Introduction to Equity Waterfalls


Key Takeaways

Key Takeaways

  • “Equity waterfall” is a term used to describe the methodology by which property cash flows are divided between groups of investors.
  • In a typical waterfall structure, there are two types of members, General Partners (GPs) and Limited Partners (LPs).  The GP is responsible for finding the property and managing transaction logistics while the LP role is strictly passive with no say in day to day management decisions.
  • Between the GP and LPs, the total amount of equity needed to purchase a property is sourced and excess cash flow is split according to the terms of the waterfall.
  • The point of the waterfall structure is to align the financial incentives of the GP & LPs.  In a typical waterfall, the GP’s share of cash flow and profits grows as the return that they deliver to the LPs gets larger.
  • The specifics of a waterfall can vary widely from one transaction to another so it is important to understand the details of the Operating Agreement prior to committing capital to an investment. 

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Commercial real estate (CRE) assets are expensive, which means that they are unlikely to be purchased by a single individual investor.  Instead, they are likely to be purchased by a group of investors who pool their money and contribute it as equity in a real estate deal.  In such cases, it is necessary for the group to decide how the property’s cash flow and profits will be divided.  One option that is particularly common in private equity is a “waterfall” distribution model and it can be tricky to understand for those not accustomed to the terminology.

What is an Equity Waterfall?

Simply, an Equity Waterfall is a real estate finance concept used to describe the method of dividing the cash flow produced by a commercial investment property.  The specifics of the “waterfall” can vary widely by transaction, but the general spirit is meant to align the incentives of the investment manager with those of the real estate investors to ensure that everyone benefits in the transaction.

In order to fully understand how a waterfall distribution works, it is first important to review how a typical private equity commercial real estate transaction is structured.

Typical Private Equity Commercial Real Estate Transaction Structure

In a typical private equity commercial real estate transaction, the private equity firm acts as the “quarterback” for the transaction.  This means that they are responsible for finding the property, performing due diligence on it, placing it under contract and forming the Limited Liability Corporation under which it will be purchased.

To finance the purchase, the private equity firm will typically utilize a mixture of debt and equity.  Debt comes from a lender who provides a loan for 60% – 80% of the property’s purchase price and the equity comes from one or more investors who provide the difference between the purchase price and the loan amount.  The loan is secured by a first position lien on the property, meaning that all cash flows go first towards making the required loan payments.  If there is any money left over, it is distributed to equity investors whose interest in the transaction is secured by shares of stock in the Limited Liability Corporation that owns the property.  The exact amount and proportion of the distribution(s) to equity investors is determined by the specific waterfall structure outlined in the investment’s offering documents.

Transaction Structure – The Key Players  

From an equity investment perspective, there are two key groups in a typical transaction, the General Partner or “GP” and the Limited Partner(s) or “LPs.”

The role of the General Partner is played by the private equity firm.  Again, they are responsible for finding the property, performing due diligence, arranging financing, and managing the logistics of the purchase.  As the GP, they will typically provide a small portion of the overall equity needed, usually in the 10% – 20% range.

The Limited Partner(s) could be one or more individuals who provide the remaining 80% – 90% of the equity needed, but their role is strictly passive.  They have no say in the day to day management of the property and do not participate in any key decisions.

With the key transaction participants identified, it is next necessary to review the key documents and terminology.

Transaction Structure – Key Documents & Terminology

One of the things that can make it difficult to understand a typical waterfall structure is that the terminology used to describe it is unfamiliar to many.  Below is a description of the key terms and documents that are used to describe a typical equity waterfall:

  • Subscription Agreement / Operating Agreement / Owners Agreement:  The legal document(s) that outline the specifics of the waterfall structure.  It is acknowledged and signed by every individual as part of their investment.
  • Return Hurdle Rate:  A point at which the cash flow split between the GP and the LP changes.
  • Return Measure:  A description of how the property’s return will be measured in the transaction.  Two of the most common options are Internal Rate of Return (IRR) or Equity Multiple.
  • Cash Flow Split:  A description of how the property’s cash flow and profits will be split between the GP and LP at each return hurdle.
  • Preferred Return or “Pref”:  A priority return given to Limited Partners, which means that they have a first claim on the property’s cash flow that must be fulfilled before the General Partner is entitled to receive any funds.
  • Promote:  A “bonus” paid to the general partner for meeting certain return hurdles.

To use the key terms in context, an example is helpful.

Equity Distribution Waterfall – An Example

Assume that a private equity firm has identified a retail investment opportunity that they would like to pursue.  The property has a purchase price of $10,000,000 and a Limited Liability Corporation (LLC) is quickly formed to place it under contract.

To finance the purchase, an $8,000,000 loan is obtained from a bank and the remaining $2,000,000 is raised from investors by selling shares in the LLC.  The General Partner (GP) contributes $200,000 of their own money and the remaining $1,800,000 is raised from Limited Partners (LPs).  As shareholders in the LLC, equity investors (GP & LP) are entitled to the excess cash flow produced by the property after the loan payments have been made.  The amount and proportion of the distributions are governed by an equity waterfall whose parameters are described in the Owners Agreement as follows.

The return measure used is the Internal Rate of Return and the waterfall structure has three tiers.  In the first tier, the GP (the private equity firm) and the LPs (the investors) are entitled to a pro-rata cash flow split, meaning that they each receive the proportionate share of the equity that they contributed (10% for the GP and 90% for the LP), when the property earns an IRR of 0% – 8%.

If the IRR exceeds 8% (the return hurdle) but is less than 12%, the GP is entitled to a promote, which means that their share of the property’s cash flow jumps to 20% and the LPs share is reduced to 80%.

In the third tier, which is reached when the property’s IRR exceeds 12%, the GP receives another promote, which increases their share of the property’s cash flow to 30% and reduces the LPs share to 70%.

This structure is summarized in the following table:

It can be a bit complicated to calculate the exact dollar amounts involved in a waterfall distribution and it is not the intent of this article to get into the specifics.  Instead, it should be noted that they are commonly modeled in a spreadsheet program like MS Excel and provided to potential investors as part of the offering documents.  It should also be noted that calculation methodologies can also vary, but they are always described in detail in the offering documents.

What is the Point of a Real Estate Waterfall?

From the example above, the design of the waterfall model for a typical commercial real estate investment should be clear, it is meant to incentivize the GP (as the investment manager) to deliver the highest return possible so that they can make the most money possible.  When they do this, the Limited Partners also benefit because they have received a high return on their investment.

In the example above, if the GP is able to deliver a return in excess of the 12% IRR hurdle, they stand to benefit disproportionately because their initial investment was 10% of the total equity needed, but they are entitled to 30% of the property’s cash flow, which could include the sales proceeds in the final year of the investment holding period.  This is a big win for the GP.

But, the LPs also benefit because they have earned a return in excess of 12% on their invested capital, which also includes a share of the profits from a property sale.  This return is likely higher than what they could have earned by investing in another asset.  So, it is a win for the LPs as well.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

We use a waterfall structure to distribute cash flows in all of our deals and believe it is the best way to align our own financial incentives with those of our investors.

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or for more information.

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