In a typical private equity commercial real estate investment (like the ones we offer), there are two groups of participants. First, the General Partner is the deal leader who is responsible for finding the property, underwriting it, performing due diligence, raising the necessary capital, and managing it once the purchase is complete. Second, the Limited Partner(s) are a group of investors who contribute capital to the deal, but their day to day role is passive.
Given the two parties, there needs to be an agreement about how to split the investment property’s cash flow and profits. In most cases, the split follows a “distribution waterfall” structure that is designed to incentivize the General Partner to deliver as high a return as possible. But, waterfalls and their terminology can be confusing, especially for first time investors. And, it doesn’t help that there are two commonly used structures, the American waterfall and the European waterfall.
In this article, we are going to define what a waterfall distribution is, how the American and European versions differ, and why it can be beneficial for both parties in a transaction. By the end, readers will have a higher degree of comfort with the reason for using waterfalls, the terminology that surrounds them, and the key differences between the European and American versions.
At First National Realty Partners, we utilize an American waterfall distribution structure in all of our deals as we feel it is the best way to align our own financial interest with those of our investors. To learn more about our current investment offering, click here.
What is a Distribution Waterfall?
In the simplest terms, a distribution waterfall is a methodology that is used to split a property’s cash flow between a General Partner (GP) and their Limited Partner(s) in a commercial real estate transaction. As the word “waterfall” implies, a typical structure contains multiple tiers that must fill up before spilling over into the other tiers.
It is important to stress that the structure of a waterfall is unique to each individual deal and the details are contained in the investment’s offering documents. However, they generally contain up to four tiers:
- Tier 1 – Return of Capital: In the first tier, the Limited Partners would receive 100% of the property’s cash flow until they have received their initial investment back.
- Tier 2 – Preferred Return: Limited Partners continue to receive 100% of the property’s cash flow until they have earned a certain return on their capital. This rate of return is known as the “Preferred Return.” NOTE: On occasion, tiers one and two could be combined.
- Tier 3 – The Catch Up: Once the Limited Partners have received their Preferred Return, the General Partner receives 100% of the property’s cash flow until they are “caught up” with the return earned by Limited Partners.
- Tier 4 – Carried Interest: Once the Limited Partners have received their Preferred Return and the General Partner is caught up, there is a final split of the cash flow between the two parties. This is where the General Partner usually makes their money because their share of the cash flow is typically disproportionate to the amount of money that they originally invested.
To illustrate how this may work, consider an example. Suppose that a private equity firm has found a property that they believe will be a good investment. It has a purchase price of $10,000,000. They are able to obtain a loan for $8,000,000 and must raise the other $2,000,000 in equity.
As part of the equity raise, the firm creates a limited liability company (LLC) and makes an allocation of $200,000 of their own money (10% of needed equity) and raises the rest from Limited Partners (90%). So, at the outset of the investment, the firm acting as the General Partner, owns 10%, of the LLC and the Limited Partners own 90%. In the Limited Partnership Agreement that governs the LLC, the distribution waterfall is described in 4 steps:
- Tier 1 – Return of Capital: The Limited Partners receive 100% of the property’s cash flow until they receive their initial investment of $1,800,000 back.
- Tier 2 – Preferred Return: The Limited Partners continue to receive 100% of the cash flow until they have earned a preferred rate of 8% on their investment.
- Tier 3 – Catch Up: Now, the distribution of cash flow switches so that the General Partner receives 100% until they are caught up to the same return that Limited Partners have earned.
- Tier 4 – Carried Interest: In this final tier, any remaining cash flow is split with 60% to the Limited Partners and 40% to the General Partners. This is the key tier because it is meant to incentivize the General Partner to deliver a high return so they can get to this step. If they do, their reward is a 40% share of the profits, even though their capital contribution was only 10% of the total equity.
Again, the intent of this structure is to align the financial incentives of the General Partner and Limited Partner(s). In the example above, the General Partner’s financial incentive is to get to that last tier. If they do, the Limited Partner(s) are also happy because they have received a good return on their investment. It is this incentive structure that is the key difference between the European Waterfall Structure and the American Waterfall Structure.
American vs European Waterfall Structures
The primary difference between the American-style waterfall and the European-style waterfall is the treatment of the carried interest tier.
In a European waterfall, the General Partner is not entitled to receive any portion of the carried interest tier until the Limited Partners have received all of their capital back, plus the preferred return. Only then can the General Partner participate in the carried interest tier. The example above is a European structure.
Pros and Cons of the European Structure
For the Limited Partners, the major benefit of this structure is that they are paid first. In addition, the General Partner’s incentive is to deliver a high return so they can get to the carried interest tier. If they can, the major benefit for the General Partner is that they often get a disproportionately high share of the profits at the carried interest tier.
For the Limited Partners, the major con of the European structure is also that they are paid first. This means that the General Partner is incentivized to return their money as fast as possible so they can also get paid. As a result, they may take a shorter term view and more risk to get to their carried interest tier. For the General Partner, the major con is that it can take years to receive any sort of payout so they must have the financial strength to support the investment for that period of time.
The European waterfall model is most commonly used in a whole fund or private equity fund investment structure where the returns are measured at the fund level, not the individual investment level.
An American waterfall is the opposite. In this structure, the General Partner can receive carried interest before the Limited partners have received their money back. This arrangement is sometimes referred to as the deal by deal model and is more favorable for the General Partner.
Pros and Cons of The American Structure
The pros and cons of the American structure are the opposite.
For the Limited Partner, the pro is that the General Partner gets paid earlier, which means they can afford to take a longer term approach to a property’s business plan. In commercial real estate, this is particularly important because it can take years to successfully implement a new operational strategy.
But, the major con is that the General Partner may not work as hard to get to the highest return tier because they receive their money back earlier.
The American structure is most common when waterfalls are used on a deal by deal basis.
Other Important Points When Reviewing the Waterfall Structure
Whether a waterfall structure is American or European is only one important component of evaluating the composition of a waterfall structure. Other important points include:
- How Are Returns Measured: Returns can be measured using a number of common commercial real estate metrics including the equity multiple and internal rate of return (IRR).
- Fees: How are the General partner’s fees incorporated into the cash flow split? For example, a General Partner often charges management fees, liquidation fees, and origination fees. Are they taken from the property’s cash flow before it is split?
- Hurdle Rates: Sometimes a waterfall has multiple “hurdle rates” where the cash flow split changes multiple times. In general, the higher the rate, the greater the share to the General Partner.
- Clawback/Lookback: On occasion the structure will contain a lookback/clawback provision, which means that the Limited Partners are entitled to receive the General Partner’s carried interest if they don’t reach their preferred return.
- Investment Period: Depending on the business plan, the investment may have different holding periods. For some it could be 5 years. For others, it could be 10 years.
Summary and Conclusion
A “waterfall” is a methodology of splitting cash flow and profits between commercial real estate investment participants. There are two major types.
In a European waterfall, the General Partner does not receive any carried interest until the Limited Partners have received their invested capital back, plus interest.
In an American waterfall, the General Partner is entitled to carried interest at the same time as the Limited Partners.
But, these aren’t the only considerations. Other factors that influence the cash flow split include things like: how the returns are measured, what fees are charged, and whether or not the waterfall structure contains a clawback provision.
Most importantly, investors should remember that waterfalls are unique to each individual deal. The General Partner is in charge of structuring the waterfall and the split should be equitable. For complete details on the waterfall structure for any given deal or fund, it is critically important to read the offering documents.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.