate of return is the most popular technique used to determine how income and profit are divided. These may have established several breakpoints at which the proportionate share of earnings will have changed when the sponsor surpasses specified IRR-based return thresholds.
A Vanilla Waterfall
In a vanilla waterfall, investors get an 8 percent preferred return, the most frequently preferred return (40 percent of all projects), after payments to senior lenders and before the sponsor receives an incentive payment. The investors will then get a return on their invested cash, and only then will the sponsor receive a payout that exceeds their fees and represents a part of the deal’s residual earnings. The “promotion” is what is meant by this. Investors and developers have divided the most common types into 90-10 or 80-20.
Some investors may like incentivizing sponsors to outperform by giving more lucrative promotions upon reaching particular return thresholds. To accomplish this: an extra layer had added to the scenario described above, in which the splits shift to 70-30 when, for example, investors earn a 15% IRR.
The Double-Tier Waterfall
The vanilla waterfall covers systems where a single set of rules governs cash flow and any payouts resulting from a capital event such as a refinancing or a sale. According to Investor Management Services (IMS), the industry-leading investment management technology business for commercial real estate, these structures account for around 75% of all projects and are the most common.
In some projects, sponsors divide the waterfall into two distinct rulesets, one of which applies solely to operational cash flow and the other to capital events. These two-tiered waterfalls occur in around 24% of instances, and the outliers contain more than two waterfall sets, but since they are so unusual, there is no pattern to how they are organized.
Frequent Waterfalls
IMS, which manages over 7,000 projects on its platform, finds that around 75 percent of all projects have two equity splits inside their waterfall structures. The most frequent desired return is 8%, according to their findings.
The 8 percent preferred return is used in approximately 40 percent of projects, followed by the 10 percent preferred return used by roughly 30 percent of sponsors. Finally, the 7 percent preferred return is used in approximately 8 percent of project waterfalls, followed by the 12 percent and 9 percent preferred returns, with the remainder ranging from 2 percent to 22 percent.
The IRR, which accounts for 80 to 85 percent of all industry-wide obstacles, is the most prevalent. Other obstacles include:
- Achieving a specific rate of return
- Equity multiple
- The proportion of repatriated capital
- The paid-out balance of the preference
When it comes to uncommon waterfalls, the outliers have less to do with distributing cash flow – whether operational or return of capital – and more with how the organizations had organized.
There will be many entities inside the organizational framework for these outliers, the intricate waterfalls. There are the typical General Partners (GP) and Limited Partners (LP), but in more complex cascades, GPs and LPs may have subdivided into a large number of other organizations and classes.
Further complicating waterfalls is that distinct classes may have varied return criteria, such as different preferred-return thresholds, multiple barriers, and several splits; 90-10, 80-20, 70-30, 60-40, and 50-50. 40-60. the most complex waterfalls may have seven to ten levels of computations.
Returns Irrelevant to Complexity
Notably, a convoluted waterfall does not significantly affect a sponsor’s actual returns. The difference between the return profiles is negligible when putting the identical values through a waterfall with 2 – 4 levels and comparing them to those with 7 to 10 layers.
Nevertheless, sponsors see benefits in creating complex deal structures by separating different classes of investors. However, whereas returns to sponsors do not vary considerably as transaction complexity increases, the risk of making a calculation error and the resulting liability increase: Most sponsors do their waterfall calculations in Excel, but with so many levels, Excel has pushed beyond its limits, and in many instances, this results in improperly performed analyses.
Knowing how your waterfall compares to industry norms, given that industry standards are more publicly available, is a fantastic way to persuade investors of the value of your offering.
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