- Private equity commercial real estate transactions often involve a “waterfall” return distribution model. This structure may be unfamiliar to many first time investors so it is important to understand how they work. In particular, there are two key terms to understand.
- A Preferred Return is an incentive offered to equity investors to obtain their capital. If the waterfall contains one, it means that the investors or Limited Partners get 100% of the property’s income until a certain return threshold is reached.
- Beyond the preferred return hurdle, the transaction sponsor or “GP” may be entitled to a “promote”, which is a bonus share of the property’s cash flow in return for property performance.
Most private equity commercial real estate deals follow a “waterfall” return distribution. For many investors, the term “waterfall” can be intimidating, but it is simply a method of describing how a property’s returns are split between the various individuals involved in the investment. For anyone considering a private equity real estate investment opportunity, it is critically important to understand how these splits work so that an accurate assessment of the opportunity can be made.
The most logical place to start is with the investment participants.
A typical private equity commercial real estate investment involves two groups: the General Partner or “GP,” and the Limited Partners or the “LPs.”
The General Partner is the private equity firm. They act as the deal leader and are sometimes referred to as the “sponsor.” They play a very active role in the investment and do all of the legwork necessary to get it set up. This includes: filing the paperwork for the acquiring entity, finding the property, arranging the financing, performing due diligence, coordinating closing logistics, and managing the property once the transaction is complete. As part of the financing structure, they will likely invest some of their own capital, typically 10% to 20% of the total equity needed.
The Limited Partners are the individual investors who entrust their capital to the private equity firm. They will provide the remaining 80% to 90% of the total equity needed to get the transaction closed, and their role is strictly passive. They have no say in the day-to-day management of the property.
When it comes to splitting the property’s cash flow between the GP and the LP(s), the best private equity firms structure the return so that the financial incentives of both parties are aligned. In many cases this means offering a Preferred Return, or “Pref” for short.
What is a Preferred Return?
To incentivize investors to work with them, many private equity firms may offer a “preferred return” on the investment. This means that the investors are entitled to 100% of the property’s cash flow until they have received a certain return on their investment. For example, the sponsor could offer an 8% preferred return to the Limited Partners.
For potential Limited Partners, it is important to note how the preferred return hurdle is measured because it varies by transaction. In most cases, it is measured using a metric called the Internal Rate of Return or “IRR.” It is also important to note how IRR is calculated.
Once the preferred return hurdle is met, the remaining cash flow is split between the GP and LP in a manner that is outlined in the investment’s offering documents. More often than not, the split involves a series of “Promotes.”
What is a Promote?
The easiest way to think about a promote is that it is a bonus paid to the GP as a reward for delivering strong returns. The idea behind a promote is the incentive alignment mentioned above. It incentivizes the GP to manage the property in a way that will deliver the highest possible return. When they do, they also have an opportunity to earn the most money. The GP only does well if the LPs do well. However, there are two major considerations for the promote that potential LPs should be aware of:
- Who Pays the Promote? There are two ways that the promote could be paid. The first is that it is paid by the LPs to the GP. This means that the LPs percentage of cash flow goes down the same amount that the GP’s goes up. The other option is that the promote is paid by the entire partnership, of which the GP is a part. This calculation is a little bit more complicated, but it is the more favorable option for the LP.
- How Much is the Promote? Ideally, the promote should be progressive, meaning that it gets larger as the return for the LPs grows. This is where the term “equity waterfall” comes into play. Imagine that a property’s cash flow is a waterfall. As it falls over the ledge of the cliff, it lands in pools. As those pools fill up, the excess water spills over into other pools, sometimes in an unequal manner.
To illustrate how a promote works, consider the following example. Assume that a private equity firm finds a property that requires $1,000,000 in total equity investment. They put up 25%, or $250,000, themselves and the remaining 75% or $750,000 is raised from Limited Partners. As an incentive to obtain their capital contribution, the equity investors are offered a preferred return of 8%, measured using the internal rate of return. The following table summarizes the waterfall structure:
In plain English, the sponsor promote structure in the table can be interpreted as follows. The Limited Partners are offered a preferred return of 8%, which entitles them to 100% of the property’s cash flow until the total returns reach a level of 8%. If the GP is able to deliver a return of higher than 8%, but less than 12%, they get a 10% promote. This means that they get their 25% share from their initial equity contribution plus the extra 10% bonus. This means that they get 35% of the property’s cash flow and the LPs get 65%. However, if the GPs are able to deliver a return in excess of 12%, they get another 10% promote, which means that their share is now 45% and the LPs share is 55%.
This example of a simple equity distribution waterfall schedule should demonstrate the incentive alignment discussed above. The GP earns the most money when delivering the highest return. In fact, at the highest tier, they earn a disproportionate share of profits in the sense that they only put in 25% of the required equity, but get 45% of the cash flow. Another term for this is “carried interest,” and it is the primary way that the GP earns a profit.
Best Practices for Potential Investors
The waterfall model of return distributions is unfamiliar to many first-time investors. To that end, there are a number of best practices for investors evaluating these types of deals:
- Read the Operating Agreement: The Operating Agreement contains all of the details about how the property will be operated, how returns will be split, and how the return hurdles are calculated. Investors should read this document carefully and ask the sponsor any questions they may have.
- Understand the Capital Stack: Equity is only part of the equation. Potential investors should understand how the transaction is being financed and what percentage of debt and equity is being used. The property should not be over leveraged as it raises the risk profile of the transaction.
- Understand The Waterfall Nuances: Often, the waterfall structure will contain nuances like a “catch-up clause” or a “lookback provision.” These are additional wrinkles in the investment structure, and all real estate investors should be able to identify them in the operating agreement as well as understand how they affect the risk profile of the transaction.
- Ask Questions / Consult Experts: Operating Agreements can be very complicated. If there are any questions, investors should ask the sponsor, or seek outside advice from a qualified real estate attorney or CPA.
When the waterfall is structured equitably, the cash flow distributions can provide an excellent return for both the GP and LP and result in a project that enables both parties to win.
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.
To learn more about our real estate investing opportunities, including qualifying opportunity zone investments, contact us at (800) 605-4966 or email@example.com for more information.
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